Tackling the challenge of ESG investing in alternative credit

ESG analysis is more difficult in private debt but can uncover aspects often overlooked in traditional analysis. Less liquid and transparent, they hold some challenges for investors pursuing environmental, social and governance goals. However, if anything, it is important to evaluate ESG criteria in this part of the market to improve the sustainability profile of portfolios, uncover risks and spot potential opportunities.

At NN Investment Partners (NN IP), responsible investing is a key part of investment decision-making, not just for meeting regulatory requirements but even more so to make the right long-term investment decisions. This applies as much to alternative credit as it does to equities or bonds. While equities and bonds can be sold if they become too risky, in private debt there are limited possibilities to withdraw from a loan. As such, thorough analysis needs to be done ahead of committing capital.

Equally, as the EU’s sustainable finance efforts build momentum, asset managers and borrowers are likely to face tougher questions about their ESG criteria. The investment case and regulatory case for the inclusion of robust ESG analysis in this part of the market has never been stronger.

The challenges

Alternative credit or private debt includes investments outside of traditional, well-defined public markets such as corporate bonds and equities. They include assets like student housing and bridges to trade finance and asset-backed securities.

“It is often more difficult to evaluate ESG criteria in private debt than in public debt, because of lacking data availability and quality,” adds Senior Responsible Investment Specialist Petra Stassen, who works closely with the Alternative Credit team. “But effective ESG analysis can be a big help for investors to improve the sustainability profile of their investments, find risks and spot potential opportunities.”

Also, there is no one-size fits all approach. The asset class is disparate and ESG risk factors will be unique to each sector and borrower. While floods may be a material risk for the agricultural sector, they are likely to have less impact on IT companies. Nevertheless, in spite of its complexities, a full-fledged due-diligence process on ESG principles needs to be a vital element of loan underwriting, followed by active ownership and close engagement.

Proprietary research

NN IP addresses these challenges through well-established proprietary research and scoring. Financing is done through a variety of channels: lending directly, participating in new loans or buying them in the secondary market and whether it’s infrastructure or project finance, commercial real estate, residential mortgages, corporate loans or trade finance, the bank, tenant and other counterparties need to meet clear ESG criteria. ESG needs to be integrated into the investment process from origination to repayment, with criteria on when to invest, how to monitor investments and what to do when investments don’t perform. NN IP has developed ESG scorecards for each asset class based on its materiality framework and the EU Taxonomy.

At NN IP, the loans granted will be asset or purposed-based, and some finance crucial parts of the economy. Before investing, it is vital to understand how the money will be used in the next 10 or 20 years. The central role of ESG criteria in decision-making helps uncover aspects that are often overlooked in traditional financial analysis.

Ulla Fetzer, Client Portfolio Manager at NN Investment Partners, says: “We are long term lenders and monitor our investments closely. If something goes materially wrong from an ESG angle, we will discuss with the borrower how to mitigate the consequences and will ultimately suspend the relationship if there is no progress or no commitments on the ESG front. If a long-term, illiquid investment needs to be sold because of the borrower’s ESG or reputational issues, then it would be at a discount and may result in a hefty trading loss. Because a sale will raise the refinancing risk for that counterparty, increasingly both parties agree on ESG KPI’s (key performance indicators) before a loan is signed.

“A good example is mortgages – where one should not only look at the carbon footprint but also consider what potential effects of climate change mean. And adjust your stress tests to include climate change; this can make flooding an obvious risk for example.”

The impact of the EU’s sustainable finance efforts

The EU’s sustainable finance efforts will boost transparency and data availability, also in alternative credit: Europe increasingly defines sustainable investing and aims to fix the lack of standardization which was holding some investors back. It brings more transparency and less greenwashing to private debt markets, from investors to asset managers to investee companies. However, it is also likely to bring more scrutiny on the efforts of asset managers to incorporate ESG criteria.

Petra Stassen adds regulation could also lead to a more homogeneous categorization of investment strategies: “Investors who are less versed in responsible investing tend to follow the crowd. We have been using an internal categorization for responsible investing for years – distinguishing between ESG-integrated, sustainable and impact investment strategies. The way we’ve been approaching this is in line with SFDR’s line of thinking. The private debt sector has come a long way, but we are only at the beginning. A full-fledged due-diligence process on ESG principles should be a vital element of loan underwriting. Followed by active ownership and close engagement.”

The EU’s sustainable finance efforts will without a doubt boost transparency and data availability. This will make it easier to find opportunities and avoid risk when investing in private debt. But both experts agree that ESG integration in private debt markets will be a challenge in the near future.

Ulla Fetzer concludes: “Integration of ESG factors is just not straightforward enough for the diverse alternative credit universe yet, so we continuously explore new ways of further integrating ESG in our investment process. That can be through engaging with lenders, investors or regulators. We want to make sure alternative credit lives up to its promise: attractive yields and stable long-term cash-flows, even during market downturns.”

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