While fund managers have, for a number of years now, been demonstrating their commitment to ESG by signing up to the UN’s Principles for Responsible Investment (PRI) or having an internal ESG policy in place, the introduction of new regulations such as the EU’s Sustainable Finance Disclosure Regulation (SFDR) has meant that fund managers can no longer just ‘talk’ about ESG investing but must also ‘walk the walk.’
As such, subscription credit facilities (‘sub lines’) linked to ESG metrics are fast becoming a new trend, with market giants such as EQT, Carlyle and Eurazeo having all used ESG sub lines over the course of last year. This is a trend that is set to grow, with a number of sponsors willing to commit to a more sustainable approach to investing by putting their margins at stake.
Sub line boom
An ESG subscription credit line is a type of revolving credit facility linked to a set of predefined ESG metrics, primarily used by alternative asset funds. It can be a useful tool in bringing transparency to ESG investments in the private markets. The way ESG sub lines are structured largely depends on the agreement between the sponsor (the GP) and the primary bank; though often a fund agrees to a specific set of ESG metrics to adhere to when using the line’s proceeds.
Within this structure, the fund has a financial incentive to work towards attaining predefined ESG objectives, benefitting from margin rebate if its ESG metrics are met. Equally, however, the fund risks a financial penalty in the form of a margin penalty if these metrics are not met. There is also the case that the lending banks can add direct additional fees if a fund does not meet its ESG metrics.
While sub lines have a financial impetus to them, should a GP not meet its ESG targets, having to explain why to their investors acts as an arguably more meaningful incentive to perform.
Which ESG metrics to choose?
Once a fund has chosen to deploy an ESG sub line, the next step is choosing which ESG metrics to follow. Based on the strategy of the fund or overall vision of the asset manager, there are a number of frameworks they can choose to follow, such as the PRI or the Big Four accounting firms’ “Four Pillars of ESG” reporting standards (developed in collaboration with the World Economic Forum), or even internally agreed upon metrics, such as ESG standards that are tied specifically to boardroom diversity in a fund’s portfolio companies. Once the ESG metrics have been agreed upon by the fund and the lender, an external service provider is typically brought in for the computation, assessment and reporting on the ESG metrics.
Turning traditional sub lines into ‘green’ lines will have an impact on an asset manager’s costs, as they will need additional resources, especially on the ESG reporting side. However, banks are making advances in the ESG space and soon will be able to replicate the technology, processes and reporting in the subscription finance market to make the ESG sub line more accessible to funds of all sizes. At their current stage, ESG sub lines are mainly offered to asset managers who are already far along in their ESG journey.
Putting your margin where your mouth is
The question remains of how to further incentivize GPs to meet their ESG metrics. The future of private equity investing might include a link between achieving sustainability standards and the amount of carried interest GPs receive. Some impact investors are attempting to address this by tying a portion of GP compensation to the social and environmental performance of a fund. Other funds have employed unique tactics to raise their GP’s financial stake, such as distributing carried interest to a non-profit organization when a GP has not met their impact targets. This mechanism serves as an impact hedge, ensuring that any amount of unallocated incentive is used to achieve a specific social impact.
LPs are taking a variety of approaches to ensure asset managers are invested in and monitoring their ESG progress, but across the board they are looking for authenticity from their GPs when it comes to ESG. The use of subscription credit facilities is an excellent way to demonstrate a fund’s commitment to ESG, with asset managers putting their margins where their mouths are.
Justin Partington is group head of funds at IQ-EQ in Luxembourg