Sustainability-linked loans are among the new ways lenders are providing incentives for middle market companies to strengthen their ESG practices.
Approaches to ESG in private credit have become increasingly sophisticated, with lenders adopting a variety of innovations to encourage better and more sustainable practices. But there is still progress to be made, and investors, sponsors and lenders will play an integral role.
Private Credit Demands a Unique Approach to ESG
For a number of reasons, private credit requires an approach that is distinctly different from the way ESG analysis is applied with publicly listed equity and fixed-income investments. Even though every borrower must be evaluated on a case-by-case basis, certain broad considerations must be kept in mind. First, private credit is an illiquid asset class, with a typical life cycle of three to five years. In contrast to the broadly syndicated markets, there is little or no ability to trade in and out of loans or to sell out of a deal. Additionally, unlike equity investors, debtholders do not own shares of the company or sit on company boards. As a result, debtholders cannot directly influence company behavior or decision-making. These factors greatly increase the importance of conducting ESG due diligence up front and getting it right.
The attributes of the middle market companies that private credit investors loan to must also be considered. At Barings, we define the middle market as companies with earnings before interest, taxes, depreciation, and amortization (EBITDA) in the range of $20 million to $75 million. These mid-sized companies are often at an earlier stage of their development than large, publicly traded companies are. While many of these middle market companies are committed to addressing ESG issues, they generally do not have the same resources as larger firms. With staffs of anywhere from 50 to 500 people, for example, many of these companies do not have teams that are fully dedicated to ESG and sustainability—and often do not produce the substantial quarterly ESG and sustainability reports that many large companies now distribute. Additionally, they may also be earlier in their progress toward the detailed, specific procedures for implementing ESG principles that many larger firms already have in place.