Unearthing environmental, social and governance (ESG) risks is particularly cost- and labour-intensive in respect of illiquid investments such as private credit, argue insurance and pension investment executives.
This is a key issue for asset owners globally, given the the sharp rise in popularity in recent years of both private market and ESG-related investments.
The cost of applying an ESG focus to illiquid assets is higher than doing so for public securities because of the greater scrutiny required, Michael Eakins, chief investment officer at UK life and pensions firm ReAssure, said last week.
“[Illiquid assets] cost more to manage both in terms of our engagement with the managers and to avoid [ESG risks],” he said during a panel discussion at the Insurance Asset Management Summit hosted by Clear Path Analysis.
More experienced staff with very specific skill sets are required to screen the ESG aspects of illiquid assets alongside more traditional factors like creditworthiness, Eakins added.
The challenge is particularly intense in the private credit space, he said. That is because assets in sectors such as real estate or infrastructure debt are generally bespoke arrangements between the borrower and the lender, so research must be done on a case-by-case basis.
“It’s not possible just to come in and apply a cookie-cutter approach. We do a very detailed ESG screening,” Eakins said.
Such analysis is much easier to carry out on public securities, he added, as most of the necessary information is available on third-party services such as Bloomberg.
ESG risks are often buried in loan portfolios, Eakins said. He cited as an example a recent infrastructure debt arrangement that ReAssure had considered participating in. It involved a British company that undertook construction projects including schools and other local authority developments.
“We turned down that investment, just because it had the possibility that some of the funds could have been used for building and financing privately managed young offenders’ institutions,” he said.
ReAssure invest in custodial services by the private sector for social and reputational reasons, Eakins noted. In short, they don't want to be profiting from locking people up.
Mark Hedges, chief investment officer of Nationwide Pension Fund, made a similar point recently. The UK retirement scheme had turned down one US private credit fund this year because one of the loans was to an online gun sales business.
“We felt we couldn’t take that kind of reputational risk,” he told AsianInvestor. “The manager was very good. We liked the fund's underwriting and everything else, but we felt uncomfortable with the assets related to gun sales.”
It takes a lot of time and effort to adequately assess private debt opportunities, where a single loan could prove very hazardous, Hedges added.
ESG analysis provides a vital dimension to the company’s due diligence before buying a private illiquid asset, such as a commercial mortgage loan, agreed Adam Ruddle, senior investment manager at UK-based insurance company
“ESG really factors [in] making sure we understand the terminal value of the cash flows that are being used in that asset,” he added, speaking on the same panel as Eakins. “If something comes in a few years into the asset and cuts short those future cash flows? That's a big, big problem for us.”
WORTH THE TROUBLE?
Indeed some asset owners feel certain ESG-related unlisted investments may not be worth the trouble – one being John Pearce, CIO of Australia's Unisuper.
The retirement fund has not prioritised alternative assets in respect of climate change-related investments, “as the opportunities in the unlisted space can be niche, may not become commercial and have a higher administrative burden – and higher fees – to identify and assess”, Pearce told AsianInvestor last month.
Still, there are ways in which private credit investors can incorporate ESG principles, said an August report on the Asia private credit market by the Alternative Credit Council (ACC), part of the London-based Alternative Investment Managemement Association.
These include sustainability-linked loans, which set the borrower sustainability performance objectives; sustainable trade loans, which embed ESG principles into supply chain finance and sustainable securitisation; and green bonds. The OECD estimates that the annual issuance of sustainable asset-backed securities could reach $380 billion in the 2031–2035 period.
The ACC said private credit opportunities would increase in Asia as a result of Covid-19, as governments' post-pandemic growth plans fuelled demand for private capital, particularly among small and medium-sized companies.
“Covid-19 [has] increased the focus on sustainable financing projects,” the report added. ”Government policy across Asia is encouraging investment in more sustainable business models, technologies and consumption patterns."
Joe Marsh contributed to this article.