1 Dec 2021
by Adinah Shackleton & James Greenwood

Permira Credit on why LP expectations are shifting

"ESG has become a more holistic exercise, incorporating every aspect of the investment life cycle, as well as how we operate ourselves as a firm."
James Greenwood - CEO of Permira Credit

Direct lenders may not have the same level of strategic control of companies as private equity firms, but expectations around ESG are no different, say Permira Credit CEO James Greenwood and Permira’s head of ESG Adinah Shackleton.

How has the focus on ESG within private credit evolved in recent years?

James Greenwood: ESG has played a role in direct lending ever since I first started out in the industry, but the focus has certainly broadened to include greater attention on social and governance issues, where the link to cost and return may be less direct.

I would also say that the emphasis has widened from pre-deal analysis and screening to include post-investment engagement and monitoring, as well as reporting to our investors. ESG has become a more holistic exercise, incorporating every aspect of the investment life cycle, as well as how we operate ourselves as a firm.

How have attitudes towards ESG changed among your limited partners?

James Greenwood: Interest in ESG from our investors has grown exponentially, even in the last three years. We are asked questions on all aspects of ESG during almost every investor call that we have.

Adinah Shackleton: There has been a real evolution across our last three funds. Investors have moved from limited questioning on ESG to a deep- dive approach. LPs are also no longer restricting their assessment of our ESG credentials to our due diligence processes; they want to understand our approach to stewardship and reporting as well. They want to know how we collect and share data and what KPIs we use.

LP expectations have really shifted in recent years and in many ways are now similar to those that we see on the private equity side of the business. There is obviously a different relation- ship with the underlying company in the context of credit, but the expectations are very much the same.

How are regulatory drivers informing your approach to ESG?

Adinah Shackleton: There has been a wave of regulation and we are continually monitoring these developments. It started with what has come out of the EU in terms of the Sustainable Finance Dis- closure Regulations (SFDR) and the EU Taxonomy. The EU is now also looking at a Corporate Sustainability Reporting Directive, which will impact more companies than previous regulation and should lead to better data for investors like us. And the UK is developing its own climate and sustainability disclosure regulations.

We are looking carefully at what all this means for our investment and engagement processes, including what in- formation we need now and may need in the future, and how we can increase engagement with portfolio companies around reporting and performance improvements.

How challenging is it collating and reporting on ESG data?

Adinah Shackleton: Some investors have very long and detailed ESG data requests. Others are more focused. But overall there has been a huge increase in data demands from our LPs and, of course, having access to this data is useful for us too.

Last year we ran a pilot project, collecting ESG data from one fund focused on a set of KPIs including green- house gas emissions, diversity data and whether or not certain ESG policies were in place. The response was great and now we are rolling that out across other funds.

Permira’s private equity business has also recently signed up to a LP/ GP alignment initiative supported by ILPA. The initiative was created when a group of GPs, including Permira, came together to agree on a set of common metrics and definitions for reporting ESG data, because one of the key challenges until now has been the lack of a uniform approach between GPs. Six priority areas were agreed, including greenhouse gas emissions, renewables, health and safety metrics, job creation, employee engagement surveys and diversity at board level.

We have decided to expand this approach to apply the same metrics to the direct lending business as well. That makes a lot of sense because it means we should be more aligned with the equity sponsors of the companies we lend to when it comes the information we are asking of those businesses.

How do you see ESG in direct lending evolving going forward?

James Greenwood: In my opinion, as a manager it will be absolutely critical to be heavily focused on ESG going forward. It is as simple as that. It may be a year away, or it may be five years away, but it is such an important topic for our investor base that it has to be addressed. We will be as open and focused as we can when it comes to constructing portfolios that our LPs can be proud of from an E, S and G perspective.

We are also starting to see the linking of margins on loans to certain KPIs within the businesses being lent to, in the syndicated loan market and particularly the direct lending market. That may be the way things are heading, although, at the moment, the margin reductions we are seeing involve single digit basis points. It will be interesting to see how that product develops in the coming months and years.

We will continue to increase our level of scrutiny on the way into an investment, as well as making sure our documents are comprehensive around our responsible investment values. This growing focus on ESG is inexorable.

Adinah Shackleton: Sustainability-linked loans are an interesting mechanism in the context of supporting delivery outcomes in direct lending. Those conversations have become a lot more common in the past six months. On the regulatory side, I also believe we will start to see more Article 8 funds promoting certain environmental and social characteristics. The industry is just working out what that means in the context of direct lending, but as that becomes clearer, I think we will see movement in that direction.

How are you approaching climate risk in your portfolio?

Adinah Shackleton: In 2020, we carried out a climate risk screening of the entire portfolio. We initially planned to focus on the private equity business, but then decided to also incorporate Permira Credit’s direct lending and CLO strategies. We looked at physical risk such as severe weather events, and we also looked at transition risk. That process really helped to raise awareness around this topic and enabled us to understand how exposed the current portfolio is and where any particular areas of risk may lie.

Our funds avoid investments in energy-intensive companies, but we do have some investments with exposure to the food supply chains, for instance. Those businesses were deemed a little higher risk in terms of transition, so that exercise really helped our investment teams start to view opportunities through the lens of climate risk.

We also conducted a carbon footprint project in 2020, collating carbon data, and supplemented that with a top-down carbon footprint assessment to fill any gaps in the data. Again, that was a very useful exercise in terms of raising awareness and understanding.

Can you share examples of when you have turned down an opportunity based on ESG due diligence?

James Greenwood: This is a question we are often asked by LPs and, although it would be unfair to share names, there are numerous examples of when we have turned a deal down because we couldn’t get comfortable with aspects of the ESG risk profile. There have also been examples where a company we invested in six or seven years ago has come up for refinancing, and our view around that industry has developed in the intervening period.

One business that  we  turned  down at the outset, for example, was an aeronautical company that supplied products and equipment for helicopters. We were not comfortable that we  could track exactly where those parts  ended up. It wasn’t that it wasn’t a good business – it was, and we could track where the company initially supplied those parts. But there is a large and active aeronautical second-hand  market  and we couldn’t be sure that parts wouldn’t end up in aircrafts in parts of the world that wouldn’t be acceptable.

There are some decisions that are black and white. We would never lend to a munitions business, for example. But a lot of the decisions we take exist in grey areas. In both situations we are weighing up the ESG issues and the potential of these to impact the value of the investment. We have to form a judgment. This was one of those cases.

Adinah Shackleton: There have also been times where issues have arisen during due diligence, but instead of walking away from the deal, we have engaged with the company on addressing those issues. For example, there was a company that was facing a potentially material fine over a health and safety incident. We worked with the business to understand how it was responding and what improvements were being made to health and safety practices. In the end, the fine was much smaller than it might have been, because of how the business had responded and we ended up with a good result. 

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Adinah Shackleton