Fair Oaks Reflections – Issue 5

30 March 2019

While responsible investing is increasingly gaining traction among investors and asset managers, the CLO market has been slow to embrace it. In this note we explore the reasons for this and the steps that some CLO managers are taking to become more responsible investors.

Responsible investing is the incorporation of ESG (Environmental, Social, Governance) factors into investment decisions. As we see it, responsible investing is trying to avoid negative impacts on the environment and society while seeking a financial return. This should go beyond blacklisting certain industries but it does not go as far as impact investing, which involves actively seeking a positive environmental or social impact in addition to, or instead of, a financial return.

Fair Oaks assesses CLO managers’ ESG policies as part of its diligence process and has found that the majority of CLO managers fail to incorporate ESG considerations into their investment processes, sometimes even when they are part of a larger organisation which does have a responsible investing policy.

We consider four primary reasons for the slow adoption of ESG policies among CLO managers:

  • a perception that responsible investing is more relevant to equity investors than debt investors;
  • a notion that responsible investing is not practical for broadly diversified portfolios;
  • a belief that responsible investing may compromise financial returns to their investors; and
  • a lack of engagement and pressure from CLO investors.

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.

We also dispute the thesis that financial returns may be compromised given (a) the small proportion of loan issuers that in our experience are likely to be excluded and (b) the correlation between ESG concerns and the fundamental credit risks of increased regulation or loss of customers.

The lack of engagement between CLO investors and CLO managers on ESG issues is understandable given their lack of voting control and the way in which CLO liabilities are usually raised, i.e. more by the arranging bank than the CLO manager. However, both CLO equity and debt investors have the ability to influence CLO managers and both thus bear responsibility for how their capital is invested.

The majority of CLO managers are still failing to incorporate ESG considerations into their investment processes. Some exceptions worth describing include:

  • managers who consider their firm-wide responsible investment policy without formally incorporating it into their loan approval process.
  • managers who exclude one or two industries from their investment universe
  • managers who have formally incorporated ESG criteria into their investment process and reflect this in their CLO documentation.

The first example is clearly weak and unlikely to be effective. The second set of managers are generally reacting to specific investors’ requirements rather than developing and implementing firm-wide internal ESG policies.

We strongly believe the third approach represents the most effective route to responsible investing. As examples of this approach, we note the adoption of detailed ESG language in the documentation of the Providus I and II CLOs managed by Permira Debt Managers.

Perhaps the greatest challenge to the effective incorporation of ESG factors in the CLO market is the difficulty in defining responsible investments: Is gambling socially harmful or a recreation activity that may be abused by some? While avoiding investments in cigarette manufacturers may be obvious, how about a diversified manufacturer whose products include cigarette filters?

No written policy can adequately cover every potential ESG-related issue and responsible investing will always require a detailed, case-by-case, analysis. A sensible approach to responsible investing will encourage the identification and discussion of all potential ESG issues during the investment process.

How ESG issues influence investment selection will ultimately reflect a firm’s values. This is sometimes overlooked as the investment industry focuses on the potential fund-raising benefits of ESG policies. When fund-raising is seen as the sole goal of implementing a responsible investing policy, it risks being reduced to a bullet point in a factsheet or a UNPRI logo in a marketing presentation.

At Fair Oaks, ESG criteria are formally incorporated into the investment process across funds and analysts regularly engage with CLO managers to encourage them to embrace responsible investing. Similarly, we consider the social and environmental impact of every borrower we review for our own direct investments in loans. This approach will be clearly reflected in the documentation of our upcoming European CLO which will incorporate ESG eligibility criteria similar to those in the Providus CLOs, hoping to encourage their broader adoption and, eventually, to establish them as a CLO market standard.