Private Credit

The term ‘private debt’ is typically applied to debt investments which are not financed by banks and are not issued or traded in an open market. Private debt investments are typically used to finance business growth, provide working capital, or fund infrastructure or real estate development. In private debt investments, the primary focus is typically on protecting the downside risk that may lead to a default. The analysis and integration of ESG factors provides an additional level of risk analysis and has therefore been embraced by a growing number of investors. Several other pressing factors are driving the private debt sector to consider sustainability such as the mandatory disclosure regulations and the increasing demand for sustainable products.

Stafford Private Credit invests in the semi-liquid and private credit funds with highly experienced specialist credit managers. Our private credit portfolio consists of primaries, secondaries and co-investments, primarily in North America and Europe, across the liquidity spectrum in direct lending and specialty finance opportunities.

Stafford Private Credit in a nutshell*

2017

Launch year

USD 200m

Assets under management

18

Fund and co-investments

*Data as of December 31, 2021.

ESG integration in private credit

Private credit is a relatively new asset class within alternative investments when compared to more established areas like private equity or real assets. Therefore, it is not surprising that private credit managers are less advanced in terms of ESG integration in comparison to private equity. According to our 2021 ESG survey, conducted through the new PRI online reporting tool, just about one-third of private credit fund managers are signatory to the UN PRI, incorporate ESG considerations in their investment decisions and report ESG information to theirLike in other asset classes, the most practiced responsible investment approaches in terms of objectives within private debt are negative and positive screening, thematic and impact investing, ESG integration and engagement. The private credit strategy of Stafford is focused on investing in and alongside private credit managers and applies ESG integration and engagement, combined with negative screening.

While in certain asset classes, like private equity, ESG integration has become a mainstream practice, this is not the case in private debt, where it is still nascent, though increasing in importance. A survey of asset owners, performed by bfinance in 2021, showed that 67% of investors surveyed in the private debt sector partially or highly integrate ESG, compared to 76% in private equity and 92% in developed market equities.1 The report also states that in private lending decisions, one of the most common integration strategies is negative screening, where exclusion criteria are applied within a portfolio so that investors will not provide credit to companies that are active in sectors considered harmful by the lender, e.g., the tobacco industry.

 

Sustainability-linked loans

In the direct lending space, sustainability-linked loans became more common in the past years. Most of these loans have been based on margin ratchets – designed to reward borrowers for meeting key performance indicators by reducing the interest on their loans if they meet certain targets. It is expected that the next phase of development will focus on the covenants of the loan, where the breach of an ESG covenant could result in penalties. When it comes to specialty finance, which includes strategies such as credit opportunities, non-performing loans and royalties, the managers are much more involved in the operations of the business and are (similar to private equity managers) well placed to be influential and hands on partners.

Monitoring private credit managers’ ESG performance

The results of Stafford’s 2021 manager ESG survey, conducted via the renewed PRI reporting tool, concur with the conclusion of the Bfinance report. It was noted that just about one-third of the private credit fund managers who participated in the survey, were signatory to the UN PRI, incorporated ESG considerations in their investment decisions and reported ESG information to their investors. All responding fund managers from our private credit portfolio stated that they had an ESG policy in place.

Highlights from 2021 ESG manager survey

33%

PRI signatory

100%

ESG policy in place

33%

Reports ESG data to investors

33%

ESG incorporated in investment decisions

Source: Fund managers, PRI, Stafford; data as of December 31, 2020.

 

Fund managers’ responses to the 2021 survey were assessed and scored, and the scores then translated into star ratings.1 The distribution of ratings for private credit managers who responded to our 2021 ESG survey is showed in the figure below.2 A five-star rating reflects the current best practices in the investment management industry while one star suggests a very early stage ESG integration.

Based on our discussions with numerous private credit GPs we can conclude that the ratings of managers in our private credit portfolio might be a good representation of the status of ESG integration in private credit. While a growing number of private debt fund managers reports on their ESG activities, their efforts and results vary widely. On the one side of the spectrum are the managers who have just started incorporating ESG elements in their pre-investment analysis. At the other end are managers that have made substantial progress in ESG integration and are monitoring the impact of their investments on the Sustainable Development Goals and measure carbon emissions of the companies they finance. This is also reflected in the managers’ ratings.

 

Distribution of private credit fund managers' star ratings for responsible investment and stewardship policy

Source: fund managers, PRI, Stafford Capital Partners; scores as of 03/08/2022, based on December 31, 2020, data.

Generally, the biggest challenge for ESG reporting in private markets is the collection and tracking of the relevant data. ESG information for non-listed companies is normally more difficult to collect and third-party data is not available. Small and middle-sized companies, which dominate private markets portfolios, face intense data collection challenges by nature. Considering the mandatory EU disclosures on how sustainability risks are managed and their impact on financial performance of investments, we observe that managers are strengthening their data gathering processes and improving data quality of ESG indicators to support better performance management at a portfolio level.

 

Engagement with private credit managers: an example

Stafford started a dialogue on ESG reporting with a private credit GP early in the 2021 reporting cycle. The manager was considering signing up to the PRI and was new to ESG reporting. After responding to the PRI questionnaire, we shared the initial assessment results with the manager, providing a detailed analysis of the areas in which the manager falls behind the industry best ESG practices and the policies and ESG integration practices of their peers. We discussed how the manager can decrease the gaps in these areas and shared an ESG tool for private credit managers which has been developed by the PRI-led working group.  

The manager has since signed up to the PRI and we plan to have further dialogue once the PRI 2021 assessment reports have been finalized. We see this as a good example of an engagement with a GP that was at the beginning of its ESG journey just a year ago and is making significant steps in ESG integration and reporting, also through Stafford’s engagement efforts. 

[1] The star ratings are assigned based on the percentage scores across managers of all sectors as follows:

Percentage thresholds Number of stars
0 ≤ 25% 1
> 25 ≤ 40% 2
> 40 ≤ 65% 3
> 65 ≤ 90% 4
> 90 ≤ 100% 5

[2] Stafford used the PRI’s 2021 survey and assessment methodology. Managers are being assessed on multiple indicators that are related to their responsible investment policy, strategy, governance, stewardship, climate change and transparency. The resulting ISP score ranges between 0% to 100%. Details on the PRI’s 2021 assessment methodology can be found here: https://dwtyzx6upklss.cloudfront.net/Uploads/v/g/y/2021_assessmentmethodology_jan_2021_403875.pdf