The evolution of ESG in lower middle-market direct lending

Written By: Jens Ernberg Managing Director Capital Dynamics

& Bryn Gostin Managing Director Capital Dynamics

Jens Ernberg and Bryn Gostin of Capital Dynamics provide a detailed guide to building an ESG monitoring and screening network and outline many benefits of improving a corporate ESG profile

The US middle market is a significant growth engine of the US economy, accounting for one-third of private sector gross domestic product¹. As one of the largest contributors to employment, small companies also play a critical role in the social welfare of society. Historically, US middle market companies relied on commercial banks to meet their debt financing needs. Since the global financial crisis, a combination of regulatory pressure and market dynamics has resulted in an exodus of commercial banks from the space. Dedicated private credit funds have emerged to fill this significant financing gap and participate in building institutionalised and resilient small businesses over time.

While evaluating corporate ESG performance has always been integral to underwriting processes, it is typically used by middle market lenders as a negative screening mechanism to eliminate investments from consideration. For example, companies operating with little regard for the environment or with poor employee relations open themselves up to, among others, financial, legal and reputational risks. Identifying and quantifying those risks often leads such investments to fail review from rigorous investment committees. That said, leveraging ESG performance as a positive screen to identify companies that are likely to outperform their peers and command premium valuations over time and across cycles is an emerging and invaluable tool in credit investment selection and underwriting. Importantly, an improving corporate ESG profile is often rewarded with enhanced financial performance, valuation, multiple expansion and greater access to capital markets. As such, identifying and underwriting resilient business models requires not only screening those investments for ESG attributes at the time of underwriting but also ensuring that those companies prioritise sustainability along the three dimensions of ESG over time.

Refocusing the lens from negative screening to using ESG metrics as an investment selection and management tool, however, is not a trivial undertaking. Part of the challenge in implementing the practice lies in the role that private creditors assume in transactions. Lenders are often expected to be silent partners with, absent the occurrence of an event of default, limited input into the strategic direction or operating trajectory of the company being financed. Nevertheless, middle market lenders are in a position to influence corporate behaviour. As essential capital providers, private creditors have the capacity to engage with management teams and private equity sponsors during underwriting and post-closing of a financing and to motivate behaviour through inquiry, dialogue and contractual stipulations, such as maintenance covenants or financial incentives, including, for example, positive or negative interest rate ratchets.

Another challenge with building a strong ESG screening and monitoring framework is access to measurable and predictive data. Middle market, entrepreneur-owned companies often lack financial, technological and human resources to identify, gather and synthesise key performance data. That includes financial and operating data as well as data directly related to a company’s ESG attributes. Lenders, along with private equity managers bring both capital and strategic/operational oversight to assist companies in improving data gathering, analysis and reporting capabilities. As such, lenders can be influential in determining how ESG performance is measured and monitored, and in defining key performance indicators (KPIs) that help drive improvements across ESG dimensions over time.

The benefits to a company of enhancing its ESG profile are evidenced not just through improved relative financial performance but also by the impact that it has on its employees, the environment and communities in which it operates. Strong ESG performance drives growth in employment, reduces environmental waste, generates incremental tax revenues that fund essential social services (education, healthcare, law enforcement, etc.) and helps raise living standards. Given the critical role they play in providing essential capital to support the growth of middle market companies, private creditors have an opportunity to meaningfully impact society by working with borrower management teams and private equity owners to design, implement and institutionalise strategic and operational ESG priorities.

In this piece, we explore several aspects of responsible lending in lower middle-market credit, including:

• The benefits of strong ESG on the performance of small companies
• Techniques to underwrite ESG as a direct lender
• The strategic use of influence on the sponsor and borrower absent the ability to control corporate action

The performance benefits of ESG for smaller companies
Small companies with strong ESG attributes outperform their peers for several reasons. These businesses often exhibit higher relative top-line growth because 1) they can attract customers and gain share by delivering more sustainable products and services, and/or 2) they can command premium pricing based on the positive attributes associated with their brands and/or organisational reputation. Such companies often enjoy operating expense advantages relative to peers from investing in health and safety (resulting in fewer accidents), lowering waste and energy consumption, and reducing personnel turnover due to greater employee job satisfaction. Greater job satisfaction may also translate into increased productivity from reduced absenteeism, greater employee motivation, and the ability to attract and, critically, retain better talent. According to a 2017 survey, 88% of consumers will be more loyal to a company that supports social or environmental issues.² Furthermore, the effective implementation of an ESG strategy at a company can impact operating profits by as much as 60%.³ Companies with better ESG also tend to have greater strategic freedom due to enhanced public support and less scrutiny from regulatory agencies or advocacy groups. Combining better operational performance with more strategic freedom facilitates longer-term thinking, including investment in more sustainable plants, equipment, and business models.⁴

ESG is increasingly becoming a point of interest for discussions with respect to company earnings, valuations and strategy with executive management, analysts and other stakeholders.⁵ Conversely, companies with weak ESG profiles face obstacles. Unsustainable practices or the perception of unsafe products and services can lead to loss of customer support, legal proceedings and potentially damaging remediation expenses. These businesses also have more difficulty accessing resources, may experience operational disruptions, and often have poor community and labour relations. They commonly generate unnecessary waste, experience relatively higher employee turnover, and have limited capacity to pass through input cost increases, all of which negatively impact margins and financial performance. In addition, they are more likely to attract greater regulatory scrutiny, exposing them to potential fines, penalties and enforcement actions. Opaque governance structures can also lead to both inefficient decision-making and poor job satisfaction levels. On their own, each of these challenges present a credit risk and collectively they may result in greater financial stress on the business through economic cycles.

At first glance, it may appear that the benefits of good ESG practices accrue mostly to equity investors as stronger relative performance typically translates into valuation multiple premiums; private credit funds (outside of a default and workout scenario) typically do not participate in the equity upside of a business. That said, outperformance in credit is often the result of loan portfolios experiencing fewer defaults and minimising losses if, and when, such defaults occur. As discussed above, companies with stronger ESG profiles tend to be more resilient. They have greater flexibility to manoeuvre challenging environments, given stronger profit margin and cash flow profiles, the capacity to pass along increased input costs (labour and/or materials) to their customers, and greater resources in terms of both access to capital and talent that can help navigate market dislocations. In addition, the favourable investment characteristics of companies with strong ESG attributes provide lenders and private equity managers with more degrees of freedom when faced with market headwinds. Besides the aforementioned operating flexibility, if warranted, recovering proceeds through a sale of the company is also likely to be more successful (in terms of valuations and proceeds received) with companies demonstrating strong ESG credentials than for those that do not.

How to strategically influence positive ESG outcomes as a lender
Lack of control creates a challenge for private credit managers seeking to promote strategic and operational actions designed to enhance ESG attributes at companies they finance. In private equity buyouts or corporate mergers / recapitalisations, the sponsor (private equity manager) and / or other equity owners control the business. As such, they are in charge of plotting the strategic direction of the enterprise, overseeing its operations, building the senior management teams and shaping boards of directors. They are also responsible for designing and adopting ESG-related policies, and identifying ways to promote sustainability goals, including setting, measuring and interpreting ESG KPIs. While senior creditors have a priority security interest in the cash flows and assets (including equity) of a company, they are not in a position to exercise control over corporate actions. Unless lenders have the experience to influence corporate behaviour more subtly, they are expected to be silent partners absent a covenant breach or other event of default.

Unlike the syndicated and core-middle market, a meaningful supply-demand imbalance exists in the smaller end of the credit market, offering experienced lenders the opportunity to have a greater say in the pricing and structuring of loans. Inefficiencies in our market also means that we, as critical capital providers, often have multiple weeks or months (not weeks or even days as is often the case in the syndicated and core-middle market) to underwrite a transaction, allowing us more time to analyse the ESG merits of a borrower and evaluate means to enhance those characteristics over time. These same favourable supply-demand dynamics make it easier to secure covenants and other protections in the governing documents.

We believe that ESG covenants are powerful tools that lenders can utilise to influence sponsor and management team behaviour. These covenants can be structured with both negative and positive incentives. One example which has received growing media attention is ESG ratcheting, a tool which is increasingly being implemented in Europe and to a lesser extent in the North American lending market. ESG ratcheting is a mechanism by which a company may lower its borrowing costs with a lender by achieving pre-set ESG KPIs (e.g. improvements in environmental performance or increased diversity in positions of responsibility) over the holding period of the loan. In theory, this should better align the sponsor and portfolio company to achieve environmental or social objectives to reduce borrowing costs. In practice, however, the effectiveness of this tool has been mixed because ESG ratcheting faces an intrinsic problem: if the ratcheting mechanism results in only a modest reduction in borrowing costs (we have observed that ESG ratcheting usually improves borrowing rates by 10 basis points or less), it is not likely to influence behaviour; whereas, if the ratcheting mechanism results in materially lower yields the loan may have limited uptake and prove difficult to syndicate (an important aspect of functioning credit markets). Furthermore, poorly- designed ratcheting mechanisms may lead to companies making short-term decisions without considering longer-term consequences to enjoy the immediate economic benefits resulting from such actions.

A further challenge with implementing ESG covenants and / or ratcheting incentives in the lower middle market is related to data availability. A significant part of the sponsor’s value creation strategy involves formalising processes around strategic decision-making, board appointments, human resources, capital allocation, financial planning and other similar processes. As such, the data needed to set achievable ESG KPI goals is often not in place at the time of investment. Nevertheless, there is an important role for lenders to play in steering the sponsor to include environmental and social objectives as part of this institutionalisation of the entrepreneur’s business.

Conclusion – ESG in direct lending, a tool for both enhanced returns and real-world impact
As an asset class, private credit has been slower to adopt formal ESG guidelines. In practice, however, experienced direct lenders have been underwriting environmental, social, and governance risks since before ESG became mainstream. Doing so is an indispensable part of fundamental credit underwriting. When lending to smaller companies, the importance of evaluating ESG risk may be even more pronounced. Not only can ESG issues be more acute at smaller companies, but these organisations also stand to benefit the most from the institutionalisation that accompanies responsible lending practices. The key is to diagnose ESG deficiencies at the outset of the investment, track them over time, and find ways to influence good ESG outcomes by establishing strong relationships with equity sponsors, sharing best practices, and focusing on contractual protections.

It is our expectation that evolving ESG screening from an exclusive focus on risk mitigation to screening for favourable and improving ESG attributes will not only result in credit portfolio outperformance, but also direct capital to companies that are contributing to an improving society. Companies with favourable ESG credentials generally outperform their peers as they experience relatively stronger revenue growth, enjoy cost advantages from reduced waste, more efficient operations, better employee and vendor relationships and fewer regulatory and legal challenges. Such businesses also have a growing base of social, consumer and governmental support. These factors contribute to such companies being more resilient across cycles and over time. Given the importance of middle market companies to the US economy and social fabric, experienced lenders have an opportunity to impact the environment and society at large by using their influence to accelerate the implementation and institutionalisation of ESG strategies.

Dynamics in the lower middle market provide direct lenders in that market with the ability to have greater influence over the borrowers. That includes being involved in underwriting ESG merits alongside the management team and private equity sponsors, and designing frameworks for implementing and monitoring ESG enhancing priorities over time.

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1. National Centre for the Middle Market (2018): The DNA of Middle Market Growth. The Three Types of Growth Champions and the Factors that Drive Their Success. Available at: https://www.middlemarketcenter.org/Media/Documents/three-types-of-growth-champions-and-factors-that-drive-success_NCMM_DNA_of_Growth_FINAL_Web.pdf (Accessed 24th November 2021).

2. 2017 Cone Communications CSR Study

3. Capital Dynamics based on McKinsey & Company, McKinsey Quarterly ‘’Five ways that ESG creates value’’ November 14, 2019

4. Capital Dynamics based on McKinsey & Company, McKinsey Quarterly ‘’Five ways that ESG creates value’’ November 14, 2019

5. SS&C Intralinks. “How Top M&A Professionals Are Embracing ESG in the Deal Process”