ESG integration in private debt, challenges and opportunities
4 - minute read
Sustainable finance has become mainstream and gained traction in most debt market segments, including the rising private debt market. Global investment in private debt exceeded US$1 trillion in volume in 2021 and is expected to reach US$1.5 trillion in 2025.
With the influx of capital in this area, what are the challenges and opportunities in terms of ESG?
As an early innovator in this market, Natixis CIB held its first Private Debt Forum on June 28th, 2022 to consider recent trends in the context of global Net Zero transition strategies and growing requirements for ESG disclosure.
What is private debt?
Institutional investors’ interest in Private Debt is relatively recent compared to other types of investments. Private debt has key characteristics: its illiquid nature and the participation of institutional investors instead of traditional bank lenders. This can be considered as part of a wider trend of bank disintermediation in the regulatory climate following the Global Financial Crisis. From the demand side, private debt can offer institutional investors higher yield hence its attractiveness among non-bank lenders.
In addition, this asset class offers investors diversification in terms of industry exposures and risk/return profiles. As seen during the Forum, private debt can be very diverse by nature and in turn offers a breadth of assets.
During the ESG Panel, the discussion focused on corporate loans as well as asset-based debts in Infrastructure & Energy and Real Estate & Hospitality.
ESG is on top of the agenda for investors
When it comes to sustainability, market interest in both ESG and private credit investment combined reflects wider ESG integration into debt capital markets. This is reflected by the over-US$750 billion equivalent in issuance across green and sustainable bonds and loans as of mid-July this year (), despite the wider market downturn.
According to a survey sent to the investors prior to the Forum:
- 52% of investors view ESG as one of the 3 main factors driving successful investment in private debt (whether driven by regulatory ESG risk disclosure requirements and/or Climate/ Net Zero emissions strategies);
- 65% have appetite for sustainability-linked debt products with a pricing adjustment mechanism;
- 70% see ESG integration as a way to strengthen risk management and lead to better returns in the long run in Infrastructure and Real Estate private debt investments; 90% in Corporate loans;
- 90% see ESG monitoring tools as one of the 3 most important digitalization developments in private debt over the next 5 years.
These results clearly show that ESG is on top of the agenda for investors.
In its report “The growth of ESG in Private Debt Markets, October 2021”, ELFA explains that an increasing focus on ESG issues and more stringent regulation are the key forces driving the ESG trend in private debt. From the demand side, investors’ attention on ESG is mostly driven by regulatory scrutiny especially in Europe. The report emphasizes the pulling effect of Sustainable Finance Disclosure Regulation (SFDR) for not only investors but also companies who have to meet the reporting metrics required by investors. That is to say, investors seeking to deploy ESG funding strategies will demand greater and more detailed disclosure on the ESG risks and impacts of borrowers’ products or services. This growing demand simultaneously creates business opportunities for borrowers from the supply side. As was mentioned during the ESG panel, meeting investors’ desire for SFDR Article 9 funds (i.e., pursuing a sustainability impact objective) has become a challenge for asset managers. Actors who are able to meet this expectation are more likely to seize market advantages.
What is at stake?
Despite the accelerating requirements for ESG integration in the private debt markets, there are still insufficiencies in the integration approaches due to two main challenges: the lack of regulatory clarity and inadequate ESG data.
Lack of regulatory clarity
Market participants need to comply with an increasing number of regulations including SFDR, upcoming Corporate Sustainability Reporting Directive (CSRD), EU Taxonomy, and Article 29 of Climate & Energy Law in France. The complexity of the regulations per se and their interconnection bring challenges for asset managers to understand, and not to say implement, the regulations into their investment strategies. One specific example raised was the question of classification of legacy funds, namely the funds for which the period of investment or fundraising is over.
Moreover, the lack of regulatory clarity could hinder asset managers in their efforts to deploy more ambitious ESG funds. This is mirrored by a panelist’s hesitation to classify debt or real estate activities as Article 9 funds due to the current legal uncertainties surrounding practical application of technical terms. Since there are no agreed definitions for concepts such as Do No Significant Harm (DNSH), there is also a need for language alignment between different industries to facilitate ESG communication with portfolio companies and private debt investors.
Difficulties in accessing appropriate ESG data
The biggest and most relevant challenge is data availability to meet regulatory requirements. Some panelists mentioned that it is more difficult to have reliable ESG data in debt activities given that asset managers usually do not directly manage the assets. Therefore, communication with counterparties such as equity sponsors and project companies to set common ground on ESG approaches is essential.
The difficulties in data accessibility also come from the nature of private credit borrowers themselves. Given they are often smaller-scale, non-listed companies, and hence not regulated by the Non-Financial Reporting Directive (NFDR), there have been some constraints to estimate the scope and the quality of data available to the lenders.
Conversely, some panelists considered that it is easier for single lenders to obtain information from a smaller-scale company, as opposed to being a small player in a larger lending group.
In any case, from a climate change perspective, under SFDR, asset managers are obliged to align with the climate mitigation and adaptation criteria of EU Taxonomy. Despite increasing Net Zero pledges emerging from the financial markets, a shortage of data makes it difficult for private debt investors to calculate emissions trajectories, exposing them to a risk of greenwashing.
With the abovementioned challenges, ESG integration in the private debt markets consequently requires proactive approaches. Some steps taken by the asset managers include incorporating regular ESG questionnaires or maintaining close dialogue with management teams.
Another urgent gap to fill is the provision of reliable ESG data and ESG advisory expertise. With our dedicated commitment to energy transition and responsible finance, Natixis has developed the Green Weighting Factor (GWF) as an internal business monitoring and capital allocation tool, which is to align the climate trajectory of our balance sheet with Paris Agreement objectives. With this tool, Natixis is dedicating to deliver systematic data to respond to the investors’ need for regulatory compliance and more ambitious ESG investment.