By Prudence Ho
LONDON (LPC) - Private equity firms are under pressure to boost their use of environmental, social and governance (ESG) criteria as debt investors and limited partners in their funds increasingly use sustainability criteria to drive investment decisions and manage risk.
The use of ESG standards in Europe's leveraged loan market is still in its infancy. Spanish telecom operator Masmovil completed Europe's first ESG-linked leveraged loan in May, while nearly $30 billion of investment-grade ESG-linked corporate loans have already been completed in 2019, according to LPC data.
Debt investors are increasingly citing ESG criteria as reasons to join deals or not, and private equity firms' limited partners also have sustainability targets, but private equity firms are skirting the issue as they try to deploy record amounts of cash.
"We know ESG is very important to many of the limited partners in private equity funds, but it hasn't yet settled down into a direct consistent impact on either asset selection or pricing," said David Gillmor, sector lead, European leverage finance at S&P Global (NYSE:SPGI) Ratings.
Private equity sponsors raised only $2.5 billion of funds with ESG mandates in 2018, which at 0.5% is a fraction of total global fund raising, according to data provider Preqin.
Private equity firms are using their own ESG definitions to avoid any restrictions and maintain flexibility as they struggle to spend a record $1.54 trillion of dry powder, or uninvested capital, after raising multibillion-dollar funds.
"If it (ESG) is strictly applied, that could narrow down the choices of M&A targets. Even investing in a plastic packaging firm could be a problem," a fund manager said.
NOT READY YET
Europe's leveraged loan market is struggling to incorporate ESG criteria into deal structures. Its use has been limited to capital expenditure and revolving tranches to date, which are mostly sold to banks, while institutional term loans have remained unchanged.
Masomovil's loan totaled €1.7 billion, but only the €250 million capex and revolver tranches were ESG-linked, which will give a 15-basis point margin reduction if the company's sustainability rating improves.
Some investors oppose ESG margin ratchets, which could reduce their income and increase the sell-down risk in general syndication for underwriting banks.
"You are not doing ESG to get a lesser return. It's not a trade-off between the two," said Stephane Michel, senior portfolio manager at Hermes Investment Management, "I want to keep the upside because I have selected a better credit by filtering out poor ESG performers."
The use of ESG ratings across private equity firms' portfolio companies is currently limited. S&P has no ESG evaluations for leveraged loan borrowers, and many middle-market or SME companies currently have no ESG scores.
Even if ESG ratings or scores were available for leveraged companies, not all fund managers think that they should necessarily be linked to pricing.
"It's not a 100% correlation to improving credit. You could have a super ESG rating, but it's not the sole determinant of spread performance," Michel said.
GUIDING DECISION
Although private equity firms are dragging their heels on ESG, portfolio managers are increasingly facing questions from leveraged loan investors about underlying investments, portfolio breakdowns, ratings exposure and other related issues.
"Every fund-raising meeting, investors asked about it, and you have to reflect that in your investment decisions." a second fund manager said.
A $500 million-equivalent leveraged loan for Israeli cyber surveillance firm NSO Group was one of the first deals to highlight negative ESG issues. The deal was placed at 90 percent of face value after it was revealed that the company's spyware tool Pegasus was used to target human rights activists.
At least four European CLO funds have been issued with an ESG focus since March 2018. The funds adopt negative screening to avoid investing in sectors including tobacco, gambling, pornography, weapons and hazardous chemicals.
European banks including BNP Paribas (PA:BNPP), ING and HSBC are at the forefront of sustainability financing. BNP Paribas has a team working on ESG structures for different financing products and ING aims to double its funding by 2022 to companies and sectors that are helping to keep global warming below 2 degrees Celsius.
"We believe sustainable business is better business," said Leonie Schreve, global head of sustainable finance at ING. The bank has established a global team to grow the sustainable finance business, covering green bonds, ESG linked loans, green loans and green equity.
Although it is still at an early stage, the inclusion of ESG criteria in leveraged loans is expected to develop quickly.
"It's almost exponential the acceleration, it (ESG) is here to stay and it will force private equity to pay attention," a senior banker said.