Private debt started in 2008 as an answer to bank retrenchment, but as time goes on, its reach has extended far beyond the purely financial. “Lenders like Ares can provide more than just capital. We can share resources to portfolio companies and sponsors alike to help drive greater ESG integration,” said Fitzgibbon. “Structuring sustainability-linked loans (SLLs) is a way to do this.”
Sustainability-linked loans are a way of incentivising borrowers to comply with ESG targets in a similar way to which performance-related loans might reward the hitting of financial targets. SLLs typically include sustainability targets (STPs). If the borrower reaches these targets, they can benefit from a decrease in the margin that they pay the lender. Conversely, if they fail to meet the STPs, they may instead face a margin uplift. The so-called one or two-way margin ratchet is determined on a case-by-case basis with Ares and designed specifically for the borrower.
Driving a sustainability agenda
It is useful, said Fitzgibbon, in an industry that is still in the process of adopting sustainability characteristics. “In our experience of offering sustainability-linked loans and integration of ESG principles, we have observed that about one-fifth of sponsors and just under half of the borrowers we have engaged with do not have a formal ESG plan,” said Fitzgibbon. “That’s where we see opportunity.”
The opportunity, according to Fitzgibbon, extends beyond individual borrowers to developing ESG standards across private credit. “Ares is committed to being a leader in the industry dialogue to develop ESG standards. The global alternative investment manager is chair of the United Nations Principles of Responsible Investment Private Debt Advisory Committee, something that it believes can help shape market standards in this area.”
On top of this, Fitzgibbon points out that the industry body Loan Market Association and the Loan Syndications and Trading Association have published “sustainability-linked loan principles, in which key areas of agreement are that there should be third-party verification on outcomes related to STPs and that ESG targets should be material beyond traditional business operations.”
Multiple parties in a deal
However, private debt often shares its interest in the underlying borrower with a private equity sponsor. The sponsor will also have ESG criteria, and the trick is to get these to align rather than to burden the borrower, or worse, even create conflicting incentives.
“Ares typically has worked to align incentives with sponsors and borrowers to improve their ESG initiatives,” said Fitzgibbon. “One of these aims is to establish tangible STPs that are aligned with the overall business strategy.”
This also applies to other lenders in the deal--where they occur. The results of this kind of work have been promising. “The industry has increased adoption of sustainability characteristics in private debt funds, and we have seen a convergence around Article 8 [where a financial product promotes environmental and sustainable characteristics] funds,” said Fitzgibbon.
In fact, the industry is beginning to understand that financial performance climbs hand in hand with better ESG. “Nearly 70% of LPs surveyed by the Institutional Limited Partners Association have investment policies that include an ESG approach, with one of the primary motivations being the belief that ESG factors are additive to performance.”
This article originally appeared in the Delano 2022 alternative funds supplement