The quest for sustainable CLOs — and standards
Sustainable securitization is moving into the mainstream, with a growing number of managers adopting ESG language in CLOs — usually through excluding specific industries from investment. What’s next in the green securitization revolution will depend on building a rigorous framework for assessing ESG factors and how to create standards. Paola Aurisicchio reports.
So broad and deep is securitization investor interest in ESG that many CLO bankers and sponsors now find that the majority of their meetings with investors is devoted to answering specific questions about the subject.
“Do you have a dedicated ESG platform within your firm?” “What ESG approach do you use?” “What weight do you assign environmental versus social versus governance factors?” And so on.
The incorporation of ESG into CLOs has evolved so much in recent years that the CLO community is now working hard to reach common ground on ESG standards, and make criteria more uniform across the market.
From the start of the year to February 3, there were 21 CLOs issued with ESG-friendly language, according to a Deutsche Bank report, with CLO managers mostly adopting the negative screening approach to meet ESG criteria.
The approach essentially restricts a manager from investing in loans issued by borrowers in certain types of industries. The list of excluded sectors, usually military, mining and minerals, extreme fossil fuels, tobacco, gambling and pornography, is often similar, but often subject to a revenue percentage limit.
Some sectors are more conflicted than others. Dutch manager NIBC, for example, includes fracking in its definition of extreme fossil fuels, something not all other firms with an ESG screen do. Gambling is considered a sinister sector for some managers but a highly regulated industry for others.
Despite similar language in deals, some disparities persist — although the shift towards an inclusive screening is on the menu.
“While negative screening is a strong starting point, we will eventually see a market-wide shift towards positive screening which could incorporate perhaps a more standardised approach, such as external agencies assigning an ESG score to issuers,” says Andrew Lawson, head of capital markets at Permira Credit. “This is one way that will help to bring market-wide standardisation and transparency to an increasingly relevant investment topic.”
Permira Credit was the first manager to feed ESG into CLOs in March 2018 with Providus CLO 1, which included a list of sectors the manager excluded from its vehicle.
This included blacklisting sectors such as gambling, fossil fuel industries and loans to firearms providers.
Other managers soon followed, with Fair Oaks Capital targeting ESG credentials for its debut European deal. Danish fixed income boutique Capital Four applies ESG language across its investments and included this approach in its debut CLO. Bardin Hill and THL have also included ESG language in deals or investment approaches.
Later, Permira would commit to a minimum ESG score across its portfolio, taking the next step in sustainability compliance.
Dutch manager NIBC then raised the bar for ESG standards with North Westerly VI, a €410m deal priced via MUFG Securities, the first seen as a “fully-compliant” ESG CLO. The deal incorporated an ESG scoring system, in addition to prohibited industries and the manager assigning an ESG score through the trustees reports.
At the beginning of May, the manager priced a follow-up deal with North Westerly VII, a €400m ESG-compliant transaction with senior notes, rated triple-A by S&P and Moody’s, sold at 84bp over three month Euribor.
ESG criteria are now commonplace, with Moody’s saying that 85% of new European CLOs issued in 2020 and 2021 have incorporated, explicitly or implicitly, sustainability factors.
The rating agency predicts that in the next two to five years, regulatory initiatives and standardisation, together with strong investor demand, will probably foster further evolution of ESG investment criteria in both CLO and its collateral.
But what is going to happen in the shorter run and how the industry can create a more standardised approach remain unclear.
“In 2022, I hope we get to a point where issuing companies get comfortable supplying annual ESG data to investors in a regular and consistent format,” says Lawson. “It’s not just the CLO investment community that would like to see more transparency, it’s also certain separately managed account mandates with a particular ESG focus.”
Lack of data versus need for transparency
A rapidly expanding number of investors are requesting ESG information from borrowers that they consider material to inform their investment decisions. But a lack of disclosure, adequate data and how to interpret this information to conduct ESG due diligence are still the main challenges.
Alcentra, like other asset management firms, has developed an internal ESG scoring system that forms an integral part of its investment process. The manager assigns ESG rating scores with four components — environmental, social, governance and climate change — and weighted sub-scores related to the underlying sector, says Jerome Ingenhoff, executive director at Alcentra.
“Companies with better ESG reporting and data will be viewed more positively, as it highlights commitment to managing ESG related risks,” says Ingenhoff. “However, lack of data won’t necessarily prevent us from investing, and our ratings will still reflect positively on companies that aim to improve, have clear targets to establish a sustainability framework and stated key performance indicators (KPIs) for the future. Overall, we have seen a clear shift over the last 18 months. Issuer responsiveness and number of companies being proactive in posting ESG information has significantly increased, which is positive.”
ESG credit scores: internal and external, what’s next?
For CLOs, an ESG designation can still mean many different things. The vehicles comprise hundreds of loans, from many different companies, which are largely private and sponsor-owned. That means the burden falls on the CLO manager to assign ESG ratings for each individual company, ahead of declaring their deal to be ESG-compliant.
A more standardised approach, however, could be useful. An ESG credit score, for example, could be a significant factor in attracting capital and maintaining transparent communication on ESG.
Several third-party providers evaluate companies on ESG performance and more rating agencies include ESG criteria in their credit ratings, but only when such factors are relevant to credit quality. However, without harmonisation of the various different rating groups in Europe, issuer-led ESG principles will remain open to interpretation.
Palmer Square Capital Management, a US CLO manager also active in Europe, bases its approach on industry exclusion as well as on its own ESG scoring system where the firm rates E, S, G from one to five on an industry and issuers base. The scoring system has showed some progress over time.
“We have a semi-annual score review to see if a score has to be revised because more information has been disclosed that aids our understanding of their ESG situation,” says Chris Long, chairman and CEO of Palmer Square.
“We don’t see scores changing on a quarterly basis, but we have seen some scores changing on a biannual basis. Overall scores are trending higher, which is great and a reflection of the fact that the corporate sector recognises that ESG is an important focus.”
Palmer Square has priced three ESG-compliant CLOs since August 2020 — two static deals and one actively managed — and plans to incorporate ESG criteria in all its future European CLOs this year, while in the US not every deal has adopted green language.
Talking about the role of external rating agencies, Long says that at this stage it is still unclear “how useful they would be, because there is still a significant difference among credit managers on how to properly score particular companies and their respective industries”.
“The challenge is that there isn’t an easy way to standardise,” he says. “Ultimately, I do believe, though, that we will start seeing more and more standardisation, as the market would benefit from a rigorous comparison system.”
Spreads and sustainability
Investor demand and the desire to have a positive impact are driving investors towards ESG, alongside European regulation. So far there hasn’t been a meaningful price differentiation between ESG CLOs and regular transactions, as shown in research conducted by Deutsche Bank that compared ESG CLOs issued between March 2018 and August 2020 with traditional CLOs.
As deal structure becomes more sophisticated with stricter criteria, investors may be willing to pay more.
But it doesn’t mean sacrificing returns.
Palmer Square claims that it doesn’t sacrifice spreads in its ESG CLO deals, but that they are attractive for the firm.
Ingenhoff says that Alcentra supports and rewards companies that have strong ESG reporting and ambitious targets, “because it fundamentally is good business”.
“I’m OK with ESG margin ratchets, but we are very wary of greenwashing and companies that just try to reduce the margin by having unambitious ESG ‘targets’ they would achieve anyway,” he says. “In that case, we would push back quite heavily.”