Lending for impact An M&G Investments institutional perspective November 2016 The world requires investment on a huge scale to address environmental and social challenges ranging from reducing carbon emissions and pollution to controlling disease and raising populations out of poverty all necessary for continued economic growth and generation of long-term returns from investment. The resources of governments, international agencies and civil society organisations remain constrained, leading to a growing focus on mobilising private investment to bridge the gap. Institutional capital can support these goals by targeting long-term investments that offer a direct positive environmental or social impact in addition to a competitive financial return. We have financed such impact investments in private debt since the 1930s and now draw on broad expertise to create a wide range of assets that aim to actively benefit society and the environment, as well as provide attractive returns to investors. Institutional asset owners are increasingly looking to invest not only for financial return but also to benefit society and the environment. This movement is visible in the broadening range of socially or environmentally responsible investment strategies as well as in the growing emphasis on integration of environmental, social and governance (ESG) factors into asset managers investment processes. Increasing awareness among institutional asset owners, pension scheme members and individual savers is also shifting attitudes in favour of a more sustainable approach to investment. Socially and environmentally responsible investment became established first in equity markets, as shareholders voting rights enable them to influence the behaviour of the companies they own. Yet lending in all its forms accounts for far greater flows of finance to corporates and organisations and we believe the opportunity set for debt investment is commensurately larger than for equity. Sustainable bond funds are at present a small segment of the fixed income fund universe yet take a variety of approaches to investment. One is to rank companies in a given investment universe using an ESG scoring system based on their environmental and social credentials. This enables an investor to target companies with high ESG scores relatively straightforwardly, but the net positive outcome is limited. ESG scoring typically covers companies with liquid fixed income securities only, with little information available on private assets. It can also have unanticipated outcomes such as encouraging investment into banks and other financial institutions, which tend to attain high scores. Another strategy known as negative screening excludes from an investment universe all companies involved in certain activities such as fossil fuels, alcohol, tobacco or weapons. While simple to implement, this does not target a direct positive impact at all. Making an impact Two other approaches to sustainable debt investment focus on producing a direct positive impact as well as a financial return. These strategies lend to projects that can, for example, reduce an organisation s carbon emissions, generate clean renewable energy or construct new social housing, among many others. One provides investment through liquid debt markets in the form of green bonds, while the other lends directly to companies and organisations as private debt impact funds.
Green bonds are a specific type of tradable bond in which the amount raised is earmarked for projects with environmental benefits. As well as ring-fencing the proceeds, green bonds involve compliance with governance requirements and often verification by a third-party consultancy. Though demand for green bonds is high and rising, the market is in its infancy with a total outstanding value of 106 billion 1 (in comparison, the value of outstanding euro-denominated investment grade corporate bonds stand at more than 1.92 trillion 2 ). The first green bond was issued only in 2007 by the European Investment Bank (EIB), for renewable energy and energy efficiency projects, and issuance is still concentrated in supranational and government agencies such as the EIB, the World Bank and Transport for London. Supply is consequently not yet sufficient to construct diversified portfolios, particularly since many investors buy the bonds to hold to maturity, which limits secondary trading activity and increases prices. Beyond green bonds, investors typically turn to impact funds for positive direct outcomes from investment. These source, create or acquire assets that target demonstrable direct environmental or social benefits alongside financial returns and report the impact each investment generates. Impact funds are often small, concentrated products such as microfinance (small loans to individuals, usually in developing countries, to start enterprises) and in many cases they focus primarily on the impact of the investments with financial returns a secondary consideration. However, we see an opportunity to create a more diversified impact investment strategy that provides direct private loans to corporates and organisations. This can prioritise both financial return and impact and can connect institutional capital with the expertise of investment managers to create new investments offering environmental, social and financial rewards. Financing solar energy with Lightsource Our infrastructure finance team completed an impact investment in November 2015, funding a 250 million refinancing of debt facilities for Lightsource, a solar energy company. Investment in solar parks provides a significant net positive impact to the environment as the clean energy they produce with growing efficiency plays a crucial role in lowering UK carbon emissions. We expect this investment to generate over 100,000MWh of electricity annually, leading to a reduction in carbon-dioxide emissions of 48,000 tonnes per year. Lightsource is keenly aware of the importance of ESG considerations: its panels are fully recyclable and the land surrounding the solar panels doubles up for agricultural use such as livestock grazing. We monitor the borrower to ensure it stays fully compliant with the Equator Principles, a risk management framework for ESG in project finance, and that it possesses all relevant certifications across product quality, environmental management and systems environmental management and systems standards. Our due diligence includes site standards. Our due diligence includes site visits by technical advisers who review labour visits by technical advisers who review labour practices and manufacturing processes. practices and manufacturing processes. The Lightsource deal has won the Bond of the The Lightsource deal has won the Bond of the Year Award 2016 from Environmental Finance, Year Award 2016 from Environmental Finance, an online news and analysis provider. an online news and analysis provider. Lightsource s solar f arms. Credit Lightsource 1 Source: Climate Bond Initiative, Labelled Green Bonds, July 2016 2 Source: BofA Merrill Lynch Euro Corporate Index (ref: ER00) full market value as of 31 July 2016
Why private debt? In our view an impact investment 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 across different asset types. We believe private lending supplies the greatest breadth of attractive opportunities to achieve these goals and our long experience of sourcing and creating these assets ensures we have the resources and expertise to find and acquire them. Private debt includes a wide range of assets that offer sustainable outcomes, and many more pure-play impact opportunities than liquid bond markets, often because they are financing discrete projects rather than broad corporate loans. This is important to create scope to diversify portfolios. While many impact funds are single-area focus, we advocate a multi-focus approach that includes both a broad range of environmental and social impacts to ensure diversification and provides a wide opportunity set to maximise returns. In Europe the majority of companies and organisations borrow privately, traditionally from banks, since they typically require finance on a smaller scale than obtainable from public capital markets. Some have been affected by the withdrawal of banks from long-term lending since the financial crisis and institutional investment, with its longer investment horizons, is well-placed to support their sustained growth. Opportunities for impact investment include: Private debt impact investments can offer returns comparable to other private debt strategies and will often pay a premium over public bonds to compensate for their lack of secondary trading opportunities. In addition, the ability to negotiate any lending directly with the borrowers allows us to have higher protections if things were to go wrong. This style of investment emphasises all the advantages of active management (indeed, it cannot be accessed in a passive manner). It 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 to ensure each asset delivers not only sustainable benefits but downside protection for the creditor. Managing and measuring impact assets Investing in sustainable private assets also requires an excellent knowledge of environmental and social standards. Bespoke assets like this are often considered buy and hold investments, so require careful agreement and regular monitoring to ensure the quality of both the credit and the impact remain high throughout the investment s life. A robust process to measure and report the social and environmental outcomes of each investment is essential for any impact strategy, in addition to typical financial performance metrics. Impact can be measured through tangible outcomes: the megawatt-hours of electricity a solar park generates or the reduction in carbon dioxide emissions as a result of the construction of a new renewable energy project, for example. Social benefits could include the number of social houses built or students from low-income backgrounds in student accommodation. Assessing and quantifying impacts such as these are integral to our analysis and due diligence prior to making an investment. Impact measurement must also be an ongoing process throughout the life of each investment with regular monitoring and reporting of non-financial outcomes alongside continued financial analysis. We use external partners to provide specialist ESG research and sustainability and impact assessment criteria appropriate to the private and illiquid assets we source. Engagement is also vital when managing these investments. Keeping open lines of communication with the borrowers allows us to advise and support management should any risk to either credit or impact quality emerge. M&G and private debt M&G is an established investor in private debt and a large impact investor with 20 billion of impact assets under management 1. We have pioneered private and impact investment over decades for our parent Prudential plc as well as our third-party institutional clients. In the 1930s Prudential provided debt finance for the Carsfad small-scale hydroelectric dam in Scotland, one of the group s first infrastructure assets and perhaps our earliest impact investment. In 1997 we made our first investment in private placements and in 1999 became one of the first non-bank investors to enter the European leveraged loan market. We began to invest in long-lease real estate assets for our internal funds in 2000 and have offered this capability to third-party investors in the UK and Europe since 2007. In 2009, we launched a direct lending strategy for mid-sized UK companies hindered by a lack of available bank financing after the financial crisis, which we expanded with a further fundraising three years later. 1 As at 30 September 2016
About the author Richard Sherry Fund Manager Richard joined M&G Investments in 2005 as a Fund Manager within the Alternative Credit team. Prior to joining M&G Richard worked as a Portfolio Manager at JP Morgan Asset Management, specialising in the management of corporate bond portfolios. Previously, Richard was a Quantitative Analyst at Zurich Investment Management, Australia. Richard began his career working in the actuarial department of Zurich Australian Life Insurance. Richard graduated from Macquarie University, Australia with a degree in Economics and a Masters in Applied Finance. He additionally holds a Masters in Business from the University of Technology, Sydney and an MSc in Mathematics from Oxford University and is an actuary. For more information contact: Andrew Swan +44 (0)20 7548 2375 andrew.swan@mandg.co.uk John Atkin +44 (0)20 7548 3466 john.atkin@mandg.co.uk Henry Barstow +44 (0)20 7548 3469 henry.barstow@mandg.co.uk Sunita Dey +44 (0)20 7548 3393 sunita.dey@mandg.co.uk www.mandg.co.uk/institutions institutional.clients@mandg.co.uk For Investment Professionals only. The distribution of this document does not constitute an offer or solicitation. Past performance is not a guide to future per formance. The value of investments can fall as well as rise. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and you should ensure you understand the risk profile of the products or services you plan to purchase. This document is issued by M&G Investment Management Limited. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority s Handbook. T hey are not available to individual investors, who should not rely on this communication. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. M&G does not offer investment advice or make recommendations regarding investments. Opinions are subject to change without notice. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. 0825/MC/1116