Private credit and ESG have been dominating finance headlines recently.

In the ever-evolving landscape of investments, private credit, or non-bank lending, has emerged as a force to be reckoned with. Simultaneously, Environmental, Social, and Governance (ESG) considerations have taken centre stage as the world grapples with pressing global challenges. Together, the fusion of private credit and ESG considerations has the potential to reshape the financial industry and propel us towards a more sustainable and equitable future; however, we envisage that the journey presents challenges that need to be navigated with care. 

ESG integration in private credit is more than a passing trend; it is a fundamental aspect of risk management and value creation. Investors are increasingly demanding transparency and accountability regarding the environmental and social performance of their portfolios. This is typically achieved through "ESG margin ratchets" that link borrowing costs to specific ESG criteria. These innovative financing structures incentivise borrowers to improve their ESG performance, and may also penalise them for poor performance. 

Our analysis of a sample of leading private credit managers operating in the mid-market space revealed that up to 25% of loans in European strategies include margin ratchets. These margin ratchets entail an average reduction of 7 basis points for each Key Performance Indicator (KPI) and encompass the monitoring of an average of four KPIs in total. The average cumulative discount amounts to nearly 30 basis points. Our initial view is that discounts are small given how much deal pricing has benefitted from higher base rates and origination fees. This might limit their effectiveness in incentivising better ESG performance. Nonetheless, data inconsistency limits our ability to confirm whether these findings are representative of the entire market. 

Around 70% of these ratchets are “one-way”. A one-way ESG margin ratchet adjusts the cost of capital solely based on improvements in a company's ESG performance.  A two-way ESG margin ratchet adjusts the cost of capital both upward and downward depending on the company's ESG performance. We believe a two-way ESG margin ratchet provides stronger incentives for companies to maintain or improve their ESG performance, as the cost of capital can increase as well as decrease. 

About 75% of the deals in our sample were concentrated in sectors such as Industrials, Healthcare, and Consumer Discretionary. Notably, the Consumer Discretionary sector, one of the three sectors with the highest greenhouse gas emissions (sum of scopes 1-3), exhibits an average discount of around 10 basis points – about 40% higher than the average discount. We found that most KPIs are aimed at reducing emissions. 

There are still some uncertainties regarding the effectiveness and practicality of ESG margin ratchets. There are challenges in applying standardised ESG criteria across different industries and geographies, in addition to the difficulty in accurately measuring and verifying a company's ESG performance. 

Whilst it is possible to incorporate complex structures such as hybrid, reset, and combination ratchets, we found that in practice simple ratchets are used: either binary ratchets that apply a fixed increase or decrease in borrowing costs based on meeting or failing to meet specific ESG targets, or tiered ratchets that adjust borrowing costs on a graduated scale according to ESG performance. 

Other findings from our analysis include the use of third-party assessments in around 55% of the analysed loans to evaluate margin ratchet strength and verify data. Although encouraging, we believe there is room for improvement in this metric. We did not find any significant relationship between interest margin, opening leverage, opening loan-to-value, and the average discount. It will be some years, and will require a larger dataset to be maintained through a credit cycle, before we can determine whether the existence of ESG margin ratchets reduces the likelihood of default. 

Managers who have joined the Net Zero Asset Managers Initiative tend to make greater use of ESG margin ratchets and have stricter requirements for applying discounts. We were pleased to see some managers incorporating KPIs for each aspect of ESG, despite the current predominance of environmental-related KPIs. 

Despite the growing importance of ESG factors in investing, ESG margin ratchets are not yet widely adopted by private credit managers. Consequently, it is still early to fully evaluate the extent of their impact. We anticipate gaining a clearer understanding starting from 2024 when most KPIs will undergo their first evaluation. We expect ESG margin ratchets to gain more prominence, driven by the increasing significance of ESG considerations in investors' agendas.