Mike Dennis, partner and co-head of European credit at alternative investment manager Ares Management explains how financial and ESG incentives can go hand in hand Ares Management

Mike Dennis, partner and co-head of European credit at alternative investment manager Ares Management explains how financial and ESG incentives can go hand in hand Ares Management

Private debt has long been fertile territory for nurturing growth and financial performance in the companies in which it invests. Now, the strong, borrower-lender bond of private debt has come into its own in directly incentivising successful environmental and social governance too. Mike Dennis, partner and co-head of European credit at alternative investment manager Ares Management, tells Delano a little about how he supports Ares’ underlying companies in attaining the E, the S and the G of ESG.

The growth of the private debt asset class in the past 14 years has been rapid. Introduced after the retrenchment of banks following the 2008 financial crisis, it provided a crucial source of financing to small businesses that did not fit the mould for a so-called “plain vanilla” bank loan. In Luxembourg, private debt assets under management hit €181.7bn in June 2021, according to KPMG Luxembourg and the Association of the Luxembourg Fund Industry figures--a 40.6% increase year on year, driven by inflows from an ever-growing number of institutional investors attracted to its yield and low volatility.

However, what is less known is the asset class’s ESG potential.

“When you’re the only lender to the underlying company, you can work with them to make a difference,” explains Dennis.

Private debt funds have historically used debt mechanisms as part of a toolkit to incentivise underlying companies’ financial growth, including offering a bullet alternative to the traditional amortising bank loan (whereby the debt is repaid in a lump sum at the end of the loan’s life), or providing margin ratchets to incentivise businesses to reach their financial targets.

These same mechanisms now nurture ESG compliance in the asset class. “A two-way margin ratchet is one example,” says Dennis. “The borrower is offered the opportunity to pay less if they perform to certain criteria to ensure ongoing engagement with ESG.”

According to markets intelligence service, Debtwire Europe, ESG-linked private debt (specifically, a type of hybrid senior-mezzanine debt known as unitranche) now account for a quarter of all private credit market transactions. In 2021, €923 million worth of ESG-linked credits were deployed in Europe, compared to EUR 660m one year prior.

In Ares’ case, they will typically identify three or four ESG metrics specific to the company’s business model and put a framework in place around their attainment. One example is the fund manager’s £1bn refinancing of UK environmental business RSK Group in 2021, which included an annual margin review based on the achievement of sustainability targets that both meet ESG criteria and are also capable of saving RSK over £500,000 per year.

“It’s not appropriate for every deal, but we do consider whether a sustainability-linked loan works when we are taking decisions on a credit,” says Dennis.

The bilateral borrower-lender relationship gives the private debt asset class an advantage when it comes to ESG compliance, explains Dennis. With RSK, it took five months to work out the bespoke ESG metrics. “With a group of lenders, the challenge would be making the ESG metrics relevant. As the only lender, we can create bespoke metrics, receive monthly management information and measure it quarterly, so we are not just paying ‘lip service’ to ESG,” he adds. As with financial monitoring, private debt funds can monitor ESG reporting, react quickly, push out covenants and give companies support to keep their earnings and their ESG impact on track. “This flexibility has served the asset class well over the past two years of the covid crisis, and we believe it will continue to protect it as institutions reconsider their fixed-income allocations in a low-interest-rate environment,” notes Dennis.

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