London-based Fair Oaks Capital Ltd. on June 6 joined a coterie of asset managers in Europe to include environmental, social and governance criteria in a new fund that buys corporate loans and bonds. While still a small portion of the overall market, such ESG-compliant funds in Europe are another sign of emerging investor interest in responsible lending across asset classes.
Fair Oaks priced a €332 million collateralized loan obligation, or CLO, fund aimed at non-investment-grade rated — or leveraged — loans and bonds. The loans that CLOs buy are bundled to help spread risks and returns, while the vehicle itself is funded by issuing notes to institutional investors such as insurance companies and pension funds.
An ESG-focused CLO will avoid investing in the loans of borrowers whose primary business activity is in an industry considered harmful to the environment or society. While the list varies from manager to manager, these industries could include artic drilling or any other form of speculative extraction of oil and gas, thermal coal mining, electricity generation using coal, controversial weapons and firearms, tobacco, payday lending, and pornography.
"We believe that the goal of avoiding funding businesses that do environmental or social harm while investing for a financial return is as relevant for CLO managers as it is for a manager of, for example, a diversified equity fund," said Roger Coyle, a partner at Fair Oaks.
At about €1.5 billion, ESG-compliant CLOs are a small part of Europe’s roughly €27 billion CLO market, but having only launched in 2018, are growing steadily.
Fair Oaks Capital follows in the footsteps of Permira Debt Managers Ltd., the credit unit of U.K. private equity house Permira, which issued two ESG CLOs in 2018, having applied the criteria to its direct lending and private equity funds for several years. Earlier this year, Bardin Hill Loan Advisors (UK) LLP became the second company in Europe to launch an ESG CLO.
Although the €95 billion European leveraged loan market has little exposure to companies in off-limit sectors, the ESG criteria mean portfolio managers embed more vigilant screening processes by assigning dedicated teams to monitor ESG compliance.
"If you take a hard line on ESG, you are tending to screen out investments which would probably end up being at the trickier end of the industries, segments and credit risk, so it does help us to look at businesses that are a lot more solid from a credit standpoint," said Andrew Lawson, head of capital markets at Permira Debt Managers at a conference in London in May.
As such, ESG screening will help managers benefit from investments in businesses potentially less exposed to price and return fluctuations, regulatory changes or reputational issues. ESG CLOs have for example screened out the $510 million leveraged loans backing NSO Group, the Israeli software company facing allegations that it played a role in installing spyware on people’s smartphones via the WhatsApp messaging system, according to market sources.
The loans backing the group were at the riskier end of the credit spectrum when they were sold to investors before the allegations were made public in April. The loans had to clear at a 10% discount, hiking up the yield to almost 13% on the dollar portion and 10% on the euro, compared with average yields of 7.2% in the U.S. and 4.2% in the European leveraged loan market.
It is not only the CLO funds looking for ESG-compliant investments to reduce risks. For example, European pension funds, which are regular investors in CLO bonds, have been required since January to take into account ESG factors for investments under the IORP II, the key European regulation for pension funds.
"Investors in our CLO appeared to welcome the ESG criteria, especially German, Nordic and French investors," Coyle said. "ESG will probably become standard in three to five years as these factors are ultimately driven by the end investors."
But while there are proponents of boosting the role of CLOs in sustainable finance, particularly with a view to achieving the goals set out in the Paris Agreement, they also concede that there are hurdles yet to cross for ESG-compliant CLOs to gain traction, including finding agreement in the industry as to what constitutes responsible investment. "While avoiding investments in cigarette manufacturers may be obvious, how about a diversified manufacturer whose products include cigarette filters?" asked Fair Oaks in a March blog post on its website about the challenges that lie ahead.