Lifting the lid on ESG integration in private markets

ESG

By Shuen Chan, head of ESG at Legal & General Investment Management Real Assets. 

Demand for private market investments has continued to grow in the ever-present search for yield and while there remains much uncertainty around the financial impact of the Covid-19 pandemic, we believe the events of the last year could act as a catalyst for increased levels of demand from investors who wish to invest in social and environmental solutions with real world impact.

However, the asset class also presents a set of challenges for investors. While the integration of ESG criteria into public equity and credit portfolios has been significantly improving over the last few years, in private assets this has been much more difficult to implement due to the inconsistency in ESG data disclosure.

As such, we must ask how long-term investors can incorporate ESG analysis to optimise portfolio risk within private market assets and what developments and opportunities we may expect to see in this under-explored sector in the near-future. 

At LGIM, we manage a large diversified private credit portfolio consisting of corporate and alternative debt, infrastructure and real estate debt.

Private credit and equity versus public markets

At LGIM, we engage on behalf of all of our clients’ assets across debt and equity exposures. One of the key differences between private credit and public assets is the topic of voting rights. Public and private equity investors can influence company policy, operations and decisions. As owners, they have a degree of influence over the day-to-day management of their assets and can therefore seek to bring the company into alignment with sustainable practices. 

But for debt investors, including public and private credit influence is limited by virtue of being a creditor (lender) rather than a shareholder (or owner). These debt investments tend to have a long time horizon – often of ten years or more – while their more illiquid nature also means that exiting them before the intended time horizon can be difficult. 

As such, it is crucial for private credit investors to assess a company or project’s ESG credentials as part of their investment process to ensure that they are comfortable with such long-term exposures, and where possible engage with their borrowers on material ESG risks.

Another key difference between public and private markets is the data. The quantity and quality of ESG data available to investors in public markets has multiplied over recent years. However, with companies in the private credit space, it remains clear that the journey is only just beginning. Due to the diverse nature of the asset class, there is currently no market standard for ESG management and disclosure. While we at LGIM are championing several initiatives and working with industry bodies and borrowers to improve the comparability of data sets, along with consistency of reporting, this remains an area where further work is required. 

Looking ahead, we believe there are plenty of reasons to be excited about opportunities for investments with strong ESG profiles in private credit and to have real world impact. We highlight some key areas below:

Renewable energy: As renewable energy becomes a greater proportion of our energy mix, it continues to attract support from the government and from private investors. With increasingly ambitious climate change targets, the number and scale of projects has been increasing.

Social – affordable housing: The UK continues to suffer from a shortage of affordable housing, with 1.3 million households on local authority waiting lists. Private capital will be a key role in ensuring this gap is closed. For example, we recently made a GBP100 million long-term loan to Bromford Housing Group, the largest provider of affordable homes across Central and South West England.

Smart/low-carbon grids: In addition to more visible clean-energy projects, such as wind turbines and solar panels, we believe there are also opportunities in interconnectors and Offshore Transmission Owners (OFTOs). These are key parts of the system for transmitting energy to homes and businesses, and to different countries. Renewable energy output is less predictable than fossil fuels, and interconnectors enable countries to import power to maintain a constant supply and create the greenest, most cost-efficient energy mix possible. 

Sustainable outcomes 

By supporting transparency, data availability and disclosures, we aim to improve ESG standards across the private credit market. This should facilitate further qualitative and quantitative ESG analysis of the asset class, leading to better and more sustainable outcomes for investors, in our view.

More broadly, as the world faces multiple global systemic crises – from the pandemic to climate change – we believe that now more than ever before is the time for responsible investing, regardless of asset class. 

Rather than being an obstacle, the private nature of the private credit market can also mean that many investment opportunities, from clean energy to social housing and infrastructure, are naturally aligned to more sustainable and resilient investment objectives by virtue of their purpose and the long-term solutions they contribute towards.