Private credit
Forging sustainable investments in European leveraged finance and CLOs: Part 1
6 min read 13 Jul 23
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In the past two years, the proportion of European assets under management with an ESG overlay (as measured by funds that are categorised as Article 8 and 9 under the Sustainable Finance Disclosure Regulation, or SFDR) has risen to nearly 60%1. Given the size and maturity of the private companies that populate the large-cap European leveraged finance markets as well as the sophistication of their private equity owners, is it reasonable to expect that leveraged finance assets under management – in funds and collateralised loan obligation – will advance at a similarly frenetic rate?
“The good news for the large-cap European leveraged finance market is that the raw materials with which to judge a company’s ESG risk management credentials – and sustainability intent – are growing fast.”
Using the SFDR as a basis for terminology, European leveraged finance investment strategies – whether in fund or collateralised loan obligation (CLO) form – can promote the environmental and social characteristics of underlying portfolios, identifying precisely the characteristics of each company’s activities that are being “seen” and evaluated in a consistent and precise way, writes Fiona Hagdrup, Fund Manager for Leveraged Finance at M&G Investments in the first of our two-part analysis.
Such strategies may be expected to evolve just as in public markets, increasingly incorporating a sustainable investment objective too, and making commitments within a portfolio to such investments.
Just as ESG integration into credit analysis is no longer niche, so sustainable investments will permeate European leveraged finance argot and portfolios, including CLOs. In this way, the still-specialised world of CLO-investing may also transcend its niche and be absorbed more comprehensively into the mainstream investment world. As CLOs – like wider asset-backed securities (ABS) – increasingly find a way into Article 8, multi-asset funds, so a literacy and consistency with sustainability – and its proofs – will develop apace.
What is ‘promoting’ environmental and social characteristics?
Promotion can be understood partly in the negative i.e. not investing in economic activities that are considered harmful to the environment or society. Investors may vary in their judgement of the degrees of harm. Some may have longer lists of precluded activities than others; some will have low (or no) tolerance for trace involvement in certain activities – but there is already a solid ground of consensus emerging in this basic approach. Weapons, fossil fuels, tobacco and the contravention of global norms – these preclusions tend to be omnipresent with other topics having a groundswell of support, such as palm oil, gambling, alcohol, exploitative financing, opioids, genetically modified crops and animal testing. An exclusion list of sorts will appear in nearly every new European CLO as well as being a feature of Article 8 or sustainability-aware loan funds and segregated mandates.
More substantively, promotion also means applying positive selection criteria, tilting investment towards those companies deemed to have strong environmental and/or social characteristics. This means more than risk mitigation – it is evaluating the forward trajectory of a company across a variety of environmental and social topics.
Promotion of environmental and social characteristics also involves effective stewardship (in the broadest sense of the word, acknowledging that lenders and bondholders are not equity stakeholders but nonetheless have significant ‘soft’ power) via engagement. As per the Principles for Responsible Investment (PRI) definition, this means a purposeful dialogue with a specific objective in mind.
Engagement is not just the sending of a questionnaire or seeking clarification of an issue. Importantly, engagement is not only bilateral. Indeed, for some topics like emissions target-setting in high intensity sectors, it can be most effective when it is collective. In order to conduct effective engagement in leveraged finance markets, the creation of investor collectives, for example a leveraged finance equivalent to Climate Action 100+ could be warranted.
Climate Action 100+ is the world’s largest investor engagement initiative with more than 100 companies in its sights that are considered to be the highest emitters in the MSCI ACWI. It has concluded its first phase and will now enter its second, which will run to 2030. The objectives comprise a schedule and appropriate escalation options – plus supporting networks – as part of its evolution. Capex alignment is in its focus too as this “bridges the extra-financial with the financial”2, and it is where a company’s words most obviously become its actions. In a similar way, leveraged finance investors can take a lead from this important action group on climate, capex interrogation being a key part of cashflow-lending decisions.
A strategy, fund or CLO, should disclose its sustainability indicators – the metrics by which attainment of the promoted environmental and social characteristics are measured – to investors.
Systematic approach, increased data
The good news for the large-cap European leveraged finance market is that the raw materials with which to judge a company’s ESG risk management credentials – and sustainability intent – are growing fast. So too is the reach of data aggregators and ESG content providers. These entities provide analysis of company disclosure, including assessments of corporate behaviour and compliance with global norms, as well as thought-pieces to help with data assessment (e.g. the worth of ISO certification). All inputs are welcome for the leveraged finance analyst or fund managers looking to make a balanced assessment though the approach should be systematic and in accordance with a framework.
Regulation helps here too, both with comprehensive compilation of all adverse indicators worthy of consideration as well as with systematising corporate disclosure. Key data will also be digitally tagged, if the EU authorities get their way, creating capture and improving the quality of analysis.
Some indicators can already be identified, categorised and evaluated in a more systematic fashion than was possible in the past. Investment managers – especially those from large firms that are active in a range of public asset classes, like equities and investment grade bonds worldwide – also benefit from context. An ability to place what may be measured by a private company and set it against public, sectoral peers gives some substance to tags like “best-in-class” or “laggard”. Investors need a common framework for assessing ambition and intent. It should not be left only to the companies themselves to articulate their qualities.
For now, leveraged finance investors are missing a market-specific means of benchmarking. Currently, the context is typically created in-house and large asset managers can do it by dint of their investments in other markets which provide a backdrop, be they developed markets equities or emerging market corporate bonds. The advent of an ESG index for broadly syndicated loans (BSLs) would be a welcome development.
The EU Council and EU Parliament’s agreement on a single point of access for publicly-disclosed sustainability data should ultimately help investors. The EU-wide platform is being designed to be a core part of enabling access to finance for companies. It is a means of promoting the digital-tagging of information too to aid machine readability which, in turn, should contribute to systematic collation and reporting.
In the meantime, the leveraged finance market trade bodies – the Loan Market Association (LMA); the Association for Financial Markets in Europe (AFME); and the European Leveraged Finance Association (ELFA) – play their part in advancing systematisation. ELFA, for example, has produced important, sector-specific ESG data disclosure recommendations to companies (after much consultation between issuers and investors, intermediated by PRI) and the leveraged finance investor collective has also published a standardised means of collating CLO manager ESG data to aid the ABS-investing community. This initiative recognises that ABS investors require information not only on an underlying portfolio, but also on the vehicle’s most important counterparty (e.g. the sponsor, the originator, the manager) to meet their own disclosure requirements.
There is scope for more co-ordination of approach, but this has been an important step in advancing the most important investor community underpinning large-cap European BSLs and floating rate notes (FRNs).
1 Morningstar, “SFDR article 8 and article 9 funds: Q1 2023 in review”, morningstar.com, 4 May 2023.
2 Responsible Investor, “CA100+ tightens signatory requirements, ups ambition in phase 2 launch”, responsible-investor.com, 8 June 2023.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
