Framework for RI in private debt

This should not be viewed as a standardised checklist to suit every type of investor, but rather a menu of possible approaches to consider, depending on the investor’s responsible investment policy, organisational structure, client needs and other considerations.

Figure 10: typical private debt investment process, including ESG and engagement considerations

	Typical considerations for private debt investment	ESG considerations	Engagement activity
Pre-deal cycle	Develop statement of investment principles Define investment universe – geography, sector, credit strength, deal size etc.	Develop responsible investment/ESG policy Define ESG screening criteria Educate external agents on RI policy Define ESG impact or thematic requirements (specialist funds only)	Not applicable
Pre-transaction
Phase I Origination & Pre-assessment	Sourcing & origination: Generate investment ideas Identify investment opportunities Engage agents to source deals Pre-assessment: Conduct high-level due diligence Identify any red flags for further consideration in due diligence process Take decision to proceed to due diligence phase	Apply negative ESG screens Identify any ESG red flags for consideration in due diligence process Consult ESG team or independent advisory committee Consider jurisdictional ESG issues such as local governance, legal systems, ESG policy and regulation	Engage senior management of prospective borrowers for disclosure of potential ESG risks
Phase II Due diligence & Investment approval	Conduct credit analysis Conduct in-depth due diligence Appoint technical consultants Determine interest rate Write up investment memorandum Negotiate/finalise terms Take investment committee decision Transact	Conduct ESG due diligence Conduct ESG technical assessment Integrate ESG summary in investment memorandums Educate investment committee on relevant ESG considerations Include ESG reporting requirements for borrowers in terms Determine ESG monitoring needs	Request management changes relating to ESG (e.g. board independence) Arrange regular dialogue with borrower management Educate borrowers about investor ESG needs Define requests for ongoing monitoring of pertinent ESG criteria
Post-transaction
Phase III Investment holding period	Ensure on-going borrower reporting and monitoring Address developments and incidents that pose risks/potential defaults Provide technical assistance Undertake restructuring process (common in distressed debt)	Carry out on-going ESG monitoring Support improvements that address ESG risks Measure ESG outcomes linked to investment (mostly impact funds) Identify potential positive impacts (mostly impact funds) Ensure manager ESG reporting to investors	Include ESG agenda items in regular borrower meetings Manage ESG risks relating to potential defaults
Phase IV Exit	Consider possible refinance options Close out process	Undertake ESG impact assessment (impact funds) Facilitate manager ESG reporting to investors Consider internal close-out process including ESG lessons learned	Consider close-out process with borrower, including ESG lessons learned

Phase 1: origination and pre-assessment

As investors identify potential private debt deals, they will engage with the borrower and consider whether the deal suits their investment approach, based on criteria such as loan size, EBITDA, industry and geography. In addition, they may also consider whether the borrower meets their ESG screening criteria. During this phase, they should be able to identify factors (ESG or otherwise) that may prove to be deal breakers, or which raise red flags for further consideration during the due diligence phase.

Negative screening/exclusions

Around half of the funds interviewed for this report have formal responsible investment policies that include negative screening criteria or guidelines. Others mentioned client-specific exclusions which are set out in side letters. Common exclusions relate to the production or distribution of controversial weapons, tobacco, alcohol and pornography, as well as other socalled ‘sin stocks’, which increasingly include the most carbon-intensive sectors such as coal, oil and gas. Some funds base their screening practices on norms such as the UN Global Compact Principles, which relate to corporate sustainability. While some screening criteria may be clearly defined, greater consideration is needed for grey areas where a company may be indirectly involved with an excluded sector – say as part of its supply chain or as a landlord. In these cases, the investor must take a view, typically based on the proportion of revenue derived from excluded activities relative to a pre-determined threshold.

Positive screening, impact investing and the UN Sustainable Development Goals

The lack of consistent and comparable publicly reported ESG data on private companies means that positive screening based on relative corporate ESG assessments is rarely a realistic option for private debt investors. There are few ESG benchmarks that cover a sufficiently large universe of private companies from which to conduct objective positive screening.

Increasing numbers of investors want to target positive environmental or social investment outcomes, such as reduced environmental impacts, or contributing to the UN Sustainable Development Goals, alongside financial considerations. During the pre-assessment and due diligence phases, these investors should identify specific ESG themes and measures to assess environmental and/ or social outcomes, as well as methods for measuring additionality (that is, that the outcome goes beyond that which would have occurred in the absence of the investment), and methods for reporting on impact to clients. (See section Thematic investing, impact investing & green loans for further discussion.)

Phase 2: due diligence and investment approval

The pre-due diligence phase permits investors to quickly assess whether they should commit further resources to appraising a potential deal, based on an understanding of industry or sector risks. Once committed to the next investment phase, in-depth due diligence, to examine detailed company-specific risks, can begin.

Due diligence

Private debt investors, as lenders rather than owners of companies, often have little or no direct influence over the strategic direction of a company, so the assessments made prior to investment are critical. Investors should aim to identify potentially credit-relevant ESG issues that may occur over the life of the investment. All the investors interviewed for this report mentioned considering ESG issues when conducting their due diligence. Information for due diligence can come from a number of sources, including sell-side materials, legal and technical due diligence (for example environmental, health and safety assessments), private equity sponsor materials and the lender’s primary research.

Due diligence may be based on:

• Investor ESG questionnaires to be completed by borrowers (and, where relevant, private equity sponsors);
• Environmental impact assessments, compliance with industry standards, ISO standards etc.;
• Desk research or advice from technical consultants to explore flagged issues;
• Third-party data analysis, e.g. media feeds on controversies relating to ESG issues;
• Technical appraisals, which assess the need for specialist ESG research and/or ongoing monitoring of specific issues (e.g. compliance with environmental regulations); and
• PE sponsor or other lenders (where relevant), to assess whether they are aligned with the investor’s views on ESG and that they have the competencies required to address ESG factors on an ongoing basis.

When you are looking at the private markets, you cannot apply a onesize- fits-all analysis of ESG on certain factors, because those factors just won’t be available. But because you have this close working relationship with the borrower, and you are often talking over a period of many months, and any information you are sharing is private and does not have to be disclosed publicly, the company is free to discuss sensitive issues with you…You are working almost in partnership on those transactions.

M&G Investments

Investment decision

Investors should consider integrating relevant ESG factors alongside credit factors such as condition, cash flow and collateral. Many investors see ESG factors as an important element of the borrowers ‘character’ in credit terms. A 2017 survey by Preqin reported that 61% of investors surveyed currently consider ESG factors as part of their investment process. Investors often include a dedicated ESG summary in their investment committee memorandums to ensure this research is considered and discussed by the committee. Some memorandums include a traffic light or red-flag system to ensure that any major concerns are addressed before a decision to invest is made. In some cases, ESG professionals have the right to veto an investment on the grounds that it does not meet ESG screening criteria or another aspect of the investor’s responsible investment policy.

Transactions: ESG considerations in lending terms and documents

Depending on the type of private debt deal in which a lender is involved (i.e. whether investing in a syndicated or bilateral loan), the lender may be able to negotiate certain terms in legal documents. One advantage of private debt is the potential for flexible terms, such as bespoke repayment schedules and operational covenants22. In an ESG context, some investors request terms relating to high-level governance matters, such as the percentage of independent board members, or requests for regular reporting on, for example, adherence to environmental regulations or staff turnover rates.

In connection with corporate direct lending transactions, or where the sponsor is not proactive in terms of ESG, an ESG clause can be a good starting point for addressing ESG factors, as it offers an opportunity to engage the parties on ESG from the inception of the transaction.

Our standard ESG clause requires the parties to recognise that we are committed to invest responsibly, adopt a progressive approach in terms of corporate responsibility, and use best efforts to answer an annual ESG questionnaire. Recently, we were very satisfied to see certain companies hire a CSR director a few months after the closing of the transaction

Tikehau Capital 

The consensus among interviewees was that they have the power to amend terms on direct lending, but not on syndicated deals where it would create too much complexity given the number of stakeholders involved. Investors will often find it easier to incorporate ESG terms into side letters than directly into contracts. In a ‘covenant-lite’ environment where the usual protective covenants typically found in more traditional loan facilities are lacking, investors may consider turning down deals where the borrower is not open to negotiating credit-risk mitigating requirements in lending terms. This is an area we expect to evolve but, in an increasingly competitive market, lenders may be reluctant to insist that borrowers undertake additional (ESG) reporting or impose other requirements.

We negotiate ESG reporting provisions, which are included (when possible) in the term sheet and subsequently in the loan agreements. Such provisions are generally in line with the sponsor’s ESG requirements

LGT European Capital

Ideally, dedicated responsible investment professionals, or ‘ESG champions’ in related investment roles, should support the deal team throughout the process by joining relevant investment committee meetings. Alternatively, they may choose to brief the deal team prior to such meetings, so that the deal team can maintain full ownership of the process. We explore ESG analysis and integration in the Integrating ESG into private debt investment decisions section.

If anything [ESG-related] has a material impact on the business, then we require [the borrower] to report that. If we find out subsequently they have not reported on something we considered to be material, then the ultimate sanction we have is to call a default under the documents

Permira

Phase 3: investment holding period

On-going monitoring after a transaction has been completed is an essential part of any investment. During the due diligence phase, investors identify any material ESG issues that they believe should be monitored for the life of the investment and consider emerging issues on an ongoing basis. This typically involves monitoring for ESG incidents and identifying growing exposure to ESG risks, changes in management, etc.

If an event occurs that is deemed to have material ESG significance, we demand full details, explanation and advice of remedial and preventative action

M&G Investments

In terms of levers to manage risk during the holding period, although lenders cannot impose any ownership rights over a borrower, they may still hold influence as a lender of capital. In addition, there may be options for investors to share expertise on ESG matters with borrowers, co-lenders and/ or private equity sponsors in order to manage specific risk exposures. Companies preparing for an IPO often welcome investor insight on corporate governance and reporting. Larger stakeholders may be given an opportunity to take an observer seat on the board, which allows the investor further insights into the workings of the borrower, and to monitor ESG issues more closely.

Phase 4: exit

Exits from private debt investments are typically driven by the refinancing of existing loans, a change-of-control event or the completion of loan terms. It is in a borrower’s interest to maintain strong relationships with lenders, particularly when it is looking to refinance. This may provide investors with further opportunities to influence how a borrower addresses specific ESG issues.

In the case of refinancing because of business growth, lenders can rely on insights gleaned from the previous deal cycle and apply those to additional ESG due diligence or reporting requirements. The borrower will typically be open to more demanding ESG requirements in order to secure refinancing under mutually improved credit conditions.

If we want to make sure that all these [ESG] issues are considered in the investment decision, we have to make sure [information] is shared by everybody. We are trying to do this by making our ESG due diligence available to everybody upon exit

LBO France