Private credit could be 'catalyst' for ESG change

Written by Sophie Smith

26/07/2023

Private credit markets could act as a catalyst for ESG change, although more work is needed to develop robust ESG frameworks, analysis from LCP has suggested.

The firm acknowledged that fixed income assets, such as bonds and other debt instruments, can have less ESG impact compared to equity or direct ownership of assets.

However, it argued that private credit, a sub-asset class within the broader fixed income category that lends to non-public companies, has the potential to drive change, revealing that ESG "margin ratchets" are gaining popularity in European private credit strategies.

Indeed, the analysis, based on a sample of well-established private credit managers across Europe’s mid-market space, showed that about 25% of loans include ESG margin ratchets.

These financing structures offer companies lower borrowing costs for meeting ESG targets, providing an average reduction of seven basis points for each Key Performance Indicator (KPI).

Despite increased interest, LCP found that these arrangements remain the exception rather than the rule, arguing that improvements are needed in the transparency and verifiability of company performance.

Based on the responses to its survey, LCP also suggested that discounts could be further stretched given deal pricing improvements underpinned by higher base rates and origination fees.

LCP found that while the ratchet is 'one-way' in most cases, meaning borrowing costs adjust downwards, in just under a third, there was a ‘two-way’ ratchet, where borrowers might be penalised, meaning that the interest rate can be adjusted upwards if they fail to reach performance targets.

LCP argued that ‘two-way’ ratchets should be the preference as they build in a stronger alignment of interests of both borrowers and lenders, as well as a more efficient risk mitigation mechanism.

Despite this, it acknowledged that there are still concerns about measuring and verifying performance against these indicators.

In addition to this, the research found that only around half of all loans were linked to an independent third-party validation of performance, raising concerns about investors’ confidence when companies’ mark their own homework’ when assessing whether ESG targets have been met.

However, the research found that those asset managers that were members of the Net Zero Asset Managers initiative were more likely to make more use of these ESG margin ratchets and to be stricter on ensuring compliance.

LCP CFA investment consultant, David Garcia, stated: “As the importance of ESG considerations continues to grow across investors’ agendas, private credit managers have the potential to be a catalyst for change, leveraging their prominent influence and addressing pressing global challenges.

"Nonetheless, there is still work to be done to develop more robust ESG frameworks, standardised metrics, reliable data, and offer stronger economic incentives.”

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