Corporate private debt: ESG performance is an essential selection and structuring criterion

DaAt the ESG & Impact Investing Forum held by L’Agefi on 22 June, Isabelle Luy Landès, Head of Corporate Debt at LBP AM, spoke during a panel discussion on “ESG in private debt”. Isabelle provides us here with her insight into extra-financial research methodology, ESG’s importance in due diligence, and how to structure financing.

What is your view of the boom in ESG research in corporate private debt?

We are currently seeing a very fast acceleration in the integration of environmental, social and governance criteria in the asset class. 46% of transactions last year in France came with extra-financial criteria, according to France Invest.

Integrating sustainability criteria into researching and selecting the companies that we assist in private debt, aims first of all at ensuring us of their solidity. Failing to take sustainability sufficiently into account could constitute an additional risk factor, with, for example, more difficult access to financing and, ultimately, higher financing costs. ESG criteria are accordingly increasingly important in structuring loans and therefore offer a truly positive societal impact opportunity.

What is the best way to promote societal impact?

Dialogue and engagement are the hallmark of the relationship between the private debt portfolio manager and the managers of financed companies. It is through this relationship that commitments to progress in sustainability are negotiated with the companies and that the company receives support in achieving them. 

At LBP AM, as investors in small and mid-sized companies throughout France, we can play a key role in assisting them in better taking ESG considerations into account in their business models and in adjusting their strategies. This is even more of a challenge for smaller companies, which are more embedded into the real economy, as they are, on the whole, less mature than large companies in terms of sustainability, and generally have fewer resources to devote to it. 

So, raising awareness among company managers is a must?

Absolutely, but in addition to entrepreneurs, the entire ecosystem must be incentivised to share practices in integrating ESG challenges into corporate private debt. At LBP AM, we have launched a campaign to raise awareness among business finders (M&A and debt consultant, banks, etc.), which helps broaden origination opportunities. This experience-based awareness campaign will continue with other actors, in order to be a creative force.

Is the regulatory framework increasingly stringent for small and mid-sized companies?

Yes it is. These companies must now converge towards large companies’ management and reporting practices. With the entry into force of CSRD and the gradual widening of its scope of application, the number of European companies concerned by the release of extra-financial reporting is expected to rise from 12,000 currently to 50,000. 

On the whole, we find that integrating ESG is regarded as more of an opportunity by company managers. They realise that this could help make their company more attractive to their financiers.

How does LBP AM integrate ESG criteria into its investments in this asset class?

At the due diligence stage, investments under consideration must be compatible with LBP AM’s regulatory and sector-based exclusions policies (e.g., oil & gas, coal, tobacco and gambling). They are then systematically subjected to an SRI review, to see whether they are opportunities, on top of the review done of their financial parameters.

This review is based on “GREaT”, our proprietary methodology, which is set up the same for all of LBP AM’s investment strategies. It is based on four pillars: responsible Governance, sustainable management of natural and human Resources; the Economic and Energy transition; and Territorial development, each subject to its own criteria.

In corporate private debt, the methodology is adjusted to each sector of activity to better express the materiality of environmental or social risks. This grid is updated regularly. In recent years we have developed climate and territorial impact criteria. In practice, a 70-question ESG questionnaire is then sent out to companies.

Could you give us some examples?

Each criterion consists of a series of four questions: Has the company formalised a policy to address the challenge in question? If so, what is its action plan? What metrics has it chosen? How has its performance evolved in addressing this challenge (has it worsened, improved or stayed the same)? 

Companies are relying increasingly on external ESG audits to fill out this type of questionnaire, which has a dual benefit – the datapoint is already available and it is more reliable as it has been certified. Once they have filled out this questionnaire, LBP AM holds a dialogue with the managers to deepen their analysis and understanding. Lastly, LBP AM’s SRI Solutions team produces a GREaT rating for the company (ranging from 1, the best rating, to 10, the worst). The team-member specialising in real and private assets has a non-binding say on all the management team’s investment decisions.

Lastly, how do you follow up on the ESG review throughout the loan’s running time?  

In the case of sustainable-linked loans or impact loans, several sustainability performance metrics are determined for each investment. For each criteria, a progress curve is laid out over the life of the financing operation for follow-up purposes. To top it off, there is a system of bonuses (if the curves are adhered to in all criteria) or maluses (if this is not the case for any one of the criteria) on the financing margin.
During the life of the loan, the companies’ trajectories on these KPIs are calculated annually, with the progress curve certified by auditing firms. Following up over time is meant to encourage the companies to improve.