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By putting ESG at the heart of due diligence in private debt investing, lenders can focus on sustainable companies that will deliver better investor outcomes over time.
Why should investors consider ESG when conducting due diligence as we go into a more recessionary period?
Investors should always consider ESG when conducting due diligence – even more so during a recessionary period.
We firmly believe that ESG should be a core part of due diligence, both to derisk an investment from a credit perspective and because – given the increasing regulatory focus on ESG – it is increasingly important to avoid potential material regulatory risks arising through the life of a loan.
Taking this one step further, in a recession and a complex geopolitical environment, gaining access to capital is much harder than it has been for a long time. Incorporating ESG risk into your analysis not only means that you will be lending to more sustainable companies, it also means you will back companies that will continue to have a higher chance of accessing the capital markets going forwards. If there are two companies and one does not focus on ESG and the other does, it is now common to find a greater willingness among lenders to provide capital to the latter over the former. In the mid-market, businesses increasingly appreciate that there are real implications for those who do not take ESG seriously, in the same way public markets have had to adapt over the past decade or so. Our firm belief is that sustainable companies are stronger companies that will ultimately deliver better investor outcomes over time.
What are the key things to focus on when conducting due diligence?
Due diligence carried out at a company level is usually comprehensive. It will include the traditional elements including company fundamentals, the macro environment, the capital structure, how the company has performed in previous recessions, and so on. What we do at Fidelity is embed a full ESG assessment into the structured due diligence process. This assessment is conducted internally by our private credit team, supported by our team of fundamental research analysts and ESG analysts.
This provides a level of granularity and insight that using a third-party provider, who is not close to our different strategies and investment processes, cannot provide. One reason for this is that it is very hard to separate out all the diff erent risks and opportunities – in terms of what is ESG and what is normal credit work – because a company that is not strong on ESG may eventually be impacted in an economic manner.
A good example of the intertwined risks is a consumer products company that holds consumer data, where data protection and the safeguarding of customer information is very much an ESG issue. In our ESG analysis, we look at the policies and procedures in place to safeguard customer data, but if we were to ignore these and focus only on traditional financial analysis, we could ignore the risk of being exposed to a company that is at risk of significant fines for not treating customer data appropriately.
In terms of the key things to focus on during due diligence, we have a framework that we developed over a number of years in the public markets based on our coverage of more than 4,000 companies. It has since been applied to private markets. Our knowledge base allows us to understand what best-in-class looks like, and this also enables us to materiality map our investee companies, to what is important in their respective industries.
An ESG assessment will be very diff erent for a software company versus a consumer staples company, and as such our framework assigns a company to a subsector and then outlines what should be the focus of an ESG assessment in relation to environmental, social and governance factors. The same analysts responsible for the fundamental research carry out a thorough assessment of the company, so we are in a strong position to produce an appropriate ESG rating for each company.
At what stage of the process do you consider ESG?
We certainly look at ESG factors at the outset, but the due diligence process for direct lending takes multiple weeks and has different stages, with ESG analysis featuring throughout. This includes during our loan documentation negotiations because we will be looking for commitments from borrowers that pertain to ESG.
A key factor in our perception and rating of a business is our assessment of what that company’s general commitment is to engagement and change on ESG. You can send a 160-page questionnaire to a company to fill out and they can respond, but we are not just looking for disclosure, but a genuine assurance from companies to commit to substantive ESG targets.
Once we actually complete the investment, we then look to engage with the borrower on ESG as part of our regular catch-ups with sponsors and management teams. These typically take place once a quarter and ESG will be a topic of conversation. We also carry out an independent quarterly portfolio review, with ESG assessed during those reviews, alongside the financial performance of the companies.
How do the private markets differ from the public space?
What can private markets learn from public? And are there attributes within private markets that are beneficial compared with public markets? The public markets have traditionally been ahead of the private markets on implementing ESG, and of course there are additional challenges for private markets. A large part of this is because – from a private equity sponsor perspective – ESG has only become more of a core focus relatively recently. For a long time, the primary approach has focused on exclusion criteria and this created the lag in private markets, rather than any inherent difference between public and private companies.
Although ESG has long been an important part of our analysis in the private markets, we have more recently been able to supplement our approach by drawing on and implementing our substantial public framework with an even more defined framework and more substantial data, which has accelerated our expertise on the private markets side.
For example, when we launched our CLO management business in 2021, we led the market on ESG by being the first CLO to align to Article 8. There were more than 60 managers in the European CLO market, and who all had detailed ESG policies, but almost all of those were exclusion-criteria based.
We were the first, even though the CLO market had been around for 20 years, to not only score all our names on ESG but to commit to specific ESG targets in our CLO documentation. The majority of our investments in the CLO are in what we consider to be sustainable companies based on our ratings methodology.
In the direct lending market, it is a similar process, and we are able to bring the expertise we have developed within our syndicated loans business and our public markets business to our direct lending capability. In fact, in private markets, we are generally able to have substantially more influence because of the direct relationship we have with the borrower and the sponsor. Moreover, the duration of our expected relationship with the borrower creates significant potential to make ESG impact.
" “We are not just looking for disclosure, but a genuine assurance from companies to commit to substantive ESG targets“"
How do you ensure management oversight through the life of the loan?
As a direct lender, we catch up with management on a regular basis, normally at least quarterly, and our investee companies are subject to specific reporting requirements. Incorporated into these reporting requirements will be ESG considerations – we will require companies to report on the KPIs we agreed with them as part of our investment plan.
Reporting is reviewed by our investment committee throughout the life of the loan, so it is very much a case of active monitoring and continuous dialogue with our borrowers in an ESG context. We are dedicating resources to the specific oversight of ESG and to delivering our ESG strategy for direct lending, as well as driving forward engagement and oversight.
In addition to the oversight carried out by the investment team, who are monitoring the transaction over its lifetime, we also have specific governance and oversight activity to monitor ESG progress. These include the Fidelity Sustainable Investing Oversight Committee and Compliance Function, which ensure we are delivering the ESG commitments we make to our investors.
How should investors approach their own due diligence on ESG?
There are lots of products that declare they champion sustainability and show off convincing ESG policies, but having a policy is not the same as ESG being an authentic part of a manager’s investment philosophy and process. Investors have to do their own due diligence and seek out managers that share their values when it comes to ESG, and assess who they believe will deliver on these values.
Investors need to ask detailed questions around a manager’s philosophy, values and policies, as well as the frameworks they use to assess the companies that they lend to. Does a manager use third-party providers or does it have its own proprietary framework? Is it a framework that purely assesses what disclosures are available from the company, or does it try to understand what the company is doing on both a qualitative and quantitative basis? There are many people out there selecting two or three KPIs, such as carbon emissions targets, but they are not all asking how the KPIs really relate to a specific industry or business.
Fidelity has had the advantage of building private credit investment strategies with ESG at the centre from the outset. We have had a positive response on our proposition from investors and borrowers alike in the private and specialist credit capabilities we have built.
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This interview was initially published by Private Debt Investor in the publication „The A-Z of ESG“, December 2022/January 2023.
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