PRIVATE LENDING: Can you achieve stability, responsibly?
As private lending offers some shelter against the unpredictability of today’s economy, the increasing attention for Environmental, Social and Governance (ESG) filters poses a challenge for institutional investors: how to effectively manage volatility while also investing responsibly?
In the era of The Great Instability, unprecedented public market volatility and the prospect of continued low-interest rates are shaking investors’ confidence. Many are exploring alternatives for long-term, predictable and stable income, like private lending markets. Highly diversified with their wide range of risk and return drivers, less exposed to rapid movements in investor sentiment, and estimated to offer a $1 trillion opportunity1, these markets also allow investors to finance the growth of the real economy.
Though this level of direct lending activity might reduce through 2020, after the market impact of Covid-19, this still this means that even more opportunities will arise for institutional investors with a long-term view. But can a shift from listed to unlisted markets allow the same level of choice and control when it comes to sustainability?
THE ROLE OF ESG
Initially focused on negative screening, ESG or sustainable investment factors have evolved rapidly. Today, their evaluation into traditional investments is proven to be positively correlated with performance2, especially for long-term investments.
Aside from this evidence, investors are also aware of the ongoing regulatory push towards sustainable investment. The EU aims to support the European Green Deal by channeling investment to the transition to a climate-neutral economy, to complement the public money governments will commit3. International efforts to address climate change have increased, with agreements such as the COP21 Paris accord forcing institutional investors to consider climate-related financial risks within both portfolio construction and reporting. Moreover, since the global financial crisis, regulators are asking investors to focus on governance – now recognised as systemically important to the worldwide economy – to promote a fairer, more representative and inclusive economy.
Regulations are surely influencing the freedom of investors heavily, but with these new requirements also comes significant opportunity. The energy transition is creating attractive investment prospects, alongside other environmental themes like air, sea and water pollution, deforestation, waste management, resource depletion and biodiversity. So, for investors eager to move away from the uncertain nature of public markets while still allocating capital sustainably and responsibly, are there opportunities to combine these two aims?
FROM WONDERING ‘IF’…
For some time, ESG investing was initiated and confined mainly to public equities. But, by lending to private companies using an ESG lens, investors could create sustainable long-term value in line with their beliefs while helping the real economy get back on its feet.
Within private markets, some equity investors have adopted ESG practices, as they are in an even stronger position than those owning publicly listed companies to influence underlying businesses. So, they can directly – and potentially more rapidly – benefit from improved governance and access the burgeoning range of opportunities. Still, there are challenges to overcome to apply and benefit from ESG factors, when making investment decisions and maintaining oversight.
Assessing infrastructure or commercial real estate assets is quite distinct from assessing corporate lending to small and medium enterprises (SMEs), for example. SME loans sizes tend to be relatively small, and Corporate Social Responsibility (CSR) policies tend to be absent, board diversity may be irrelevant, and data is often unavailable. This means customised ESG processes need to be applied within private credit to ensure meaningful management of these risks.
…TO FINDING OUT ‘HOW’
Although private debt holders have typically argued that equity-owners of individual projects are in a better position to manage and monitor ESG risks, this might not necessarily be the case. Direct engagement with project sponsors allows us to verify key ESG assumptions and challenge on business practices.
Another element making primary private credit attractive to those focused on sustainability is the fact that investors can be directly involved in the drafting of key covenants, triggers and waivers embedded in loan terms, to ensure compliance with key financial metrics. These triggers can also incorporate ESG performance indicators in line with an investor’s overall policy.
INSTABILITY PRODUCES OPPORTUNITY
Even before the Covid-19 outbreak, OECD nations (Organisation for Economic Co-operation and Development) were struggling to meet the burgeoning social, transport and energy infrastructure that was required to sustain economic activity levels. Now, the role of investment is becoming ever more critical.
A significant number of government-led projects, combining public, bank-loaned and private investor capital will inevitably be launched to support and rebuild a paused economy. Therefore, it seems likely that ESG benefits of individual projects will form a larger-than-ever proportion of the assessment of bids for competitive tenders.
REAL EXPERIENCE IN THE REAL ECONOMY
In conclusion, as investors choose the breadth and depth of private credit for the diversification, long-term cash flow, liquidity and secure lending benefits offered in today’s unstable world, there are solutions to integrate ESG factors with further advantage. And the greater the experience, the better these solutions become.
The BNP Paribas group has been lending to the real economy in the UK for over 150 years, and our Asset Management division has broad, global expertise in originating and managing private credit transactions for institutional investors. We do not seek covenant-light transactions in our private debt and real assets division, as the ability to remediate or restructure transactions gives investors the greatest downside protection and is particularly pertinent given recent market turmoil. Partnering with us offers investors access to a process that incorporates the expertise of our underlying investment teams, in order to help them navigate today’s complex investing world and its myriad of interconnected variables.