Sustainable finance has become a focal point for capital markets participants and will likely gain significance in the years to come. Penfund recently invited RBC Capital Markets to discuss their perspectives on ESG and sustainable finance including implications for middle market lending. Below is a summary of that conversation. Participating in the discussion were Sarah Thompson, Managing Director, Sustainable Finance and Henry Wagram, Vice President, Financial Sponsors at RBC Capital Markets along with Penfund’s investment team.
Q: What’s been the primary driver of the growing emphasis on ESG over the last several years?
A: The main driver has been investor adoption of the wholescale integration of ESG factors into their respective investment processes. Historically, ESG was focused more on negative screening, norms based screening or thematic investing like clean tech or renewable investing. Better data and analytics have given investors the tools with which they can appropriately integrate ESG factors into their broader investment processes.
Q: How has the COVID-19 pandemic changed how investors view ESG?
A: COVID served to shine a spotlight on systemic inequalities. It has effectively evened out the three legs of the ESG stool. Though the focus on climate change has not abated, there is now increased focus on other important societal issues relating to diversity, equity and inclusion; labour practices; and employee wellbeing.
Q: How do investors evaluate a company’s ESG performance and strategy?
A: There are three pillars by which investors evaluate a company’s ESG performance and strategy: 1) how well a company is managing the current impact of its existing operations; 2) how controversies impact ESG ratings and perception; and 3) how the company is positioned to capture growth opportunities with positive environmental and social impacts.
Q: Have you seen instances where enterprise values have been meaningfully impacted by ESG? If so, is there any particular focus around the “E”, “S” or “G” that drove valuation changes more so than others?
A: There have certainly been some high-profile cases. Many readers will be familiar with the “#metoo” movement, which impacted and continues to impact many companies. Other ESG controversies could involve toxic waste spills, community relations or bribery and corruption. Valuation impacts can occur across all three pillars of ESG and can have a meaningful impact on the investor’s view of the business. It is a signal in terms of how well a company is managing its key risks and opportunities.
Q: What ESG diligence are private investment firms doing?
A: Part of the challenge is that much of the ESG ratings and research used in the public markets is simply not available in private markets. More ESG rating agencies are starting to cover private companies within their ratings universe, but that is taking time. This makes voluntary company disclosure very important. At this point in time the key diligence variables are how a company approaches ESG, how they define material issues, and what policies and practices are in place to manage those issues.
Q: Most of the sustainability-linked loan and bond volume has been raised by large-cap, public companies. How do you see that evolving and what does that mean for the middle market?
A: Most adoption has indeed been with investment grade borrowers. Today, larger companies are more advanced in their approach to sustainability and that’s why they have comprised most of the issuance. However, the structure is being adopted across the credit spectrum. In Europe, there is tremendous interest in incorporating these principles into leveraged finance. Private equity sponsors are asking for these principles to be incorporated into leveraged loans and adoption in the U.S. is increasing.
Q: What is driving increased sustainability-linked leveraged finance transactions in Europe relative to North America? How do you see this evolving?
A: Europe has historically been a few years ahead of North America from an ESG perspective. This is true of leveraged loans and middle market leveraged finance as well. ESG and by extension sustainability-linked loans have started to become more prevalent in the U.S. and we expect to see that start to occur in Canada as well.
Q: What are the execution considerations associated with sustainability-linked leveraged finance transactions? Do these loans price at a premium relative to traditional leveraged loans?
A: One key appeal for private equity sponsors is the potential pricing benefit. The magnitude ranges. In Europe, most pricing is tied to KPI or performance targets that can sometimes move the margin ratchet up or down by 10-15 bps. In North America, particularly in the bank market, the standard adjustment is 5 bps regardless of borrower.
Q: Are there any concerns or unintended consequences relating to the increased focus on ESG, both from a societal and capital markets perspective?
A: The biggest concern is greenwashing or making claims around ESG benefits that are exaggerated or untrue. Some participants are also concerned about activity in sustainability-linked products not actually having a meaningful impact. The best way to mitigate these concerns is to align with market best practices, including the LMA/LSTA/APLMA Sustainability Linked Loan Principles. Others worry about the potential for reduced government focus on important ESG initiatives if the private sector assumes more responsibility. We need both public and private sector engagement on these topics.Back to All News
Penfund is a leading provider of junior capital to middle market companies throughout North America. The firm is currently investing its most recently established fund, Penfund Capital Fund VII. Penfund manages funds sourced from pension funds, insurance companies, banks, family offices and high-net-worth individuals located in Canada, the United States, the Middle East, and Europe. Penfund has invested more than $3 billion in over 225 companies since its establishment. Assets under management are approximately $2.8 billion.