August 2, 2023 - “The How and Why of ESG in Credit and PE” session of the LSTA Summer Series unpacked a topic that is often talked about, but less often explained. Speakers Jeff Cohen, Oak Hill Advisors, Catherine Isabelle, PSP Investments, and Ben Morley, Boston Consulting Group, explained what ESG is, how it is used, why information is often unavailable and how that can change. (Spoiler alert: industry collaboration is the solution!)
What is ESG?
ESG – Environmental, Social, and Governance – is the umbrella term for what are in reality separate factors, sometimes independent of each other and even sometimes at odds. Some examples of environmental factors include greenhouse gas emissions, energy management, or water management. Social factors include workplace safety and data security, and governance factors include compliance, risk management and audit.
These ESG factors inform the overall view on a credit or investment. As risk or opportunity factors, ESG may be very important for some companies and not at all for others. ESG is typically viewed through an industry-specific lens. For example, where greenhouse gas emissions may not be as material when underwriting a software company, they are highly relevant when underwriting a metals and mining company. Human capital is very relevant for companies in the insurance or financials space and may be less so in heavier industries.
Which factors are material?
When discussing ESG, materiality can focus on financial materiality or impact materiality and must always be viewed dynamically. The SASB Standards are the primary lens through which speakers look at financial materiality. These industry-specific standards narrow the universe of ESG factors to focus on those that are financially material for a majority of companies in a given industry. But each credit must be approached pragmatically with a company’s idiosyncrasies factored in. Not every company fits neatly in an industry standard and so the approach must be tailored. In credit analysis, the focus is on those factors that are most likely to manifest in the short to medium term and can manifest very acutely so as to affect a company’s cash flow. Credit analysis largely looks at ESG factors for risk mitigation, where investment analysis in private equity looks to both risks and opportunities. Given the longer investment horizon and ownership aspect, ESG opportunities are more naturally realized in a PE investment than in a credit investment where the focus is on the borrower’s ability to repay (lenders won’t benefit from further upside to the company). Materiality is also jurisdiction dependent. Europe, for instance, focuses on both financial materiality and impact materiality (“double materiality”), where impact materiality – the impact of the company externally – is not a focus in the U.S. This is not to say that a financially material factor cannot also have a positive external outcome. Recognizing that, managers monitor investments and engage with companies to help companies maximize the total value of their prudent management of ESG factors.
How do managers integrate ESG in investment analysis?
In the beginning, ESG was client driven. Clients made it a priority so managers followed suit with adopting policies around ESG integration. This led to ESG being integrated into the diligence process and investment process. ESG integration also requires ongoing monitoring and engagement with the investment. It has also led to multifaceted and multijurisdictional reporting by asset managers. Where ESG appeared originally as exclusionary screens for controversial industries, an approach that is still common today, ESG integration has become much more sophisticated with positive ESG criteria now being applied. Indeed, many managers have developed proprietary integral ESG ratings frameworks. Aside from the evolving nature of ESG and the different jurisdictional approaches and investor preferences, the biggest single challenge is accessing decision-useful information about private companies.
How can the availability of robust ESG information be improved?
Two answers: 1) industry collaboration and 2) taking a pragmatic approach (i.e., don’t let perfection be the enemy of the good!). Two broad industry collaborations have emerged to improve ESG reporting in private equity and credit. The EDCI is a data collection and reporting initiative that uses a standard set of metrics for reporting. In this initiative, LPs agree to request the standard set of metrics and GPs agree to report on them. These metrics are applicable to all companies, e.g., carbon footprint, renewable energy, job creation, board diversity, and GPs report to Boston Consulting Group (BCG) anonymously and securely. A further benefit of this industry approach is that BCG then develops industry benchmarks based on the metrics and that information is available to all EDCI members. Recently, EDCI opened the initiative up to credit investors so that those who join the initiative will have access to those benchmarks. Interested firms can email info@esgdc.org for information on joining.
While not a data collection initiative, there are similarities between EDCI and the ESG Integrated Disclosure Project – and very intentional alignment. The ESG IDP is the credit market’s answer to this shared data challenge. Through its Template, the ESG IDP seeks to develop a global baseline of ESG information on private companies. The initiative does not collect this information. The solicited information is shared directly by companies (and arrangers) with lenders. Like EDCI, use of the ESG IDP Template drives consistency which results in comparability.
Are stakeholder interests aligned?
Absolutely! These industry collaborations bring advantages to sponsors/companies, managers and investors. For investors, by agreeing to a core set of practical and achievable metrics in the near-term investors will see more meaningful information and the breadth of that information can grow with time. Managers will similarly benefit in having decision-useful information to input unto their investment frameworks. Managers also can use the IDP Template and EDCI reporting as a means of engagement – opening a door for ESG information which was formerly closed. Finally, sponsors and portfolio companies/borrowers can take advantage of a streamlined and efficient means of reporting ESG information. Rather than fielding numerous different questionnaires, companies can focus on the industry standard set of questions. And because 100% of the EDCI metrics are included in the ESG IDP Template, private equity reporting can be repurposed as credit reporting.
The flow of information is improving dramatically and market participants should be excited about this progress. Click here for more information on EDCI and here for more information on the ESG IDP.
