Across market sectors, investors are increasingly focused on ESG investing given the urgency of climate change, governance, representation, and other social issues. In parallel, the size of the ESG marketplace has grown rapidly with new investment options proliferating. Yet navigating the ESG sector remains more art than science. What do investors need to know?
First, there is no standard definition for ESG. Since asking five different global institutions will elicit five different answers, investors may want to see what large investment institutions gravitate towards. Many use the voluntary UN Principles for Responsible Investment (UNPRI) as a benchmark, while others look for guidance from other eminent global institutions such as the OECD1. Given that each investor is likely to prioritize different components of ESG, any of these can offer a strong starting point.
Second, consider who is determining whether an issuer, corporation, or other entity is ‘ESG compliant’, which is based on specific criteria, and what factors are being used to make that determination. ESG scoring generally focuses on some common themes:
- Environmental impact – aggregate use of natural resources, environmental stewardship, carbon footprint, and use of green technology.
- Social compliance – workforce diversity, stakeholder rights, anti-discrimination policies, and community relations.
- Governance concerns – level of independence for the Board of Directors, commitment to shareholder rights, oversight of corporate ethics, and executive compensation levels.
A number of prominent institutions offer ESG scores and ratings based on specific criteria. Each can be useful based on what an investor is looking to measure. ESG ratings and scores are available from diverse entities including MSCI, Sustainalytics (a Morningstar subsidiary), Refinitiv (a LSEG business), Bloomberg, Moody’s, S&P, and Fitch. This list is not exhaustive, but while the range of options continue to grow, it is likely that over time the marketplace will gravitate towards a smaller set of key ratings and score providers.
Finally, understand the opportunity posed by the size and potential growth of the ESG sector. Although there is no universally agreed-upon measure of this sector’s size, given variations in definition and scoring, the Global Sustainable Investment Alliance sizes ESG assets under management at about $35 trillion globally2 (as of 2020). A recent Bloomberg article estimated that the market has room to grow to over $50 trillion over the next three years.3
For a young market, ESG investments are growing rapidly and attracting significant investor interest. However, it is not without growing pains and some controversy. For example, a recent press release from the US Sustainable Investment Forum noted that total US assets designated as ESG had shrunk as investment managers began responding to new SEC proposals regarding misleading fund names and as they began implementing new transparency requirements designed to prevent (among other things) ‘greenwashing’.4
So what’s an investor to do?
As a broad, complex, and developing market sector, ESG does not lend itself to a one-size-fits-all investment approach.
- Some investors may be satisfied with a generic overlay and legitimately meet their requirements with third-party confirmation for a particular portfolio.
- Others may focus on particular ESG elements and components. For example, an Environmental focus may drive divestment from certain companies/industries and increase allocations to others based on defined objectives. Some investors may target investments based on Social themes such as diversity, community involvement, and anti-discrimination. Still others may look at Governance, which addresses investor concerns such as management compensation, director independence, and shareholder rights.
Importantly, these considerations, and the ability to invest based on them, are not restricted to the public markets. Investors who are looking to diversify their investments and bolster yields by adding alternative investments to their portfolios can still pursue ESG objectives. Increasingly, they cite ESG as a critical decision factor in these investment decisions.5
The key is having transparency into the typically smaller and younger companies who are offering private investments.
The opportunity for private companies
While many corporate borrowers are just beginning to recognize the value of communicating areas of ESG alignment, including governance matters important to investors, ESG concepts are often already incorporated in their business models. As relatively new businesses with younger management teams and employees, they have grown up with these values and understand their importance to investors. Borrowers who can quantify their company’s ESG efforts have access to a broader pool of investors and an edge when negotiating terms.6 They will also gain an advantage as regulatory scrutiny inevitably increases over time to include private companies issuing debt.
Leveraging platforms like Percent’s private credit marketplace can allow these private companies to broadcast their ESG compliance across a standard set of measures that make them comparable to other private companies from the investor’s perspective. Whether it’s periodic attestations or tracking of key ESG-related KPIs, the transparency that can be offered to investors can drive the inclusion of these companies into the ESG investment universe.
The challenge for investors
For investors, one challenge is that ESG data is typically absent from initial due diligence packages7 for private credit investments. But there are proxies that can help them understand the borrower’s priorities. For example, Percent’s platform gives investors the ability to compare different offerings, get to know the companies behind each investment, and see a variety of metrics core to assessing the company and/or debt offering. This information can give the investor insight into the borrower’s management structure, business approach, and ESG focus. Furthermore, ESG-specific measures can be added to be more explicit and offer a more standardized basis for comparability.
The fact that many private corporate borrowers, particularly non-bank lenders, have a strong community focus is also appealing to investors. These borrowers lend to consumers to enable access to medical care; finance entrepreneurs to get small businesses up and running; and offer solutions to businesses and consumers who might otherwise be overlooked by the major financial institutions. This type of community-focused business mission satisfies important ESG criteria and should form part of an investor’s evaluation.
2 Global Sustainable Investment Review 2020, July 2021
4 IOSCO defines “greenwashing” as the practice of misrepresenting sustainability-related practices or the sustainability-related features of investment products. Given inconsistent taxonomy, regulations, and enforcement, it can be difficult for investors to validate ESG claims made by institutions, funds or managers. International Organization of the Securities Commission, July 2022
5 https://gsh.cib.natixis.com/our-center-of-expertise/articles/esg-integration-in-private-debt-challenges-and-opportunities, July 2022
6 European Leveraged Finance Association, October 2021