Is The S Now More Important Than E Or G In Private Debt?

Recent events in Ukraine have prompted many investment firms to exit investments in Russia and Russian companies, as the financial sector tries to do its bit in terms of supporting Ukraine. In finance circles, the situation has brought the ‘S’ leg of the ESG stool more into focus as stronger questions are being asked of each other by investment managers and investors when it comes to their exposure to social-based factors.

The Hague, Netherlands-based investment manager NN Investment Partners ran a survey of institutional investors in 2019 and the results showed that only 15% of survey respondents said that they see potential in social factors when it comes to generating returns, compared with 40% for governance and 66% for environmental.

The lack of potential – at least, when compared to the E and G legs of the ESG stool – is understandable, according to Jovita Razauskaite, Portfolio Manager, Corporate Loans at NNIP.

“Social has a broad definition both generally and in terms of the ESG lens that investment managers use. Social metrics are more difficult to come by and there is a lack of standardization around them, so that each investor has to do its own due diligence” she said. “Each strategy usually determines its own S-related KPIs – ones that we can track or measure, that are material, and that we can present to investors. But they’re not universal and it’s important for investors to understand that.”

The lack of universality in social-based investing necessarily means a due diligence process that the manager has to get right. In private lending, whether to public or private companies, the investment manager is tied to the underlying borrower to a certain extent; certainly, more than in, say, public equities, where stock can be sold quickly to exit a position if an ESG issue arises. Whilst covenants can be put into the terms of the loan agreements, a critical part of the pre-investment process is digging into the weeds of a potential portfolio company’s exposure to social-based risk.

“We look at the company’s track-record concerning public controversies, adverse legal/regulatory rulings regarding any social issues, and the mitigants in place to minimize any chances for such negative events to occur and adversely impact the financial performance of a borrower. If we find any material social-based issues, the deal may no longer be considered,” said Razauskaite.

The illiquid nature of private debt means that investment managers have to war-game their investments out. For instance, if a potential portfolio company previously used asbestos as a raw material and doesn’t now, on the surface, that’s a tick in the S box, or at least, it might not be excluded from the initial screen. But have there been any claims against the company for asbestos-related diseases? Are there any coming up? Is there regulatory change on the horizon? These are all considerations that a private lending investor needs to investigate.

“You’re looking to create several lines of defence to select a future-resilient investment while minimizing risks of stranded assets. We use a proprietary ESG scorecards which shows us how negative or positive ESG developments can impact the decline or increase in the ESG score of a borrower,” said Razauskaite.

Another challenge in extracting alpha from the S is the lack of available data, at least when compared to environmental factors.

“Accessing emissions data and putting KPIs around E is getting easier,” said Razauskaite. “But for the S – and even the G – there are a number of KPI’s which are still difficult to quantify and compare across the market participants. There’s definitely a lack of harmonisation and lots of work still needs to be done.”

Investors shouldn’t be put off, of course. That’s because there is a degree of symbiosis between the E, S and G. The situation in Ukraine has prompted governments to consider more closely their energy security policy, which in the short term may mean producing or importing more fossil fuels to provide power to their populations. The S giveth, and the E taketh away.

“Each crisis highlights certain factors of the economy which are more discussed at that point in time than they were before. The most important is that investors would look at the material and relevant ESG factors for the specific investment on a continues long-term basis,” said Razauskaite.

Institutional investors tend to implement a longer term investment strategy across a range of underlying asset classes based on risk-return analysis so it’s unlikely that investors as such would shift from one asset class to another solely based on S (or E or G). According Razauskaite, investors that look for ESG factors would like to have sustainable investment criteria consistently applied across the asset classes they invest in. And now, an ESG attribute is quickly evolving in the private markets where investors can exploit an opportunity to further extend the ESG-related investment base next to the illiquidity premium this asset class says that it offers.

“While still being at the infancy stage, ESG is quickly evolving in the private debt market. Data quality and availability is improving, thanks to increasing regulations, but portfolio company engagement still remains a key source of information. Additionally, I’d like to stress that the three – E, S and G – work hand in hand even though there is an increased focus on social factors right now. We think a holistic look at the space is the best approach for investors which consider ESG-compliance in their asset allocation model.”