Private Credit Investors and ESG

With assets under management in private markets soaring in recent years, private market participants face unique challenges in building investment or reporting programs around sustainability or environmental, social, and governance (ESG) factors. Limited data, lack of standardization and limited expertise in quantifying the impact of ESG factors create numerous challenges for general partners (GPs).  Institutional investors like pension plans, sovereign wealth funds and insurers increasingly expect – or indeed require – private market firms to incorporate ESG factors into their investing practices.

GPs Embrace ESG

Once a niche topic in the private markets, ESG is now permeating across the investment landscape. Stakeholders in every sector are focusing more attention on the potential positive and negative impacts, influencing deal decision-making and valuations.

Overall, policymakers are increasingly focused on how financial services businesses can drive positive change. This pressure applies to both GPs and the portfolio businesses in which they invest. While Europe is leading the charge with initiatives like the Sustainable Finance Disclosure Regulation (SFDR), new ESG regulatory reforms are emerging in every region, many of which are focused on disclosure and reporting requirements.

Responding to these demands can be a complex task, but there can be many benefits for private market participants to embrace ESG as a business-as-usual activity rather than a standalone specialty, as it can help them:

• Manage risk. As materiality concerns go beyond financial data, ESG metrics enable a more in-depth assessment of risk during the due diligence process and throughout the investment period.
• Maximise profitability. Sophisticated fund managers are actively factoring borrowers ESG credentials as portfolio companies can get potentially attractive rates on loans if they hit certain ESG targets, most notably around carbon intensity.
• Drive value. The practice of ESG reporting can be an indicator of strong corporate oversight, controls, and a commitment to transparency.
• Create differentiation. As investors prioritize ESG, GPs tracking and reporting on portfolio company ESG metrics can demonstrate their commitment to driving better financial performance and supporting E, S, and G improvements.

ESG and Credit Risk

The conversation around sustainability is getting a lot more attention in discussions about financial wellness, as ESG factors obviously impact the creditworthiness of loans and investments. But, in prior schools of thought, ESG was a separate conversation. Now the market is shifting to how E, S, and G can also impact probabilities of default (PDs) and creditworthiness. It is no longer just a credit conversation, but ESG and credit. Of course, everyone is trying to understand the best approaches to drive these assessments.

S&P Global Market Intelligence provides a complete set of sustainability expertise, workflow tools, and data insights for private markets fund managers. This includes sustainability metrics for private assets at all stages of the investment lifecycle, from investment screening and due diligence through to portfolio management. It also includes tools to help firms efficiently collect, analyze, benchmark, and report to investors.

Credit Assessment Scorecards with ESG Credit Metrics explicitly include ESG credit risk factors that are considered in detail alongside traditional credit analysis formalized in the Scorecards. The ESG Credit Metrics are alpha-numeric quantifications of the expected impact of the ESG credit risk factors on a final credit score and are shown on a scale from 1 to 5, with 1 being positive and 5 very negative.

Climate Scenario Analysis and Credit Risk

Another key consideration while investing in private markets is that holding period is generally longer than listed investments. This demands more rigorous selection criteria, but also creates the opportunity to engage with investees and support them over time in their pursuit of transition and emission reduction. As such, climate scenario analysis can be helpful in quantifying the impact of climate related financial risks and opportunities during the investment horizon and thus, may be incorporated into the investment process.

Majority versus minority stakes

A majority stake in a private company can give investors privileged access to management, the possibility to access specific data and put in place post-investment action plans.  Climate Credit Analytics can be utilized for the purposes of climate scenario analysis in such cases as it enables detailed counterparty analysis nuanced by sector specific traits and various expert judgement parameters and financial levels. Many cases involve minority stakes or debt which does not come with the same level of access to management or data. In such cases Climate RiskGauge can help estimate the financial impact of climate transition and physical risks by looking at a compact set of financials, projected emissions, and a firm’s implied market valuation to arrive at the estimation of a credit score change^[1] over a given time horizon.