By Hamlin Lovell, NordicInvestor

Nordic Investor interviewed Muzinich & Co.’s new Director of Responsible Investing, Archie Beeching, who was hired from the UN Principles for Responsible Investment (PRI), to find out how Muzinich’s evolving approach is addressing the unique challenges of applying ESG to private debt.

Beeching joined Muzinich in early-2019 and is dedicated to implementing responsible investment throughout the firm: “Our ESG Working Group contains representatives from key divisions: portfolio management; risk; research and sales, so that there is at least one champion to disseminate the work and drive things forward in each team. This works well in our entrepreneurial environment”, he says. Beeching is also responsible for Muzinich’s internal CSR work, which is looking at the firm’s operational carbon footprint amongst other areas; Muzinich has a relatively high levels of diversity with 40% of its senior management and 38% of its workforce being women, including Co-Head of European Private Debt, Kirsten Bode.

Some managers are championing ESG as a source of alpha. Beeching is of the opinion that, “ESG data in itself neither adds to nor detracts from performance. It can improve the investment process, but it is for the investment team to interpret the information and make good investment decisions. ESG is primarily a risk management tool rather than a way to express the firm’s ethical values”. That said, certain Muzinich private debt strategies do implement negative screening through an exclusion policy which includes gambling, pornography and ammunition. These restrictions may differ for other Muzinich strategies.

Muzinich already has a “best in class” ESG crossover strategy (a blend of high yield and investment grade corporate bonds), which potentially excludes 50% of its potential universe. It only initiates positions in companies that have an above-median Sustainalytics ESG rating for their sector. It practice, the majority of the portfolio is currently allocated to firms with a top quartile rating; it has some flexibility over when to sell those issuers that slip below the median, which is of course a moving target. The median is a relative rather than an absolute measure, and as companies’ ESG standards are generally rising, firms must in a sense “run to stand still” in order to stay above it. Muzinich seeks to influence companies to improve their transparency and management of ESG risks through engagement. For instance, a European property company raised its Sustainalytics rating from below median (220th/334) in 2018 to above median (54th/334) in 2019, after launching a new sustainability website, in response to Muzinich’s requests for better ESG disclosure.

In Muzinich’s view, a reasonable amount of ESG data exists for listed credit. Based on a recent assessment of Muzinich’s investment universe, Sustainalytics’ coverage of their listed credit universe is close to 100% for investment grade and around 85% for high yield companies. Through Sustainalytics, Muzinich may initiate new research on previously uncovered issuers, which is then shared with all Sustainalytics clients. “Third party ESG research provides a foundation that we can build on, plugging any gaps in the data and updating it where relevant because most ESG ratings are generally based on data that is at least one year old”, says Beeching.

Tailoring to private debt

Yet even this starting point is often missing for Muzinich’s private debt strategies, which finance smaller private companies in the US and Europe that are rarely covered by the ESG ratings agencies at present. What’s more, such companies seldom publish annual CSR or ESG reports in the way that larger companies do, and any reporting they do already provide will often fall short of typical ESG information requirements. Therefore, Muzinich is in often starting from scratch in gathering primary data directly from these companies: “the typical industry questionnaire sent to such firms may ask 10 or 15 questions about the most important issues, such as corporate governance, environmental liabilities, and employee relations, depending on the industry”, he adds. Muzinich may also try to negotiate reporting of relevant metrics (e.g. staff turnover rates) at regular intervals, where, “typically we have more influence in a bilateral deal than in a syndicated club loan”, admits Beeching.

Of course, not all of this is new. Governance has always been looked at closely by Muzinich’s investment teams. Going forward, Muzinich intends for its investment memorandums to increasingly contain a broader ESG section, addressing the E and S as well as the G. The information gathered would also be passed on to investors, generally on an aggregated and anonymised basis. For Muzinich, “key ESG metrics include factors like carbon footprints, but also positive impacts such as alignment with the UN Sustainable Development Goals (SDGs) and job creation, which is of particular interest to US investors”, says Beeching.

Beeching spent seven years at the PRI, building out its fixed income capabilities, and expanded this into private equity, private debt and real assets. The paper he authored there (2018 Spotlight on Responsible Investment in Private Debt) included insights from interviewing over 20 asset managers in the space. It explains how the 6 PRI principles apply equally to all asset classes, but the 3 most relevant principles for private debt are:

  • Incorporate ESG factors into investment decisions;
  • Engage investee entities to actively manage ESG-related risks and opportunities; and
  • Ensure investors and investee entities are transparent and accountable.

Regarding ESG factors, the balance between E, S and G factors varies by company. “The SASB Materiality Map is one tool for prioritising which issues are most material for each industry or sub-industry. This is a useful starting point to engage analysts at a sector level”, says Beeching.

On engagement, Beeching is keen to educate companies: “an important part of engagement is letting companies know how it works, and why it is important for them to raise their game”, he says. Beeching empathises with the challenges companies face in attaining good scores from ESG ratings agencies. The correlation between Sustainalytics and MSCI ESG ratings has been estimated at 0.32 – and there are many cases where companies have a high rating from one of them and a low rating from the other. While one researcher will look at an electric car manufacturer and consider the resource intensity of the production process to be the most important factor, another may consider the long-term climate benefits of the product to be more important.

Collaboration

Beeching has a wide network from his time at PRI and previous roles in Australia, where he has a Masters in Environmental Management from UNSW. Muzinich is keen to pool resources with other investors, and industry groups, where this is helpful. Muzinich has been a signatory of the UNPRI since 2010 and Beeching has just joined the ESG committee of the European Leveraged Finance Association (ELFA), which is seeking more transparency from high yield and private debt borrowers. Beeching would like to see groups such as Climate Action 100 Plus, which are rather equity-centric, pay more attention to credit. Collaborating with other stakeholders can sometimes expedite data collection, but does not always work as expected: “when lending to private equity owned companies, the sponsors are not always responsive in providing ESG data”, says Beeching

An Evolving Policy

This should improve over time as a growing number of institutional investors demand more extensive ESG reporting. Muzinich’s ESG policy will also continue to evolve over the coming years. “Historically, our engagements have been more reactive. We are moving to a more proactive approach, anticipating ESG risks and looking at our portfolio exposure to them. It is becoming more acceptable for pure credit investors to engage, even though they do not typically have voting rights”, says Beeching. The ultimate sanction would be to withhold financing or refinancing; doing so would ultimately increase companies’ cost of capital. Muzinich has observed borrowers taking this seriously: “CFOs who are sensitive to the cost of borrowing are calling our analysts and being increasingly communicative on ESG issues”, says Beeching.

Longer term, Muzinich would like to focus more on the impact that companies it invests in are having on the world. “It’s one thing to show good intentions when constructing a portfolio, it’s much harder to measure real outcomes”. While Muzinich doesn’t plan to become an ‘impact investor’ in the near term, Beeching expects increasing demand for asset managers to demonstrate both positive and negative impacts of their underlying holdings. “…then we’re likely to see which managers are walking the talk”.  Muzinich is also supportive of innovative vehicles like ‘green bonds’ and ‘green loans’, and is encouraged by the introduction of ‘positive incentive loans’ and a new category of transition bonds that raise capital for transformational projects; as it believes those have the potential to create real incentive for companies to shift from ‘brown’ to ‘green’ in their operations, products and services.

Readers should watch this space as Muzinich further develops its responsible investment approach in line with arguably the most rapidly evolving aspect of the investment industry.

Footnote

[1] The source for this is CSRHub. See FT article https://www.ft.com/content/a5e02050-8ac6-11e8-bf9e-8771d5404543