ESG restrictions see limited impact on CLO credit

LONDON, Oct 8 (LPC) - An increasing number of CLOs are adopting environmental, social and governance investment criteria, but the exposure of leveraged loans to industries affected by ESG rules is limited, representing an average of just 3% of European CLO collateral, according to a Moody’s report.

CLO funds with ESG criteria avoid investing in sectors including tobacco, gambling, pornography, weapons and hazardous chemicals. However, leveraged loans from these industries are scarce, so the investment restrictions do not have significant credit impact on the CLOs and their performance is comparable to peers, Moody’s said.

“If you apply an ESG filter to the leveraged loan universe, how much supply have you lost? On the face of it, very little. It’s a nice thing to say, but if you are just using an external score, it won’t change your management style too much,” said Stephane Michel, senior portfolio manager at Hermes Investment Management.

Five European ESG-compliant CLO funds have been issued since March 2018 when Permira Debt Managers issued the first one named Providus I. PDM then issued two more ESG-compliant CLOs, followed by Fair Oaks Capital and Bardin Hill.

Tyler Wallace, portfolio manager at Fair Oaks Capital admitted the restricted industries aren’t traditionally European leveraged buyout targets.

“We looked into 150 individual credits over the past year, and we turned down three explicitly because of ESG restricted industries or activities.”

The ESG restrictions on each CLO differ slightly. For instance, PDM has excluded gambling in its ESG CLOs, while Fair Oaks does not.

“We have a firm level view on ESG restricted industries and activities and we then applied that to the CLO eligibility criteria,” said Wallace. “Gaming in our view is leisure.”


The impact of ESG-restricted CLOs is also limited because increasingly, fund managers on regular CLO funds are taking into account sustainability as part of their credit analysis.

“Do you want to look at a company every other week to see if they have had an oil spill? And you think that’s a wise credit analysis? No, it isn’t,” said Michel. “Not every CLO puts their language on that -- it’s not because they aren’t doing some form of it. It’s not necessary possible to prove that they have done it fully and all the time.”

A US$500m-equivalent leveraged loan for Israeli cyber surveillance firm NSO Group earlier this year was one of the first deals to highlight investment decisions around ESG. The deal was placed at 90% of face value after it was alleged that the company’s spyware tool Pegasus was used to target human rights activists.

In the US, almost a quarter of CLOs prohibit investment into the tobacco sector, even without any explicit ESG restrictions. But recently two CLOs with explicit ESG considerations have emerged, including Partners Group’s Pikes Peak 4 CLO and MJX Asset Management’s Venture 38 CLO. These deals closed in August and restrict industries include weapons and tobacco, according to Moody’s.

The use of ESG standards in Europe’s leveraged loan market is still in its infancy and its use has been limited to capital expenditure and revolving tranches. Bankers and investors believe the lack of deals that incorporate ESG principles remains a key hurdle for market development.

Spanish telecom operator Masmovil completed Europe’s first ESG-linked leveraged loan in May. The company agreed a €1.7bn debt package that included a €250m revolving credit facility and capex line with a margin ratchet based on an ESG rating.

“ESG continues to be on the agenda and the leveraged loan market is going to see it more in 2020,” said a head of leveraged finance. (Editing by Christopher Mangham)