ESG Talk #15 - October 2024. Integrating ESG into Private Debt
Discover how ESG practices are transforming the private debt market in this latest episode of the Candriam Academy’s ESG Talk series. Our experts dive into the growing demand for sustainable finance in private markets, exploring the evolving role of ESG as a powerful driver for change. As investor expectations shift, private debt now offers a compelling opportunity for impact, bringing ESG integration to new levels.
Discover how ESG practices are transforming the private debt market in this latest episode of the Candriam Academy’s ESG Talk series. Our experts dive into the growing demand for sustainable finance in private markets, exploring the evolving role of ESG as a powerful driver for change. As investor expectations shift, private debt now offers a compelling opportunity for impact, bringing ESG integration to new levels.
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00:00Good morning. Good morning, everybody. Welcome on our 15th ESG Talks. My name is Christoph
00:14Outers. I'm in charge of institutional business development at Candrium. The topic of today is
00:20ESG integration in private debt. I'm sitting in Stockholm. It's a drizzly day here outside,
00:28but we'll make it lively and we'll make it interesting. With me, I have my colleague,
00:35Pauline Scheemaker. She's our senior impact analyst. And we have Nick with us. Nick is in
00:42charge of the investment activities of Cartesia, a private debt specialist. Why do we have Pauline
00:48and Nick, Candrium and Cartesia? You might know Candrium and Cartesia. We're part of the same
00:54family, Norac Life. And we launched a joint venture roughly three years ago to manage
01:01an impact private debt strategy. And so that's why we have both Pauline and Nick here today.
01:08So it's about ESG integration within private debt. But first, before we take a deep dive,
01:16we do a holistic overview. We take a step back. First, we'll try to explain a little bit,
01:24private debt, it's part of what we call private markets. Where does this sit in the whole
01:29financial market segments? What kind of asset class is it? And then if we talk about ESG
01:34integration, also very high level, we'll go over the various definitions of ESG and
01:40ESG integration. And I'll start the session by explaining a little bit
01:53about private debt, where it really sits. So I hope everybody can see the slides.
02:00Private debt, of course, is part of what we call private markets, which is part of what we call in
02:04the industry, alternative investments. Now, alternative investments, if you will see on the
02:10slides, the size of each segment, if you do the sum, you'll see it's roughly 17 trillion.
02:1617 trillion, if you compare it to the overall global financial market, there are over 300
02:22trillion. So it's roughly, roughly 6 to 7% of the financial markets are alternative investments.
02:29Within alternative investments, and it's a big chunk, you see private capital. You also have
02:34still what we call liquid alternative. We're not going to talk about it, but you know, it exists.
02:39Liquid alternative means hedge funds going long short. Of course, you cannot go short if there's
02:46no liquidity. So that's why hedge funds, it's called liquid alternatives. And then we have the
02:52private capital, truly private, and there's no listing. There's no, hardly any secondary markets.
03:00The big chunk, of course, is financing corporates, either through equity, and then we talk about
03:04private equity, or financing them through debt, and then we talk about private debt. And then you
03:10have also all the real assets, real estate, infrastructure, and natural resources. But today,
03:15it's about private debt, and more specifically, it's about direct lending. So first of all, this
03:23is the entire fixed income space, and fixed income is by far the biggest asset class on the whole
03:30financial markets. The financing happens a little bit in function, or the type of financing is a
03:38little bit in function, well not a little bit, it's mainly a function of the size. The bigger the
03:43financing need of a company, the more they will be incentivized to go to the public market.
03:52They will issue public bonds, and of course, we have investment grade companies issuing investment
03:58grade bonds publicly, and we have high yield companies issuing high yield bonds. Minimum
04:04ticket sizes are, well, the minimum on investment grade bonds is 250 million. Majority of bonds are
04:10issued between 500 million and 1 billion outstanding. That's one issue. We have these
04:17large companies, they issue tens and tens of bonds. For instance, the biggest corporate issuer in the
04:23euro investment grade universe is Volkswagen. They have roughly 30 bonds outstanding. Every
04:28bond has an issue size of 1 billion. So these are very big companies, they go to the public markets,
04:34the big bond market, either for investment grade or for high yield. When you go below that, it's
04:40much more difficult for a company, and too expensive also to do the effort to go to the public markets,
04:46so they are financed in the private debt market. If you keep to the left more investment grade
04:52companies, these companies are typically financed through banks, bank loans. Historically, the banks,
04:59they didn't offload these loans from their balance sheet, they did the originations,
05:04they were lending money to corporates, they kept the loan on their book until maturity. But since
05:09the global financial crisis, banks have started offloading these loans. So they issue the loan,
05:16they originate the loan, but then they sell the loan into the secondary market. This is what we
05:21call senior bank loans or syndicated loans. Initially, this segment used to be illiquid,
05:29but then over time, again, because after the global financial crisis, banks had to disintermediate,
05:35they had to take a step back. So this segment is now quite liquid, there's a big secondary market,
05:41so the advantage of the illiquidity premium disappeared, and also because of the success
05:46of this asset class, broker syndicated loans or senior bank loans. Most of these loans are what
05:52we call covenant-like, so there's not a lot of investor protections anymore in these loans.
05:58Whenever a bank, they want to finance a company, but they don't want to take the risk, but on their
06:04sell side, they know somebody who wants to finance a company, they will create a bespoke loan, which
06:10is called a private placement. It's a bespoke loan, created by a bank, originated by a bank,
06:16but then immediately sold to one of their clients. So that's a private placement segment.
06:21Today, we're going to talk about corporate direct lending. It is the most
06:29sought-after asset class at this moment. Most of our clients really are asking, okay, what about
06:35direct lending? Can we finance corporates through the direct lending segment? And that's why
06:42we have Nick here. Nick, I'll give the floor to you, but if you might first introduce yourself
06:48in slightly more detail than I just did. Thank you, Christoph. I'm always happy to hear people
06:54say very nice things about the direct lending market. By way of introduction, as Christoph said,
07:00I lead the UK business on the investment side, and I also sit on the investment committee for
07:06Cartesia, which includes as well our impact strategy, hence I suppose why I feel semi-qualified
07:13at least to talk to you about ESG matters. But I think first, just to continue on the market side
07:19and talk about the growth of the asset class. I understand most of you listening are probably
07:23more familiar with public rather than private markets, so probably helpful to give a bit
07:29more background as to the sort of historical growth of the market and really where we are
07:34now. This is a market you can see from this slide. Since the GFC, the market has grown
07:40significantly year on year, almost exponentially at the right-hand side of this chart.
07:45And I think if you look at the longer-term projections and where we're going, we're
07:49confident that this market has a lot further to run and is still pretty nascent. Why is this?
07:56What are the drivers behind this market? Firstly, as Christoph was alluding to, on the demand side,
08:02we have appetite from banks to underwrite debt, especially sub-investment-grade debt,
08:08has really declined due to the regulatory pressures that came out of the financial crisis
08:15and also just balance sheet concerns. I started my career back at a bank, and we were underwriting
08:21deals of 500, a billion, on a – I suppose an underwrite-to-distribute model. And post-financial
08:28crisis, the appetite to do that sort of underwriting has diminished. So, that means
08:33that there's a massive vacuum in the market, and private market participants have really taken
08:37advantage. So, they've stepped in to fill that gap. Why do – if you move on to the next slide.
08:48So, we can see – so, then, if we think about why do borrowers choose to pay more for a private
08:54product rather than use a cheaper, more liquid-cap markets, though, especially, as Christoph said,
09:00at the larger end, where it often makes sense to tap public markets. I think as we've seen
09:06direct lenders raise larger and larger funds, they've been able to dislocate the bottom end
09:11of cap markets quite a lot. I think here on this slide, you have a lot of the reasons.
09:17I think we can break it down that there's a recognition from borrowers that there's certain
09:20circumstances where there's a willingness to pay a premium for, for example, flexibility.
09:27So, we offer non-amortizing structures, so all-bullet loans, at more flexible terms than the
09:34banks. Also, deliverability and speed of execution. So, this can be if you're supporting a private
09:40equity transaction, and you need to deliver very promptly for a bidder to put them in a competitive,
09:46strong competitive position. Or, for example, on a public-to-private transaction,
09:52where both deliverability, confidentiality, and speed are all factors at play. And really,
09:59you need to work with one or two parties that you really know well and can deliver.
10:03And then also, I think just working in partnership. It can often be easier if you're a sponsor,
10:10and you're looking at a buy-and-build strategy, where you will need follow-on capital,
10:14follow-on facilities, that it can be easier speaking to either one or a small club of
10:20direct lenders, of uni-trans lenders, to ask them for more money as you execute your buy-and-build,
10:25rather than tap a hundred-plus syndicate. And often, if there are issues as well, it's better
10:32to pick up the phone to speak with one or two people who you can have a sensible chat with.
10:38Then again, trying to work with a syndicate of lenders, which may be a lot more challenging
10:43for a sponsor to get alignment within that club. Then moving quickly on the supply side. So,
10:51what we're doing now is just thinking about why – what are the attractions for LPs?
10:56Why has there been a lot of money coming into this market? So, if we move on to the next slide,
11:00you'll see that LPs, which are usually pension funds and insurance companies, in our case,
11:07they've really seen the growth of private markets. And they're willing, given they invest on a much
11:14more long-term basis, from an asset liability matching perspective, they see the value in the
11:22additional illiquidity premium that they can capture and obtain through investing on the
11:28private side. There's a premium, I think, both on the pricing of unrated debt instruments,
11:34which is public, and you can see that here on this chart, but also on the controls that we've
11:39put in place. Because they're private loans, we're able to, at the smaller end at least,
11:45Christoph mentioned that the bigger end is more looking at fewer covenants and looser loan terms,
11:50but the smaller end, we're at least able to determine to put in covenants in place
11:54and put controls which enable us to have a stronger or better recovery rate should those
12:01loans default. So, both there's a premium for the illiquidity, plus we believe there's a better
12:07recovery rate and a lower risk of default in the private market. Now, clearly, we've been in quite
12:12a benign market over the last few years. So, the true test may be to come, but those are some of
12:20the attractions of the market that has driven a large volume of capital into this market,
12:28aligning to the growth. So, enough of the general market. I think we're here to learn about ESG.
12:33So, I'll hand you back to Pauline and Christoph. Many thanks, Nick. Yeah, so, really, that set
12:40the scene on what is the asset class that we're talking about within private debt,
12:45the direct lending space, and why it is that it is so attractive nowadays.
12:54Please, we want to make this session as interactive as possible. You can't talk because you're all
13:00muted. Send your questions through the chat, please. I'll try to follow up on the questions
13:06and then hand the questions either to Pauline or to Nick. So, don't hesitate. This needs to be as
13:11educational, as interactive as possible. So, Pauline, as I said, we are still at a high level
13:18looking at everything. ESG integration, the ESG definitions, can you give us a more precise
13:27definition of what is sustainable, what is impact, and so on?
13:35Hi, Christoph, and hi, everyone. Really delighted to be here for this ESG talk in the good company
13:41of Nick. First, maybe for a bit of introduction, I'm Pauline Dechemaker, and I joined Candrium in
13:472019, first as chief of staff to the CEO, so a role that really allowed me to really understand
13:56Candrium at its roots and really understand how we operate. And I then recently changed and moved to
14:01the ESG team as their impact specialist. And in this new position, I'm now in charge of supporting
14:07Cartesia and the ESG elements of their impact fund, and also to further position Candrium in
14:14the impact investing space. And prior to Candrium, I was working in consulting and supporting private
14:20market players, just like Cartesia, in developing their sustainable investment strategies.
14:26So, maybe now back to your question, Christoph. And I think the audience is probably very familiar
14:34with ESG, but I think that it's still important to remind everyone that when we speak and when we
14:39talk about ESG, it covers a very broad spectrum, from basic risk management to actively creating
14:48a social and environmental impact. And so, maybe for the sake of simplicity, we could say that
14:54there are three main levels, so responsible investing, sustainable investing, and impact
14:59investing. So, first, we have responsible investing. And here, this approach is about
15:05incorporating environmental, social, and governance factors, so ESG factors, in order to help avoid
15:12doing harm. So, typically, this involves screening out or excluding companies or sectors that don't
15:19meet certain criteria. So, think about avoiding industries like tobacco, weapons, or fossil fuels.
15:27So, really, here, the goal is to manage risk by ensuring that you're not investing in businesses
15:33that could negatively impact society or environment. So, it's a more cautious approach,
15:39let's say. And next, you have sustainable investing, which takes it a step further.
15:45So, this isn't just about managing risk, but actively seeking out opportunities. So,
15:51investors here are looking for companies that are leading the way in sustainability. So,
15:57companies that have very good environmental practices that they implement in their
16:02operations, very high level of business ethics standards, robust governance, very good
16:09labour and social practices. So, essentially, you're investing in companies that are well
16:15positioned to thrive in the long term because they are proactively addressing ESG challenges
16:22and opportunities. And finally, at the far end of the spectrum, we have impact investing. And
16:30here, it's not just about avoid doing harm or capitalise on sustainability trends,
16:35but to create a measurable positive impact. So, these investments are generally designed
16:42to address a specific social or environmental issue. So, climate change, circular economy,
16:51renewable energies, affordable housing, healthcare access, education access,
16:57and sustainable mobility, to name just a few. And the key here, I think, is that impact investing
17:04expect a clear, measurable, and ambitious outcome alongside their financial return. So,
17:11they want to know exactly how their investment is making a difference. So, in a nutshell,
17:17all three types are part of the ESG spectrum. However, depending on your investment philosophy,
17:24proposition, convictions, and objectives, the choice of approach can vary.
17:30Excellent. And since we're talking here about ESG integration within private markets,
17:37in how is all of this different between public markets and private markets?
17:42Well, Christophe, there are a few elements by which ESG integration is different in private
17:49markets. And we can probably address some of these in more details later on. But on a high
17:55level, these are, well, first, data availability. So, private companies don't have the same reporting
18:04obligations. So, the availability of ESG data is often very limited. And as a result,
18:11investors need to rely more on direct engagement with companies to gather and collect the necessary
18:18information. So, ESG integration in private markets is much more hands-on. It's not just
18:24about reviewing a company's annual ESG report or looking at third-party ESG ratings. Private
18:31market players need to conduct detailed due diligence to really investigate the company's
18:37activities, policies, and processes to uncover ESG risks and opportunities. Another key difference
18:46is the level of control investors have. So, in private markets, investors often have a
18:53more direct influence on the companies they invest in. So, it's pretty obvious with private
18:58equity investors because they become partly owners of the company. So, they can request a seat on the
19:05board and they can be more involved in the decision-making process. But it's also very true
19:11for private debt investors who can require the borrowers and the companies they invest in to
19:17implement an ESG improvement plan or to set specific ESG performance targets as part of
19:25their loan agreements. And finally, maybe the third big difference that we see is that private
19:31market players often need to take a longer-term view and approach on ESG integration. And this
19:38for two main reasons. Private players are often invested for longer periods of time. So, on
19:44average, above five years. So, this really gives you time to work with the company to implement
19:51and to improve your ESG profile. And second, they invest in companies that are often
19:58less mature or earlier in their ESG journey. So, think about small and medium-sized companies
20:05that have only very recently started to formalize policies, processes, and reporting.
20:12But the upside here is that there's often more opportunity for private investors to work closely
20:18with the companies and with the management over time to improve their ESG practices.
20:27Many thanks, Pauline. So, let us dive into the topic of today and I'll really focus on ESG
20:33integration within private debt. Nick, how is the industry implementing ESG integration into
20:39private debt investments today? And also, how have you seen evolving this over time? Because I'm
20:45sure there has been a tremendous evolution within this. No, absolutely. It's a great question. And
20:53I think you saw the chart earlier on the evolution of the private debt market and the fast growth.
20:58Look, coming out of the financial crisis, the private debt lenders were primarily focused
21:04on financial returns. This is quite a nascent market. ESG considerations were
21:09often seen as more relevant to the public markets rather than private. Now, however,
21:13there is a growing trend with ESG moving from peripheral focus to actually that focus on
21:19integrating ESG into the due diligence and the investment decision-making process. So,
21:25this reminds me actually of where health and safety was 25 years ago. It used to be that
21:30health and safety, if no one had died on the building site this week or been injured,
21:34then everything's okay. But now, if you think about health and safety, it's much more about
21:38preventative. It's having a framework in place to protect employees in advance and to ensure that
21:43if accidents happen, then there's a change in procedures to make sure they don't happen again.
21:48It's very much the same with ESG. We've moved from screening and looking at ESG very much in the
21:54rearview mirror as to what's happened and putting frameworks in place for really the measurement
22:00and the ongoing improvement going forward. So, as with private debt funds now consider ESG factors
22:07not only in the underwriting process, so when we're looking to underwrite the deals and onboard
22:13them into the portfolio, but actually throughout the entire life cycle of the investment. So,
22:17at Cartesia, for example, we actively engage the borrowers and we will come onto it a bit more later,
22:23but we engage borrowers on sustainability initiatives and we ensure that we monitor
22:28these improvements and measure them over time. So, I suppose in this respect, ESG has evolved
22:35from, as I said, do not do significant harm and avoidance to actually looking at it as a value
22:42creation tool with a real focus on how you can use ESG to enhance long-term returns, not just
22:49reducing risk. That means if you think about it from a mindset of equity, private equity or various
22:55equity strategies, you're looking at ESG as a key value lever rather than, again, a hygiene factor.
23:03What does this mean? It means that now when processes are being run, so we have many new
23:11deals come across the desk on a weekly basis and the sales documents, the offer memorandums that
23:15are produced for these for mid-sized businesses, five, ten years ago, we wouldn't see anything.
23:20There may be one page or a couple of sentences alluding to ESG, whereas now they're really using
23:26that. There may be three, four pages covering this entire topic and how it's really driving value.
23:31Why is that? Well, the reason is clear. The reason is because they see it as a driver of value on
23:36exit to show these ESG credentials, which again, it then helps us on our side when we're going to
23:42borrowers and we're talking about ESG. Again, it's not just a tip box. We're aligned with the borrowers
23:48and the sponsors to look at ESG as a mechanism to create value, and this is where we're going.
23:53I think finally, what next or what next in the evolution? We're really looking at market-specific
23:59impact strategy debt funds. In partnership, I suppose, with Candrium, we have an impact strategy
24:07and we look not only to work with the businesses on the framework, but actually put in, financially
24:13incentivise these businesses, as Pauline said earlier, with some sort of interest rate or ratchet
24:17mechanism to reward them should they hit the objectives. I think that's what we're seeing now.
24:23We're seeing the market has evolved to such an extent that more and more impact-specific debt
24:28strategies will be coming to market over the coming years. Okay, excellent. All right, many
24:35thanks, Nick. Pauline, back to you. Pauline, you already mentioned the differences with ESG integration
24:43between public markets, private markets. Here, we're talking about private debt. That's what you're
24:48doing in your day-to-day function. You're screening all these deals, looking for ESG integration
24:54within private debt. Can you explain us how you do this? Do you use a framework? Do you use
25:00very strict due diligence documents? Yes, absolutely, Christophe. ESG integration in
25:07private debt, and this applies to private equity to a certain extent, happens, as Nick just said,
25:14throughout the entire deal cycle, so really from screening to exit. It starts at the very
25:20beginning with the deal preliminary screening, so at the deal sourcing stage. At this early
25:27stage of the process, you can conduct a review of the target company based on the
25:34available documentation and public information that is out there. Often, it's not that much
25:40of information that you can get, but at this stage, there are already some key elements that
25:46you can already analyze. The first one is the business activity of the company, really
25:52understanding what the company does, its industry, what are the competitors doing, what are their
25:58best practices, and really start building your benchmark. You can also start looking at the
26:05company's activities impact on the UN Sustainable Development Goals, so the SDGs. You will also be
26:13able to verify that the business activities of the company do not cause significant harm to any
26:20of those SDGs, so this is in line with the DNSH principle under European SFDR. Finally,
26:30the next step also is to start establishing what are the key ESG strengths of the opportunity
26:36and identify areas where the company could have a positive ESG contribution.
26:41And finally, you will also look for potential weaknesses, so assessing the risks and challenges
26:49that could negatively impact the ESG profile. So now, once we move beyond screening,
26:56and private debt investors will conduct what we call a very thorough ESG due diligence,
27:03so this allows them to dive deep in both the key ESG risks and opportunities of the deal
27:11and to define specific environmental and social targets for the short, the medium,
27:17and the long term. So for example, it's also at this stage that you can assess the carbon footprint
27:23of a company, which will then allow you to build a carbon reduction plan if the investment goes
27:29through. And for us, when we conduct an ESG due diligence, we generally use two main levers,
27:38so first, a dedicated ESG questioner to be filmed by the company to provide us with
27:45a deeper understanding of their ESG practices, policies, and KPIs. And then we do follow-up
27:53calls with the company's management, so enabling us to engage directly and explore their ESG
27:59strategy and their commitments and how it's really operationalized in practice. And there are a few
28:07ways you can conduct an ESG due diligence. Either you do it in-house, if you have the resources,
28:14if you have the right expertise, but you can also ask for the service of an external ESG
28:20consultant to do it. And Kandrim here, we play that role in the partnership that we have with
28:30Cartesia, thanks to our very long track record in ESG and our very large team of ESG analysts.
28:37And we've also developed, as you asked Christophe, an ESG analysis framework to really ensure that
28:44every investment aligns with our high ESG standards. So first, we do a norm-based analysis,
28:51reviewing the company's adherence to international standards and norms, such as
28:57human rights or environmental regulations. Then we will proceed to a business activity
29:04analysis, evaluating how a company's operations align with long-term sustainability goals,
29:12such as climate change or resource depletion, health, wellness. And finally, we will conduct
29:20a stakeholder management analysis, really assessing how the company manages its relationship
29:26with its stakeholders. So employees, customers, suppliers, communities, and of course,
29:34shareholders. And really, this in-depth due diligence process will allow us to identify
29:40the material ESG issues within the company. So for example, if a company has a very high
29:47employee turnover or a very high health and safety accidents frequency rate,
29:52and this will help us work with the management of the company to develop
29:57an ESG improvement plan, which includes specific KPIs and targets for ESG performance.
30:05And after the investment is made, as Nick said, it's not only before.
30:10Could we hold a little bit on the KPIs? Because there's also a question in the chat.
30:16It's already mentioned several times that a tool that is being used in order to really
30:22make sure that these KPIs are rich is the margin ratchet. Can you give some more details on this
30:28margin ratchet system and how it really helps to promote either environmental or social KPIs?
30:34Yeah, absolutely. It was planned also later in the presentation when we talked more generally
30:40about impact. And I think that's what is so interesting when we speak about private markets,
30:45is this capacity to really influence also through financial incentives and to influence
30:52companies to improve and to implement the right initiatives and easy initiatives and KPIs and
31:01targets, social and environmental can be very broad. And depending on the industry you're
31:06working in, depending on the size of the company and the market it operates, these can be completely
31:13different. Some companies that are going to be more on the services side are going to be maybe
31:20more around social, about turnover. If you're in the healthcare or education, you will look at
31:27training, customer satisfaction, business ethics. If you're more on the industry side, you will look
31:34more at the lifecycle analysis of the products that the company produces. You will look at
31:41suppliers' relationship and try to see if, for example, the company is doing audits of
31:50its suppliers to ensure that its own supply chain has clean environmental practices, has good
31:58business ethics standards. So it can be very broad. And we see that it acts as a true incentive for
32:08the borrowers, and we can come back to the margin ratchet, and I think maybe Nick can speak about it
32:13better than I do, but it's a true incentive for companies to know that if they do things well,
32:21they will get a discount on the interest rate. So it's a win-win situation for everyone.
32:29Yeah, quick comment for me. I think leading with this, and the margin ratchet clearly is
32:34important and a part of impact strategies and trying to, again, economically incentivise them
32:39to deliver the goals, but I think what I found is talking to the market and to borrowers,
32:45especially at the smaller end, about an impact strategy is really – they have to really buy into
32:51the ESG thesis and what they want to achieve, and the margin ratchet is a consequence of it,
32:56but it's not necessarily their number one aim or goal is to get a reduction in the pricing to
33:03partner with us. So I think I've been surprised at the value add that we can bring on taking
33:09businesses on the impact journey and putting the frameworks in place are as important, if not more
33:14important, than the actual financial gain that they can benefit from by, again, having that
33:21incrementally cheaper pricing. Yeah, and I think that's maybe the conclusion on this bit is that
33:28once the investment is made, ESG integration doesn't stop, and the investor will engage
33:34in continuous monitoring and regular dialogue with the portfolio companies, and this allows you to
33:40provide support, resources, share best practices, and really ensure continuous improvement in the
33:48company's ESG performance, and this really adds value at every stage, and ultimately enhancing
33:55the company's overall value at exit. Okay, Pauline, and can you give some
34:06information on the challenges that you face when doing this due diligence, because as you said in
34:10the beginning, private markets, private companies, they are not as big, they don't have all these
34:16data sets as public companies, so what are the typical challenges that you're facing?
34:21Yeah, yeah, I won't spend too much time on this, because I think I've talked about it
34:26already a lot, and maybe Nick can complement. For me, as I said before, one of the primary
34:31challenges that we face when incorporating ESG factors is the lack of standardized ESG data from
34:38private companies, so unlike public firms, which are subject to very rigorous reporting requirements
34:46mandated by regulatory bodies, private borrowers often operate with less transparency and oversight,
34:54and this results in the absence of formalized ESG disclosures, making it very difficult
35:00for investors to access comprehensive and reliable data, which is necessary for the analysis,
35:10but I want to maybe end here on maybe a more positive note, because among these challenges,
35:17there is a positive shift happening in the landscape of ESG data availability,
35:22and we're witnessing a growing number of service providers emerging, and that specifically cater
35:29to that market segment, and they offer very valuable ESG data and proxy information
35:37and benchmarking tools. And maybe one last thing, I think, despite the fact that it can be quite
35:43heavy, we really think that the European regulations, so SFDR, CSRD, are really
35:53having a positive push and helping us moving in the right direction in terms of
35:57having a standardized framework for ESG data and comprehensive information.
36:05All right. Yeah, I think on my side, when I think about talking to companies
36:12and trying to put this ESG framework in place, I think the fact that we are lenders to the business
36:17and we're not owners, as Polly mentioned earlier, on the private equity side, it's really easier to
36:23drive ESG when you're sitting in the board meetings and part of those conversations,
36:30how do you implement the ESG change if you're not directly involved in those conversations
36:35day to day? I think two things, I think on our side, on the smaller end, we are more involved
36:39with our management teams, so they do actively want to speak to us about this topic, and ultimately,
36:45we need to find people, we need to find borrowers who are aligned to us. So a lot of what we find is
36:51a lot of smaller businesses, they don't necessarily have the bandwidth at their end to work on ESG,
36:59or necessarily the expertise, so they don't have, they're not big enough to have a head of CSR or
37:03sustainability, yet they are becoming increasingly aware of the need not only to be ESG compliant,
37:09but as I said earlier, the ESG can be a driver of value for the business as well. So to give you a
37:15couple of examples, you know, I have a portfolio business that regularly tenders for public sector
37:21contracts. So increasingly in the UK, at least, and probably across Europe, you find that tenders
37:26are not only awarded just on the basis of value for money criteria, but really, they're also
37:32looking, and they have to prove out sustainability credentials. As far as the percentage that is
37:38attributed to sustainability is only going one way, that's only increased. So this can, you know,
37:44this can be 20, 30% of the value of a tender is having to prove this. So if you are a business
37:52that is selling into the public sector, and you want to be successful, then it makes sense that
37:58you can't ignore ESG. In fact, it's the opposite, you, the forward thinking businesses at the
38:03smaller end, they know and they see ESG as a real differentiator. And they understand that working
38:09with us, they can create their business and put their business on a much better footing to win
38:14new work. And, you know, this is good for, I suppose, employees, the staff wellbeing, the
38:21pitching for new tenders, and external stakeholders. So, you know, without sounding
38:27cliched, I suppose it can be a win-win for both parties, really. And we need to find borrowers
38:33who really appreciate that and understand that. Okay, excellent. I'm talking about all these
38:40ESG criteria and teams. Are there any ESG criteria or teams that are more material than ours, Nick?
38:50Yeah, so on, I suppose, we see on the ESG criteria, I think it's as Pauline was saying,
39:05we lend to smaller businesses in general, and look, they don't always have the required
39:11information. So there's still a lack of those tools that are dedicated to private debt to SMEs
39:18that enter the market. And as mentioned before, we're not owners, so it can be more challenging
39:23to get that direct access. So, you know, how do you overcome the challenge of the limited
39:29standardised data? I think you need to engage the borrowers early in the process and, you know,
39:36often develop bespoke questionnaires to collect the data. And then there's a question of what
39:41you do with the data when you collect it. And as a private debt manager, our focus is on the
39:48credits and on the investment rationale. And yes, we can and we do upskill our teams on ESG,
39:54but however, we have to accept, I suppose, that we aren't experts. And as Pauline said earlier,
40:01you either do it yourself or, in our case, we leverage our partnership with Candram,
40:05who are the experts, to come in and help us with some of this information. So they can help us
40:11with tailoring the ESG diligence and the data collection to be really specific to the business
40:17itself. And this is, again, this is one of the challenges, because not all businesses are equal
40:22when you look at overlaying ESG criteria and what you should be targeting. You know, take a – we
40:27have in the portfolio a waste recycling business and we have a healthcare business, which looks
40:32after vulnerable people. So, you know, it would be foolish to think that you can apply the same
40:37one-size-fits-all ESG criteria to both of these type of companies. What you need is you need
40:42experts with specific sector knowledge, which our friends at Candram have. And for those that don't
40:46have a Candram, I think you need to build partnerships with some of the third-party
40:50suppliers that Pauline referenced earlier and experts that can assist portfolio businesses
40:55to collect that data. I've seen, because my chat screen was frozen, now it's activated,
41:04I've seen a lot of questions. There's a really good question, either for you, Nick, or for Pauline.
41:10How is all of this ESG analysis integrated in the valuation of the private debt deal?
41:17So, what's the impact between the ESG analysis, due diligence, and then valuation of the deal?
41:24Pauline, perhaps you?
41:28Well, it's always the complicated thing about ESG. It's difficult to really, like,
41:33measure. And now I'll come back on that. It's really difficult to measure the impact.
41:39But I think now, and I've seen recent studies, and there's an interesting one from PwC about
41:45private investments and the integration of ESG, and we see that more and more some companies are
41:53finding it more difficult to find a buyer or borrower if they don't integrate ESG factors,
42:00if they're not, as Nick said, ESG-compliant, which also really shows that you can increase
42:08your value in the eye of the buyer, but in the eye also in proper financial valuation terms,
42:17of really having good practices in place and thinking forward. Because another interesting
42:24fact was that a lot of CEOs today think that their business models will not be relevant or
42:30will not be sustainable in the coming 10 years. So, there is really a shift in thinking and a
42:37shift saying that your business will not really have the credibility and operational
42:45capacity in the coming years. So, you're going to be losing value if you're not
42:51thinking about these issues. And there's another question, and that's...
42:56Sorry, I was going to ask, for me on the investment side, look, I mean, the credit
43:00does come first. We can't let the ESG tail wag the dog, as we say, so we have to make sure that we
43:06are comfortable with the business and the credit fundamentals. But thereafter, as Pauline said,
43:12those, and as we mentioned some examples earlier, those businesses that are forward-thinking about
43:15ESG and that are transparent and that have good governance often make very good credits to lend
43:20to. And we want to lend to businesses and have that open relationship with those borrowers.
43:26And yes, there are businesses that ignore this and bury their heads in the sand that can be
43:30detrimental to value long-term, which means an exit for us, even on the debt side, via refinancing
43:38or a sale of the business in future, could be more difficult. Okay, and perhaps link to this,
43:45because one of the following follow-up questions is how ESG might create a conflict of
43:52interest between the equity holder and the private debt holders. Have you ever come across this, Nick?
43:58If yes, how do you deal with this?
44:03Yeah, I don't know. I'd like to ask a question to the person asking the question, because
44:07I don't, I suppose I'd like to know what the assumptions are that there's a conflict of interest.
44:12I suppose on the debt side, we're taking a yield and we're clipping coupons, but ultimately
44:18our ability to add value on the ESG side often adds value to the equity side, and therefore
44:25you could argue that an impact or sustainability product is more aligned with a sponsor or a
44:32borrower in terms of value creation than a standalone debt structure, where in that situation
44:38you are literally just, every pound you are making on interest is clearly a pound you are eroding
44:43from equity. So, I think having an impact product is much more value add for the sponsor, because for
44:52us, in a lot of cases, if you think about a lot of, you know, we again, we face into both sponsor, i.e.
44:58private equity deals and non-private equity deals, even some of the smaller private equity managers,
45:04they don't have time to think about ESG. You know, again, they want to do it, like the borrowers want
45:08to do it, but to use us as an outsourced ESG function to help them drive value is seen as
45:15a better value add and alignment. All right, and to go back to our team, so we were talking about
45:23the ESG data collection, Pauline was talking about it, how she uses it in the analysis.
45:29You, Nick, with your investment team, how do you make sure you have access to this ESG data when
45:35you're negotiating with the company?
45:45Nick? Hi, yeah, that's what I was saying before about the data, you know, accessing the data
45:51is important, and I think what we need to be very clear about is trying to not overwhelm the borrower.
45:59So, yeah, as we said earlier, many smaller companies, they don't have formal ESG policies in place,
46:05and therefore, we need to work in a much more collaborative manner.
46:09I think for a borrower that buys into the ESG, you know, we need to look to put in – it's
46:15about developing a very simplified framework so that the borrowers aren't overwhelmed.
46:19So, what do we do on our side? We narrow down the framework to 10 to 12 key metrics,
46:24and we choose the most two impactful to focus on. Again, these being industry-specific,
46:30as per my earlier example. The idea is really to make a difference in these two key areas,
46:35but also begin to start turning the dial on some of the others.
46:39So, take that healthcare business I mentioned earlier. You may decide a key focus should be
46:44on the quality of care, the staff and patient wellbeing. That makes sense. But it doesn't
46:49mean you can't start to do a carbon assessment as well and begin to move them towards net zero
46:54at the same time. So, as Pauline mentioned, the important thing is for this to be measurable
47:01and to offer them support and a real roadmap to improve processes over time, including various
47:07milestones which we want to be, I suppose, achievable yet challenging. So, you know,
47:14the idea of impact strategies is to make a real difference, and we don't want it to be simply
47:20ticking a box and making a margin ratchet without really driving real impact. As these businesses
47:28mature, they can gradually incorporate those more formal policies over time.
47:34Okay. And talking about impact investing, Pauline, you mentioned that ESG integration
47:39within private markets is different. So, I'm certain that also impact investing is very
47:46specific. Can you share some highlights on this? Absolutely, Christophe. You know,
47:52that's my favourite topic. So, as I said earlier at the beginning when defining ESG,
47:59impact investing goes a step further than traditional debt investing by intentionally
48:05aiming for positive social and environmental outcome while still seeking financial returns.
48:13And this approach can be framed around three key elements that were defined by the Global Impact
48:19Investing Network, so the GIN. And these three elements are intentionality, measurability,
48:25and additionality. So, first, let's talk about intentionality. So, investments are made with the
48:32deliberate intention to create a positive social and or environmental impact. And really,
48:38intentionality ensures that the objective to achieve a positive change is embedded in the
48:45investment decision-making process. So, here, we're looking at companies that have this positive
48:51change and positive impact at the core of their reason for being, at the core of their mission.
48:56And here, an example is a company investing in affordable housing projects with the intention
49:03of reducing local homelessness while still generating financial returns. And so, the second
49:10element is measurability. So, it refers to the capacity to assess and to quantify the social
49:18environmental outcomes of an investment by using both qualitative and quantitative indicators to
49:26evaluate the effectiveness and the extent of the impact generated. So, really, measurability
49:35ensures that the impact can be tracked, can be reported, can be compared over time. So, really,
49:43providing more transparency and accountability in how investments contribute to the desired
49:51objective. So, back to our example, here, the project, for example, tracks the number of new
49:58homes built but also measures the reduction in local homelessness rates by 15%, let's say.
50:07And lastly, we have the concept of additionality, which I think is the trickiest for investors
50:16because this means that the investment should lead to positive outcomes that would not have
50:24happened without the investor's involvement. So, in simple terms, the investment should
50:29improve the impact by making it either bigger or better compared to what would have happened
50:36without it. So, in our example, without this investment, the affordable housing project would
50:42not have been possible due to a lack of funds from traditional sources. Maybe three things I
50:49want to add on impact investing that I think are interesting. The first one is impact funds are
50:56generally classified as Article 9 funds under European SFDR, meaning that they follow the
51:03highest standards of ESG. And really, this makes it crucial to respect the three elements that I've
51:08just mentioned. Another interesting element for private debt impact funds, and we've covered it in
51:16the question that was asked, is the possibility to integrate impact covenants or incentives in
51:26the ESG improvement plan. So, as we said, with Cartesia and their impact fund, they include
51:32two impact targets in the term sheet. So, they offer an interest rate discount if the borrower
51:37meets with these targets. And this approach directly links the impact achievements to financial
51:43benefits. And maybe the third interesting element about impact investing, and I see that it's also
51:51a question in the chat, is the impact investing market. And while it's a relatively recent market,
52:00it's good to see that it has now surpassed the very significant milestone of one trillion
52:07in assets under management, and that this market is expected to continue growing
52:11at a double digit growth rate over the next few years. And while this market has been gaining
52:18some tractions with very different types of investors, and it's also in the question
52:23infrastructure, real estate, private equity, it's only very recently that private debt players have
52:29started to very seriously explore this space. And so, I think there are a lot of very cool and
52:37very interesting and exciting opportunities that are going to come up for private debt players.
52:44Okay. So, we only have a couple of minutes left, but when I listen to you, impact investing
52:51is very strict, a strict definition, conditions of intentionality, measurability, additionality.
52:58So, I'm quite sure that you've come across many deals that you'd have to reject,
53:02because the impact that you're looking for is not there. Can you give us perhaps a case or
53:10tell us some examples? Yeah, I was thinking about two different cases, and we have one,
53:18I think, in the slides. And both cases I wanted to present were potential investment of the
53:26Cartesia's impact fund. And it's important to have it in mind, because as you say here,
53:30we're not only looking at ESG practices, but how a company has a direct positive impact
53:37on the environment or society. And here, the first example of an investment that we decided
53:42to turn down, it was a sustainability advisory firm that worked with the major companies,
53:49including those in oil and gas, and they supported those clients in their energy transition plans.
53:56At first, it seemed very aligned with our goals of supporting positive change,
54:02but as we looked closer, we found two main issues. And the first concern was
54:08their heavy involvement with oil and gas clients, which raised questions around our exclusion
54:14policy. So, this is something you could consider if you wish to support the shift away from fossil
54:20fuels, and you're in the transition fund, but it's essential that any transition efforts are
54:27more than just surface-level changes. And the second and main reason was the actual impact.
54:34When we dug deeper, we saw that most of the consulting seemed to be focused on CEO-level
54:43discussions. And so, it felt more as a tick-the-box exercise and closer to maybe
54:48greenwashing. So, we weren't confident that we could show that this investment
54:54would make a real difference, which is central to what we aim to achieve.
54:59And maybe very quickly, a second example, which involves a global manufacturer of safety and
55:07storage solutions, so serving a large range of corporate clients across different industries,
55:15and their activities included very impactful contributions, such as oil spill prevention
55:22and soil contamination control, which was very much aligned with our impact goals.
55:30However, again, here, as we looked closer, a key issue emerged, and there was no reliable data
55:37or established KPIs to really prove the impact that they claimed. So, this made it very challenging
55:45for us to understand the true depth and scope of their positive impact. And so, again, without
55:52solid metrics, we couldn't be sure that if the company's activities were achieving meaningful
56:00and measurable change. Again, data. Yeah, indeed. And so, almost to come back to the
56:08beginning of the session, it was said multiple times that, okay, one of the differences between
56:13public markets, private markets, when doing ESG analysing, you're much closer to a company.
56:19You're much, much closer to a private company than to if you're just a shareholder of a large
56:24public company. So, Nick, and you mentioned several times that also the advantage also for
56:29the company that you're financing is really through the engagement that you're having with
56:33the company. So, can you share an example on this, an engagement example?
56:41Yeah, sure. Happy to do so. Given the time, I'll try and be quick on this one. So, if you look on
56:48the left-hand side, Company A, this is a company that we work with in the UK. The business is
56:54called … What does the business do? It does, it provides on-site and remote interpreting services.
57:02So, for example, if someone in the UK has to attend a court and their English is not their
57:08first language, they are entitled to have an interpreter join them to translate the messages
57:15in the court. So, we worked very closely with this business and we continue to support
57:20and its development in DE&I and broader social initiatives. It's very helpful because this is a
57:27business where I think ESG is inherent in the company's DNA and culture across all levels,
57:34which means we have that trust and that transparency and that willingness to work
57:37together. And over the investment period, the companies work very hard to ensure people,
57:42they pay people appropriately, they have a very good gender pay gap, which outperforms the UK
57:48average, and they're also a champion to various social causes and multiple sort of CSR projects,
57:55including empowering orphaned youths in India, and they have free English communication programs,
58:00etc. So, I mean, quickly, how have we been involved? Well, I think we've had very regular
58:04dialogue and we share a lot of ideas and knowledge between the different teams. So,
58:09Al Corley on our side as head of ESG and their equivalent within … And then putting that
58:17framework in place to formalize some of the initiatives that they've identified and monitor
58:21them. And then, finally, just adding a spotlight on the good work they're doing. You know, we
58:25featured them within our annual sustainability report, for example. So, that just gives you a
58:30quick overview of how we've worked with the business. But there's many examples across
58:34our portfolio. I could talk all day, but given the time, I think I'll end it there. Thank you.
58:41Many thanks, Nick. And yes, time runs quickly. We're at the end of our session. I hope it was
58:48useful for everybody. We took a deep dive, but we started high-level explaining where does direct
58:54lending sit within private debt, where does private debt sit within alternative assets,
58:58where does alternatives sit within the whole financial market. Pulling clearly explained
59:03all the difference, the different ESG integration approaches between responsible investing,
59:09sustainable investing, impact investing, the difference between applying ESG in public
59:14markets, private markets. And we gave many, many cases. I've looked at the chat. There's no more
59:21additional questions. If you have additional questions, feel free to send us mails or to go
59:27to our Academy. So, this ends our session. Many, many thanks, Pauline. Many thanks to you, Nick.
59:35Many thanks for our audience, especially for those asking the questions. And hope you will
59:39remain on our platform and that you will follow our next ESG talks in a couple of months.
59:45Have a nice day and cheers to everybody.