By Emilie Juel and Prof. Kristjan Jespersen
With the planet facing unprecedented environmental challenges, social inequality, and governmental issues, financial institutions and regulators are rethinking traditional investment schemes and recognizing the potential of investments driven by sustainability. However, the unique characteristics of the private debt asset class, relative to more tangible asset classes, have caused a slow and turbulent progress in integrating ESG standards in their investment processes. Research on the intercept of ESG integration and private debt funds is very scarce. As a result, researchers have not been able to portray how ESG is being integrated into the investment practices of private debt funds.
Introduction
Private debt funds have gained significant traction as an alternative asset class, offering investors attractive returns with lower volatility compared to equity investments. However, the integration of environmental, social, and governance (ESG) considerations in private debt investments has been an area of growing importance. The thesis research of the master’s student, Emilie Juel, aims to explore the current state of ESG integration in North Western European private debt funds, examining their understanding of sustainability, use of practices, ESG reporting, barriers of integration, effect on investment decisions, and the future outlook.
Understanding sustainability and current sustainable practices to integrate ESG
The first objective of this study is to investigate how North Western European private debt firms define and understand sustainability. A shared understanding of sustainability is crucial for the effective incorporation of ESG considerations. Research suggests that private debt funds utilize recognized ESG labels and frameworks such as the UNPRI, GRI, and SFDR to guide their ESG integration. However, the level of commitment to ESG varies among private debt managers. Some managers show less seriousness about their ESG commitment, potentially due to concerns about greenwashing. The issue with ESG claims and reporting of private credit funds is the privacy of underlying portfolio data. On the other hand, a majority of private debt firms are indicating a growing commitment to making ESG an integral part of the investment process, but the lack of a how-to manual is hindering progress.
The second objective is to shed light on the current practices of North Western European private debt firms in integrating ESG considerations into their investment processes. Private debt managers in this region employ various approaches to ESG integration, with negative screening being the most prominent. Additionally, an increasing number of managers are utilizing internal or external rating frameworks, impact investing, and sustainable linked loans (SLL) to incorporate ESG considerations. However, the lack of comparable high-quality data poses challenges in fully implementing these practices. Collaboration and knowledge sharing among industry peers can play a crucial role in improving ESG practices and reporting schemes in private debt.
Barriers hindering more sustainable debt
The research highlights the difficulties faced by private debt managers in integrating sustainability considerations. Obstacles include the lack of comparable and high-quality data in private companies, limited means of measuring sustainability comprehensively, and the time-consuming nature of assessing ESG factors within the short turnaround time of debt investments. Inadequate internal expertise and a scarcity of external consultants with sufficient knowledge of private debt also pose challenges. Also, the significant use of unverified internal rating schemes with little to no validation or insight highlights the risks of inefficient ratings and greenwashing of debt vehicles. Additionally, the limited control over portfolio companies and restricted access to monitoring ESG create distinct obstacles for private debt firms in enforcing ESG standards and unifying integration practices.
The Future of ESG Integration in Private Debt
The future of sustainability in the private debt market remains uncertain yet promising. Capital allocators are increasingly pressuring private debt managers to prioritize sustainable investments, and regulatory bodies are taking steps to address issues related to disclosures, data quality, and greenwashing. Collaborative initiatives from organizations such as EBF, UNPEFI, UNPRI, and EU UN are working towards providing guidance and promoting sustainable investing. However, questions arise regarding the responsibility of private debt managers for the sustainability impacts of underlying assets, with varying perspectives on the extent of their accountability.
To address the challenges and achieve meaningful ESG integration, a collaborative effort from investors, regulators, and other stakeholders is required. Balancing fiduciary duties and ESG considerations will be crucial for private debt managers. Collaboration, knowledge-sharing, and standardization of ESG data can facilitate progress in this domain. Especially across general and limited partners as well as asset class types. By fostering broad collaboration, enhancing transparency for investors, and deepening ESG integration, the private debt sector can align its practices with the growing global sustainability agenda. A tailored regulatory system of rating debt and credit products equally through transparent processes will facilitate more truthful ESG insight. The journey towards a truly sustainable private debt market continues, with opportunities for further exploration and research on the horizon.
Closing thoughts
The integration of ESG considerations in private debt funds in North Western Europe is gaining momentum but still faces challenges. While private debt firms are increasingly recognizing the need for ESG considerations in their decision-making processes, there is still a strong reliance on financial factors that outweigh ESG factors. Quantitative standards and metrics to influence investment decisions based on ESG scores are lacking, and the subjectivity of ESG scores necessitates external validation to avoid potential biases.
Addressing these challenges and achieving comprehensive ESG integration in private debt funds will require collaboration among investors, regulators, and other stakeholders as well as regulated tailored debt rating processes. Transparent and high-quality data on private companies, along with improved means of measuring sustainability, are crucial for effective integration. Additionally, private debt firms need to enhance their internal expertise and seek external consultants with specialized knowledge in private debt and ESG. Nonetheless, the regulatory landscape is evolving, with increasing demands for transparency and accountability in ESG practices. Regulators are taking steps to address issues related to disclosures, data quality, and greenwashing. Striking a balance between fiduciary duties and ESG considerations will be essential for private debt managers, who must navigate evolving regulations while fulfilling their responsibilities to investors. Standardization of ESG data and reporting schemes can play a vital role in facilitating progress in ESG integration. Collaboration and knowledge-sharing among industry peers, including both sponsored and non-sponsored general partners, will contribute to developing best practices and improving ESG integration across the private debt sector.
The future of sustainable private debt holds promise, with growing global sustainability agendas and increasing pressure on capital allocators to prioritize ESG considerations. However, ongoing efforts are necessary to address the challenges, adapt to changing regulations, and foster a collective commitment to responsible investing. The integration of ESG considerations in private debt funds in North Western Europe is gradually progressing. While challenges related to data availability, measurement methodologies, and time constraints persist, there is a growing recognition of the importance of sustainability in private debt investments. By collaborating, sharing knowledge, and standardizing ESG practices, the private debt sector can align its practices with sustainable investing goals and contribute to a more responsible and sustainable financial system. The journey toward a truly sustainable private debt market continues, with opportunities for further exploration and research on the horizon.
This research will be shared with the involved private debt investment managers across North Western Europe to facilitate a greater understanding of ESG integration across the sector, as well as with the UN PRI to assist the research of the field.
About the authors
Emilie Juel has formerly worked as an investment analyst at Nordic Investment Opportunity, working with alternative investments as part of NIO’sinvestment team.She is currently positioned as an investment banking associate at FIH Partners, where her focus is centered on financial advisory, modelling and valuation. She recently obtained her master’s degree in Applied Economics and Finance from Copenhagen Business School (CBS), where her research explored the connection between financial concepts and sustainability, particularly focusing on the private debt sector. Emilie also holds a minor in ESG & Impact Investments as well as a bachelor’s degree in European Business from CBS.
Prof. Kristjan Jespersen is an Associate Professor in Sustainable Innovation and Entrepreneurship at the Copenhagen Business School (CBS). Kristjan is an Associate Professor at the Copenhagen Business School (CBS). As a primary area of focus, he studies the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance. He has a background in International Relations and Economics.