A privileged place in Europe’s ESG direct lending space
Unique deal with banks allows investment manager Federated Hermes to overcome asset’s challenges
3 May 2021 | Aaron Leung

Integrating environmental, social or governance (ESG) factors into the private loan investment strategies is more challenging than it is with other asset classes – not only are securities in the private debt market illiquid, the information about the borrowers and the deal-sourcing process continue to be largely private and, therefore, unavailable.

Under these circumstances, direct lending portfolio managers, who are already under pressure to source suitable deals for investment capital, will find the job even harder if an additional layer of ESG due diligence requirement is added. This explains the reason why ESG direct lending strategy is rare in the market.

So it is surprising to hear Patrick Marshall, head of private debt, at investment firm Federated Hermes, which integrates ESG into direct lending portfolios, say “I know if I turn down an opportunity, by the time I get back to my desk after making myself a coffee, I have another one waiting for me.”

Such privilege is secured, according to Marshall, because Federated Hermes signed a number of legally binding agreements with the major European banks (including Danske Bank, DZBank, RBS, and KBC). These exclusive agreements require the banks to show all the loan opportunities in the region to Marshall and his team.

Banks, following the 2008 financial crisis, had to reduce their loan limits to a single borrower in order to strengthen balance sheets and meet increasingly stringent regulatory requirements.

If the loan size exceeds the limit, banks can choose to either syndicate the loan and distribute it to the investors, or to invite their competitors to lend alongside. Neither way is ideal.

On the one hand, if the bank chooses to syndicate the loan, it has to take syndication risks. The underwriter will have to absorb any unallocated amount of the loan in the event of insufficient investor interest. The underwriter will also need to face regulatory risks if the unallocated amount exceeds the lending limit and triggers a regulatory breach after absorption.

On the other hand, if the bank invites its competitor to lend alongside, the competitor will compete with them for the clients on providing ancillary business such as opening bank accounts, hedging and all other fee-earning businesses.

This give space for non-bank creditors to thrive and Federated Hermes is one of them. By lending alongside with the non-bank creditor, the banks can still lend to their clients and retained the ancillary business with their clients, without fearing that the competitors will grab the clients. Federated Hermes, in exchange, gains access to lending opportunities that their investors client can never get elsewhere normally.  

With a secured pipeline of deals, Marshall and his team can be very disciplined in their investment process by negatively screening out companies that have material ESG risks. Apart from screening out companies that are generating 5% of its revenue from the controversial sectors – alcohol, tobacco, gambling, pornography, weapons, coal, ship-breaking, GMO animal testing, palm oil, destructive fishing, and deforestation – companies that generate 15% of their revenue by servicing these controversial industries will also be screened out. “Conferencing companies that service the defence industry or marketing company that does most of the business for marketing tobacco industry will also be excluded,” Marshall explains.

In addition to a stringent negative screening process, Marshall and his team, if needed, can also add a legal clause in the loan agreement, specifying that a default will be triggered if the borrower fails to resolve the ESG issues within a time limit.

“The reason we take this strict approach is because we can guarantee that these ESG issues will be sorted out ultimately,” Marshall notes. “There is another approach, like a green bond, offering a discount on the loan rate if the company can sort out those ESG issues. The problem is that it tends to be a reduction of yield of around 2 to 10 basis points. From a small and medium-sized enterprise’s point of view, it is around €10,000 per annum. And one cannot be sure if the company will change its behaviour with the likelihood of saving €10,000 per annum.”

While this all sounds good, it has a limitation. This approach is unique to Europe and is hard to replicate in the US where a sizeable direct lending market is present. The two markets are different in a couple of other important ways.

First of all, the nature of the borrowers is different. In Europe, borrowers tend to come from the pharmaceutical, healthcare, business services, education and IT software industries. These industries are less materially exposed to ESG risks compared with their US counterparts, which are majorly generally part of the oil production industry. Therefore, a hard-line approach on ESG may not be suitable in the US.

Second, the legal environment in Europe offers better protection for investors than it does in the US. If a company defaults on its obligations and files for bankruptcy in the US, it gets 18 months of Chapter 11 protection from its creditors. The usual consequence is that, during those 18 months, the company continues to leak cash and, consequently, the recovery rate is low. Therefore, even though one can choose to take a strict approach to ESG, a portfolio’s performance will be impacted.

Unlike in the US, the Northern European legal environment is very creditor friendly. As soon as a company defaults, creditors can go straight in and restructure it. “You recover in excess of 85% in Northern Europe, compared with about 70% to 75% in the US,” Marshall points out.

Third, the Europe direct lending market is still predominantly a bank market unlike the US where retail investors are heavily involved.

As a result, securing deal sourcing with the banks allows Federated Hermes team to meticulously integrate ESG criteria into its deals.

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