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Engagement is a central principle of modern investing. It is a tool that allows lenders to encourage companies to make better business decisions, especially around sustainability commitments, just by exerting their influence over the firms that receive their capital.
But engagement can be a nebulous thing. Though writing letters, voting at stakeholder meetings, holding one-on-one meetings with management, or even collaborating with activist shareholders can all be effective, it can be difficult to measure practically the impact of those individual actions, and even more so to track how much of a difference one single investor has made.
But the direct lending market is different. Here, investors are able to develop a particularly close relationship with a company that can help to bring about real and measurable change.
At the heart of the difference between the direct lending market and other asset classes is the insight and access that is enjoyed by direct lenders that would be unthinkable in almost any other market. Deals are completed with a very small syndicate of lenders, or even a single bilateral investor, meaning that lenders have a huge amount of control over the process and can develop a close relationship with both companies and their private equity sponsors.
Given that the companies borrowing through the direct lending market are often from the mid-market rather than huge multinational conglomerates, it is not unusual for a direct lender to have an individual connection with a firm’s CFO or even CEO.
The relationships developed between companies, sponsors, and direct lenders are usually long-lasting, and with little to no secondary market available, lenders stay involved with the companies for the entire tenor of the loan – typically around seven years. This is a relatively long time for investors to take a seat at the table, and over this time they can develop a significant degree of insight into the company and engage with it much more efficiently.
A deeper look
It is this connection that differentiates direct lending relationships, and it begins long before any transaction is ever signed. As part of the credit process, lenders can delve into a company’s practices and results and examine management plans to develop the business – both financially and environmentally. The lender can then advise, outlining norms and best practice elsewhere in the sector. When it comes to sustainability, lenders can set out their expectations for future disclosures or agree a structure of margin ratchets which cut (or hike) the yield if the company hits (or misses) sustainability-linked targets. And the trust that grows out of the personal, bilateral relationships in direct lending often means any such strategy can be more efficiently put into action.
For some borrowers, particularly those at the smaller end of the mid-market, this may be the first time that they have had to disclose information around sustainability, or embrace an Environmental, Social and Governance (ESG) strategy. While a direct lender is not an equity stakeholder that can control the direction of a company, this relationship usually works as a pull motion, working in tandem with the firm, rather than pushing them into a direction they are not interested in exploring. Management teams usually welcome the change, as they recognise the potential value in future-proofing the business
Indeed, the connection that often develops via direct lending can cast the investor in the role of partner, contributing information and influencing on best practice rather than simply being a faceless source of capital. Lenders can guide a business on how to hire ESG stewards, on appointing C-suite executives to take responsibility for sustainability practices, on establishing ESG policies, and on how to evolve operations to boost the firm’s environmental performance. But all of these actions alone are not sufficient: direct lenders can advise firms on how best to be more transparent around sustainability metrics and can help to establish a reporting system on ESG.
This is all done in partnership with a company and throughout the tenor of the loan. Because so many direct lending deals are done on a bilateral basis, a lender is in prime position to track the impact of their suggestions across all engagement strategies.
A sustainable transformation
When a private equity company acquires a new asset in the sort of deal backed by direct lending financing, they expect their ownership will transform the business. Traditionally, this could include options such as installing better accounting systems, appointing a new CFO, or exploring new territories, but increasingly sponsors are looking to bring sustainability to the fore. This is regarded as a value proposition: in some instances an improved ESG structure can boost purchase price multiple (sale price) by a full turn, but more importantly sponsors are aware that if their assets have not embraced sustainability, they may not be maximising their upside and can potentially expect lower returns on their investment in a few years’ time when they are looking to sell.
Sometimes, mid-market companies are missing easy wins relating to ESG. Sponsors do not always have the resources to advise on best practice, so a lender can step in to provide analysis on how a firm can materially benefit from taking sustainability more seriously, and to support them in making real changes.
For the lender, engaging effectively with a company on sustainability may help contribute to its own ESG goals, while also ensuring that its investment is more secure. Companies with a stronger approach to environmental issues are at a lower risk of facing penalties as the regulatory environment develops, while efficiencies and best practices adopted to reduce emissions can also have a direct business impact, reducing costs and boosting returns.
By focusing on executing small but meaningful changes, lenders can start to bring about a change in the whole narrative. While true across all asset classes, it is in the direct lending space that investors can truly get to grips with what a real and meaningful engagement strategy will achieve.