Why private credit appeals to ESG investors

This article originally appeared in Private Debt Investor in the September 2020 issue. By Sam Tillinghast, President, U.S. Private Credit, SLC Management and Liz Thorne, Senior Director, Private Fixed Income, SLC Management

In recent years, environmental social and governance investments have grown in popularity among institutional investors and high-net worth individuals. Demand has not faltered in the market downturn, as some thought it would. But with appetite for ESG growing, investors are faced with a new problem – finding enough good quality, high-yielding ESG investments.

Investment-grade private credit is becoming more popular among institutional investors as a result. The inherent nature of many investment grade private credit deals – in which individual projects or initiatives are financed – provides a clear picture of how the funds will be used. Compared to public markets, investors can tailor their portfolios to more tangible and measurable outcomes that meet their ESG goals.

At the same time, we are seeing a larger number of deals in the private markets that meet ESG criteria due to the growth in renewable energy, infrastructure and sustainability projects. The building stock in North America is ripe for energy efficiency and resiliency upgrades. Contracts for sustainable initiatives can be monetized, providing corporates, non-profits and government entities with long-term financing and providing investors with sustainable, high-quality investments. Many of these deals are investment-grade credit quality. This means they typically have durations that range from five to 30 years, often include collateral and financial covenants and are available across the rating spectrum.

But although we are seeing growth in the supply and demand for investment-grade private credit deals that fulfil ESG criteria, the sector still lags behind public markets on reporting and measuring ESG. Investors are keen to see more transparency on these deals, as information is in some respects harder to come by than in the public markets.

Greater specificity

There are some substantial advantages to investing in private credit markets when it comes to ESG. The main benefit is the specificity that an institutional investor can achieve in its portfolio. As divestment from certain companies and sectors becomes more mainstream, boards want to see more evidence for the impact of ESG investing and greater specificity in portfolios.  

Investors in investment-grade private credit are able to direct investments toward a specific use that provides environmental and/or social benefits, or at credits with revenue models tied to sustainable trends. This enables private credit investors to gain more precision around their ESG investments than they can in the public markets.

For that reason, investment-grade private credit is often an attractive funding vehicle for infrastructure projects. Investors can measure the impact of an investment in terms of factors such as amount of carbon offset and the populations who benefit. At the same time, operators are able to tailor deals to meet the needs of individual projects, which are often complex in nature.

Many of these investments fund projects that are natural fits for ESG-focused investors, such as renewable energy generation, hospitals and social services facilities. These transactions can directly be linked to projects that will help to prevent climate change and mitigate its impacts for vulnerable populations.

Not all ESG infrastructure projects are new build, though. We have also seen a lot of interest in energy savings performance contracts. These contracts support projects that improve the sustainability of existing government buildings and provide measurable environmental benefits that can be reported to investors. In the public and private sectors there will be increasing demand for buildings that are healthy both for the environment and the people who work in them. Many of these retrofit projects will be well suited for the investment-grade private market.

Attractive credit quality

In addition, from a credit quality and performance standpoint, ESG factors can also carry greater weight within the investment-grade private credit market. First, in analyzing investment-grade private credit deals, investors are often thinking about these investments over a longer time horizon than traditional bond investors. This presents a longer period for ESG factors to play out within an investment thesis.

Second, despite an active secondaries market, investors within the asset class are less able to move in and out of private deals on a frequent basis as their ESG views change. This means greater research is often required up front to ensure the deal accurately meets the goals of the investor.

The current market is providing an attractive entry point for investors looking to add investment-grade private credit to their portfolios. As well as the inherent ESG benefits discussed, investors can expect to pick up additional yield versus similar rated/duration public bonds, while experiencing lower downgrades and losses. This gives investors the freedom to add a very targeted ESG allocation without sacrificing portfolio yield to do so.

Moving toward transparency

As in most markets, the demand for ESG investments is a newer phenomenon. Even within private credit markets, this can sometimes lead to inconsistency and a lack of transparency across managers and issuers. Unlike public markets which, have numerous ESG indices and ratings, private markets are evaluated on a project-by-project basis. That means an investor has to do a lot of due diligence to establish whether or not an investment meets its ESG criteria.

To provide greater transparency to investors on material ESG factors, asset managers in the private credit space need to make their ESG assessment in bottom-up credit analyses more explicit. The advantage that private markets have over public markets, however, is that they have more access to the companies and underlying data to inform those opinions. There are multiple methods to evaluate the ESG factors of a particular company or credit issue.   

First, in a due diligence process, it is important to assess ESG at an individual issue level rather than only at an underlying credit level. This reflects the fact that each deal from the same issuer can be tied to a very different project. For example, some companies may be earlier in their  transition to cleaner energy, but an investor might still fund a project specifically tied to clean energy transition.

Second, managers can also use an expert network of former regulators, suppliers, employees and competitors to delve into the “S” and “G” factors. It is important to validate ESG data using knowledgeable sources in addition to management reporting. The Covid crisis has highlighted the importance of this risk analysis to credit underwriting. For instance, when evaluating governance impacts, companies with strong leadership were better prepared for catastrophic disruptions, and those with systems and technology that could be adapted quickly for remote work fared better.

Third, if any specific questions or concerns arise during the due diligence process or after the investment is made, a private credit investor can raise this with the management team. Conversations about a company’s forward-looking plans are not limited to scheduled investor updates, which allows for more openness. This is particularly helpful for companies that are transitioning towards greater sustainability or that have complex operating structures, as private debt markets can provide the borrower with more flexibility, while offering greater access to information for the investor. 

Although, private credits have typically lagged public credits on measuring and reporting, the ability to directly tie an individual deal to a specific project and the attached ESG benefits offers the potential for greater substance and transparency in ESG reporting. As ESG becomes more commonplace in conversations between institutional investors and private credit managers, we expect to see a further increase in the metrics that will enable the impact of these investments to be properly evaluated.