As green and social investment goes from strength to strength, it is reaching more and more asset classes. But so far, there are still some large untouched areas.
Debt investors seeking to green or socialise their portfolios have focused on the more vanilla end of the capital markets. Supranational and agency issuers pioneered green and social bonds, where they were followed by big, systemically important banks and solid, investment grade companies.
Renewable energy firm Abengoa, which went through a brutal restructuring in 2016, is an unusual exception. But the funds playing in its restructured debt — the likes of KKR, Oaktree, Hayfin, Elliott and DE Shaw — are not your classic ESG investors, not by a long way.
Green securitization isn’t exactly booming, though it does exist — the Property Assessed Clean Energy (PACE) loans market in the US, electric car ABS from Toyota, RMBS from Rabobank's subsidiary Obvion, as well as, debatably, the growing green covered bond market. All of these, though, are performing assets, and most of what's sold is senior and low yielding.
This conservatism is partly inherent in the market structure.
Many of the end investors funnelling money into ESG strategies are happy with safe, uncontroversial assets. They do not want to play in deep, dark waters, such as distressed debt, long/short credit or structured credit. Long-only investment grade is more their speed.
On the issuer side, too, companies willing to devote the time and effort to structuring green or social bonds tend to be those with stable ownership and treasury teams able to look beyond the next few years. Highly levered, sponsor-owned firms tend to be more focused on optimising their capital structures and extracting cash.
But the non-performing loan securitization market, which is set to grow in Europe, offers a potential chance to blend these two worlds — if it is handled correctly.
Contrary to the frequent portrayal of NPL investors as “vulture funds”, the first strategy for any firm wanting to make a quick buck in non-performing or impaired loans is to offer the borrower debt relief.
If the borrower accepts a discounted restructuring, the debt gets rescheduled, with a new interest rate, and, usually, a hefty principal writedown.
The NPL buyer can afford to offer this deal because it bought the loans at a discount. If loans bought at 30 cents on the dollar become re-performing at 50, that is a quick and easy return — largely at the expense of the shareholders of the selling bank.
What’s more, this surely counts as a social good — repairing the credit histories of distressed borrowers, allowing them to remain in their homes rather than enforcing security, finding a sustainable balance between creditor and debtor.
There is probably a lot more social good, in fact, in writing down debt to make it re-performing, than in many so-called social bonds.
National Australia Bank issued a gender equality bond, for example, backed simply by loans to companies that met a certain target for gender equality in the company and boardroom. It is not nothing, but it’s not going to meaningfully cut the capital costs for companies with these characteristics, and buyers should not kid themselves that it is.
Of course, it’s not always kittens and rainbows. While NPL investing can do social good, it can also be one of the nastiest asset classes in the capital markets. The designation “vulture fund” is pejorative, but sometimes accurate.
Sometimes collecting on distressed consumer debt really does mean taking single mothers to court to throw them out of their homes. Sometimes seizing hard assets really does force small businesses into bankruptcy. There is a reason why the sharp end of special servicing tends to be conducted by burly men, able to hold their own if things get nasty, a world away from the smoothly suited private equity partners who pay their wages.
NPLs can be seen, with a small switch in servicing approach, as either some of the most “social” debt one can own, or one of the swiftest ways to damage the fabric of society.
For some pension funds, regardless of the “social” label, involvement in this kind of NPL investment is an outright no. It doesn’t matter what returns might be on offer — if you manage funds for a public sector fund, the optics of a hard-enforcement NPL strategy probably do not work for you.
But the question for end investors, and for European policymakers, is — does one make sense without the other? Why would borrowers take the carrot of a discounted payoff without the stick of court enforcement lurking in the background? Is it possible to isolate the good parts of NPL investment, without doing the bad?
The answer is… maybe. Though an ESG investor in NPLs must, of necessity, lock away the stick and use only the mildest inducements to borrowers to take the rescheduling deal, the carrot is still very attractive. Because ESG types generally buy bland, non-distressed, investment grade assets, they are likely to have lower return hurdles than the hedge funds and private equity firms they would compete against for NPL paper.
A fund that mainly buys bonds with ESG characteristics might expect returns in line with a normal bond fund — say 5%, optimistically — while a fund playing in NPLs might be shooting for 15%-20% (with leverage). That is more than enough gap to allow for a more sedate approach to servicing, and such an approach would surely attract more capital to the market.
A regulatory push wouldn’t hurt, either — and would fit with existing European policy, which is even now contemplating strategies to lower the cost of NPL disposals, attract more capital and boost secondary markets.
Making the right kind of NPL investment a form of “social” issuance could help further, especially with capital treatment benefits like those contemplated for some green issues.
Such a move would be controversial — but it has the potential to help NPL sellers, buyers and the stricken debtors. All hail a new frontier for ESG?