August 4, 2021 - by Tess Virmani. It is undeniable that “ESG” is the mot de jour – this amorphous concept is dominating conversations in financial markets and the loan market is no exception. But, what does “ESG” mean? As a broad umbrella term “ESG” refers to the environmental, social and governance factors which contribute to a company’s sustainability profile and overall performance. However, ESG can be adopted in a multitude of ways. As applied to credit risk, ESG is narrowed to refer to those environmental, social and governance factors that are financially material to a company’s performance and risk profile. Some investors, however, see ESG as going beyond what is financially material to also look at a company’s environmental and social impacts. While the alacrity in which ESG has swept through the investment world has been remarkable, ESG is perhaps more relevant to corporate practices. In some cases, companies may solely focus on the ESG risks (and opportunities) that directly impact their business model or, in other cases, companies may also look to their impact on a broader set of stakeholders. Turning back to ESG in finance, there are different ways in which this concept is applied. ESG may be integrated into investment decisions – with varying shades of integration – and it can be integrated into product offerings, such as loan structures designed to include sustainability components. In this two-part series examining how ESG (and related challenges) is showing up in the loan market, this first part focuses on ESG in the institutional loan and CLO markets.
The macrotrend toward ESG is clearly demonstrated by a confluence of several microtrends: 1) the rise in number of CLO managers actively embracing ESG considerations, 2) the increasing investor demands to understand how ESG is integrated into a manager’s investment framework (which in turn has increased manager demands for ESG information on the borrowers to which it lends), and 3) the significant growth of ESG-related investment prohibitions in CLO indentures. Each is examined in turn below.
The BofA Global Research Securitized Products Strategy team recently found that 73 US CLO managers and 11 EU-only managers representing about 60% of the overall CLO market are now signatories to the UN Principles for Responsible Investment (PRI). The UN PRI, a key investment initiative, works to understand the investment implications of ESG factors and to support its international network of investor signatories in incorporating these factors into their investment and ownership decisions. Signatories commit to adhering to the PRI in their investments and to report on those efforts. As further evidence of the growing momentum of managers becoming signatories, 29 of the 84 CLO managers cited above signed on to the framework in 2021 alone. Other non-signatory managers are also adopting ESG using different strategies. In some cases, managers may adopt exclusionary policies where others instead (or in addition) develop internal ratings to assess the ESG profile of their loan assets. In the latter case, the SASB Materiality Map is reported to be a commonly used tool.
Managers have heard and are responding to the resounding call from investors to integrate ESG into investment practices, but investors are likewise demanding to understand what that means for any specific manager. Currently, managers are required to complete numerous and disparate disclosure requests and the requests are becoming increasingly granular. To assist with the process of disclosing information to investors, the ESG DDQ for Managers released by the LSTA in June. The DDQ offers an industry-approved set of ESG disclosures which, if accepted by investors, would allow managers to complete a single set of disclosure questions in a robust manner. The great challenge, however, lies in the sparse ESG information managers have about the borrowers to which they lend. Given that the majority of borrowers in the leveraged loan market are private companies – where information is shared on a confidential, contractual basis – the market itself presents a structural impediment to information access. As described above, however, the lack of ESG reporting by borrowers will need to be addressed to support ESG integrated investment frameworks. To that end, the LSTA worked with its members to develop and introduce both a disclosure tool and best practice for establishing a workable ESG disclosure hygiene. The LSTA’s ESG DDQ for Borrowers is designed to be completed by the borrower at the pre-investment stage of any loan market transaction. The LSTA’s best practice calls for the completed questionnaire to then be included with a borrower’s financial / traditional diligence materials and available to all lenders and prospective lenders. In the 18 months since this DDQ was first introduced to the market, it has been completed in some loan transactions, but adoption remains patchy. For a smooth functioning loan market, ESG disclosures will need to become a standard diligence item from borrowers.
In tandem with the trends described above, the inclusion of ESG related investment restrictions in CLO indentures has been taking hold. S&P Ratings reported in its May SF Credit Brief on “The Impact of ESG-Prohibited Industries in US CLOs” finding that: “most U.S. CLOs that have sought to incorporate ESG factors have done it through the adoption of provisions in their transactions documents (usually within the “collateral obligation” definition in the CLO indenture). These provisions restrict CLO managers on investing in assets from companies in industries that are viewed as not ESG-friendly.” Restrictions around a single industry, commonly tobacco, is not new to the CLO market. What is happening now is that CLO indentures are calling out multiple industries. This trend is newer in U.S. CLOs and is clearly growing. The BofA Global Research Securitized Products Strategy team in “ESG Considerations in CLOs” recently estimated that at least 214 CLO deals that have been priced recently adopted a negative screening criteria in their indentures (although it was also noted that 127 deals have only tobacco related exclusions). Furthermore, preliminary analysis indicated around 80% of 2021 indentures incorporated ESG negative screening criteria. Some of the common industries being excluded from CLO investments, as reported by S&P Ratings, are O&G extraction, thermal coal, production of or trade in controversial weapons, production of opioids, and the trade in any of hazardous chemicals, ozone-depleting substances, predatory/payday lending, firearms, adult entertainment, tobacco and gambling. It should be noted that the specific industries being excluded can and do vary across indentures so, despite the growing prevalence of these restrictions, these ESG restrictions are not standardized. It is also important to keep in mind that many of these ESG-unfriendly industries are not widely represented – if at all – in the U.S. institutional loan market. With the exception of chemicals and gambling, few institutional loans would run afoul of the restrictions in CLO indentures. For this reason, the development of “prohibited industries” does not currently challenge diversification in any CLO, however, it does raise the question of what “good ESG” will look like for CLOs in the future. Will investors continue to look for negative screens against prohibited industries? Will that list grow? If the answers are yes, this screening practice may become more challenging. Reliable ESG information on borrowers in the institutional market will be key to supporting the practice of investment restrictions in CLOs as well as the evolution of ESG in the loan market broadly.
Pulling together the various ESG strands at work in the loan market, one sees an undeniable shift in the loan market toward ESG. It is clear that ESG is neither a passing fad nor only relevant in ESG investing. ESG has become mainstream and the ways in which ESG will impact the loan market are (and will continue to be) numerous and rapidly evolving. What is also clear is that the loan market needs to see a standard ESG disclosure regime take hold. Continued lack of ESG disclosure by borrowers will not be tenable given the force of the trends described above. The second part of this series will look at the development of sustainable loans, and in particular, sustainability linked loans. For the LSTA’s recent webcast on the topic presented by Gibson Dunn & Crutcher, click here.
