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ESG and Direct Lending

Updated: Feb 9, 2023

David Smart of PMCL Consulting participated in the panel discussion on ESG at the Direct Lending Outlook Europe 2022 event in November. We found the event very informative and it raised a number of issues that are very relevant for charities and foundations as asset owners.

We summarised the key takeaways in this article and please do contact us if you would be interested to discuss any of these issues and how they may apply to your investment portfolio.

Private Capital AUM continues to climb

The event started with a presentation of Rahmin Maali, Preqin, which set the backdrop for the discussions and provided some useful data. According to the Preqin survey, global investors on average target to allocate over a third of their capital to private assets, including private equity, private debt, property and infrastructure.

Source: Preqin

Source: Preqin

This growing trend was confirmed by a number of other industry experts, who stated that they are now seeing structural allocation to private capital among many of their clients, while previously it used to be more of an “optional extra”. Most investors are starting with allocation to private debt of 5-10% and then may increase it to 15-20% over time. As we are seeing high valuation levels in the listed equity space, while low-interest rates create a challenging backdrop for gilts and bonds, private assets can help enhance portfolio returns without as much exposure to risk.

Diversification and capital deployment can be challenging for new investors

Diversification is crucial in private debt and direct lending and can be difficult to achieve for smaller investors. However, diversification is different in private debt vs. public markets as investors do not always have to diversify strategies to the same extent. One manager can have enough idiosyncratic risk in one fund, while liquid markets tend to have more exposure to systematic risk.

When beginning to invest in private assets it is important to ensure that capital is deployed efficiently as one can lose more return from being uninvested, rather than from credit loss.

Direct lending is still in its infancy in disclosure standards and ESG risk management

Disclosure standards in private debt can be very different from one fund to another and understanding the underlying holdings can be often challenging. For charities it is very important to manage their reputational risk and trustees are justifiably worried about the risk of a “Wonga moment”. In 2013, the Archbishop of Canterbury led a campaign against Wonga, a payday lender charging high interest from vulnerable borrowers. The attack misfired when it emerged the church had indirectly held a stake in Wonga through an investment fund. It sold the stake the following year. When charities are investing through funds with poor disclosure, they can blindly walk into something that can lead to reputational damage. At the moment, some of the private asset investment trusts that are listed on LSE and are commonly used by many multi-asset managers (including their charity portfolios) do not have stated ESG policies.

Charities as a sector are very heterogeneous in their ethical views that are influenced by their specific missions. Sustainable investing and managing ESG risks becomes increasingly difficult as one tries to balance a number of parameters and conducts a more in-depth analysis of the underlying risks. A common example is investing in cobalt mining companies with many “green” portfolios, as it is used in electric vehicle batteries. Such investments, however, raised concerns from the Social side of ESG risks given workers exploitation in mining locations such as the Congo.

At the same time, ESG reporting can become overwhelming for private asset funds and for the underlying small companies. The experts discussed that full disclosure of Scope 3 emissions, as an example, can be counterproductive for many small and mid-size companies that should focus on growing their business rather than reporting.

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