Taking into account – and even seeking to influence –Environmental, Social and Governance (ESG) factors in investments in private assets has become significantly more common in recent years. However, the way in which investors can and should think about these factors differs between asset classes. Specifically, as ESG applies to private credit, conventional wisdom is that, due to the relative lack of direct control the lender has over the portfolio company’s business, the private credit investor’s ability to (i) require ESG-related data collection and reporting, and (ii) bring about change is limited. So, the thinking goes, creditors are often looking from the outside in, unable to directly influence a portfolio company, with the focus of transparency and control rights often relating solely to concerns around the borrower’s ongoing creditworthiness. Compare this to an equity investor, who will often be given access to significant amounts of portfolio company data and reporting and may even hold a control position and/or be afforded board-level representation.

While, in many cases, the factors that drive this view hold true, they may not tell the full story. For example, the integration of ESG-related factors into the investment screening process is now an increasingly important component of investing for many institutional managers. Borrowers seeking to access this large pool of capital are now becoming more familiar with requests, for information relating to their greenhouse gas emissions, diversity figures, supply chain and governance processes and thus are more likely to collect and report this data internally.

However, ESG integration in private credit is moving beyond simply being a part of the due diligence and screening phase and is now focusing on areas where investors can influence change. Whether or not a credit investor can truly bring about change in a portfolio company will depend on a number of factors, however. For example, what does the portfolio company’s capital stack look like? If a significant part of their financing plan requires borrowing from large institutional asset managers, these lenders are likely to have far greater leverage than when facing a borrower with a diverse investor base across equity and debt. Additionally, the relationship between the debt investor and other parties in the deal is key. How broadly (and to whom) the financing is syndicated, along with the relationships between the debt investors and any private equity sponsor, will all impact how much say any one creditor can have.

There is also the question of incentives and penalties for meeting or failing to meet ESG-related targets. Private credit investments, like most private assets, are often difficult to divest from without taking a haircut on the investment – an outcome that many LPs in private credit funds are unlikely to accept (making tight integration of ESG factors into the screening process all the more important).

With limited traditional options, private credit investors may therefore need to be creative in how they seek to create these incentives or penalties. One such method of incentivizing ESG-performance is through so called ESG-margin ratchets, or the granting of decreases in the margin rate tied to certain ESG-related key performance indicators, or even increasing the margin rate for failing to meet those key performance indicators. It should be noted, however, that these margin ratchets still require ESG-data gathering and reporting on the part of the portfolio company (although the portfolio company now has a clear financial incentive to do so and is therefore able to weigh the burden of implementing the changes and gathering and reporting the data against the financial benefits of the ratchet).

However, even this creative solution, which manages to directly tie objectively determined ESG-related performance to financial incentive, is not an obvious winner. The ability of a creditor to introduce margin ratchets will again depend on the nature of the deal, whether the lender is a primary lender or following on, and whether they are lending solo or as part of a syndicate.

Perhaps more contentiously, a reduction in margin will ultimately reduce the returns to the investing fund and its LPs (conversely, an increase in margin means the investing fund and its LPs financially benefit from a portfolio company’s ESG-performance failing to improve – an odd and slightly uncomfortable outcome). This would likely be true for any mechanism tying financial incentives to ESG-related performance, so credit investors may once again be left searching for a reliable way to influence real ESG change in their investment portfolio without directly jeopardizing returns. The alternatives for credit investors to effect sustainability outcomes over the course of an investment (unless financing is limited to sustainability focused purposes or activities) beyond encouraging reporting may therefore currently be limited to sacrificing return in exchange for a more sustainable outcome.