A sponsored article by William Nicoll, M&G Investments
The world requires investment on a huge scale to address environmental and social challenges, such as carbon emissions, disease and poverty.
As such, impact investing (investing to achieve social/environmental benefits in addition to attractive returns) is a growing area and, given increasing
constraints on public resources, mobilising private investment is imperative. Impact investing is therefore increasingly becoming of interest to institutional investors. While impact investing first became established in equity markets, lending in all its forms accounts for far greater flows of finance to corporates and organisations, leading to opportunities in debt investment that are commensurately larger than for equity.
Understanding the approaches to sustainable and impact investing
Although sustainable and impact bond funds comprise a small segment of the fixed income fund universe, they take a variety of approaches to investment:
• Using an ESG scoring system, which ranks companies in a given investment universe based on their environmental and social credentials. Investors can target companies with high ESG scores relatively straightforwardly; however, ESG scoring typically covers companies with liquid fixed income securities only, with little information available on private assets.
• Negative screening excludes from an investment universe all companies involved in certain activities e.g. tobacco, weapons. While simple to implement, this does not target a direct positive impact.
• Green bonds lend to projects seeking a direct positive environmental impact, e.g. reducing carbon emissions, generating renewable energy. Though demand for green bonds is rising, the market is still relatively small, with a total outstanding value of 94 billion1. The first green bond was issued only in 2007 by the European Investment Bank, and issuance is still concentrated in supranational and government agencies such as the EIB, World Bank and Transport for London. In our view, supply is arguably not yet sufficient to construct well diversified portfolios of green bonds..
• Private debt impact funds lend to projects that seek a direct positive social or environmental impact. They source, create or acquire assets that target demonstrable environmental or social benefits, alongside financial returns, and report the impact each investment generates. Impact funds have (historically) been predominantly small, concentrated products such as microfinance and, in many cases, financial returns have been a secondary consideration. However, this is changing with the emergence of institutional sized private debt funds offering more attractive return levels whilst maintaining the positive impact.
The appeal of private debt impact investing for institutional investors
Private debt includes a wide range of assets that offer sustainable outcomes and many more “pure play” impact investing opportunities than liquid bond markets, often because they are financing discrete projects or smaller companies, rather than broad corporate loans. Many of these assets are suitable for institutional investors because they are long-term investments that require the investor to give up a degree of liquidity, in exchange fora higher premium. Since short-term liquidity is generally of less importance to institutional investors, this is exactly the type of investment that can be beneficial. Additionally, it creates scope to diversify portfolios.
Selecting an appropriate investment manager
As this market is still developing, it is essential for institutional investors to select an investment manager with proven strength in this area, e.g. breadth and depth of private debt experience to source and analyse assets, an ability to be flexible with deployment to avoid being a forced buyer of assets, and a rigorous understanding of both the opportunities and limitations of the various approaches to impact investing. With £20 billion2 of fixed income impact assets under management, M&G is a large player in the market and understands that a good impact investing strategy should target three objectives:
• A clear positive social or environmental impact
• A competitive financial return
• A high degree of flexibility to invest in a diversified manner
In M&G’s view, private lending offers the greatest breadth of attractive opportunities to achieve these goals. In our view, a multi-focus approach is best, to ensure a broad range of environmental and social benefits, sufficient diversification, and a wide opportunity set to maximise returns. Returns are generally comparable to other private debt strategies and usually pay a premium over public bonds to compensate for their lack of secondary trading opportunities. In addition, the ability to negotiate directly with the borrowers allows higher protections.
Emphasising all the advantages of active management, impact investing requires skilled and experienced managers with well-established networks of borrowers, banks and intermediaries, as well as expertise in credit analysis, structuring and covenant negotiation. Also important is an excellent
knowledge of ESG and impact standards.
A robust process to measure and report the social and environmental outcomes of each investment is
essential for any impact investment strategy. Examples of impact measurements include the number
of social homes built, , or the reduction in CO2 emissions from renewable energy projects. At M&G,
external partners provide specialist ESG research, and sustainability and impact assessment criteria
appropriate to the private and illiquid assets that we source.
When managing investments, engagement is vital. Maintaining open lines of communication with borrowers allows us to advise and support management should any risks emerge to either credit or the quality of the anticipated social/environmental benefits. Engagement is often much more effective in private debt compared to public debt, because of the closer relationship between borrower and lender. As the lender is often a key funding source for the borrower, it can have more influence.
Case study: Lightsource Renewable Energy
In October 2015, M&G agreed a £247 million bilateral refinancing of 33 solar parks with Lightsource Renewable Energy. This was a 22-year inflation-linked senior financing, secured against fully operational solar parks mainly in the South and East of England and was the world’s largest Sterling-denominated renewables bond. M&G’s role was central to the transaction – our team solely arranged, structured and negotiated the transaction, creating different payment streams for differing client funds. The debt was tranched in order to achieve differing risks and returns for differing client funds. A CO2 saving of
approximately 43,430 tonnes per annum is expected. The transaction has been recognised with the “Environmental Bond of the Year” in 2015 from Environmental Finance and “Best European Solar deal of 2015” by Infrastructure Journal Global.
1 MSCI Global Green Bond Index, as at 19 October 2016
2 As at 30 September, 2016
