By TERRY ING, JEANNIE CHO, WILLIAM NEEDHAM Jul 28, 2022
As outlined in our April Credit Viewpoints paper, the management of environmental, social and governance (ESG) issues is a rapidly evolving, increasingly important component of investing. ESG integration has moved well beyond simply screening for high risk ESG activities and controversial gating issues, towards identifying areas where investment managers can see both positive societal impacts and attractive returns.
Credit markets pose particular challenges for ESG integration, with limited issuer disclosure across Private Credit, Leveraged Loan, and High Yield markets. In 2021, the KKR Credit Team explored ways to enhance our approach to ESG integration for KKR’s Private Credit investing activities, seeking to develop a systematic process to surface and monitor significant ESG information. Working in collaboration with our investment teams, dedicated KKR ESG specialists, external consultants, investors, and a global NGO (non-governmental organization) with expertise in sustainable business, we developed what we believe to be a robust, repeatable and measurable process that we are calling “ESG Credit 2.0”.
We believe this new ESG Credit 2.0 framework creates a strong foundation for (a) unearthing meaningful ESG-related data from, and incorporating ESG-focused operating procedures into, our Private Credit investment processes, and (b) identifying opportunities to invest into sustainable solutions and ESG-committed companies, both now and in the future.
As credit investors, we understand that there are limits to our ability to mandate change. However, as custodians of $73 billion in Private Credit, we feel a sense of responsibility to try and facilitate positive change through our approach to our everyday investing activities. We aim to do this by engaging with our borrowers and their shareholders, asking difficult questions, maintaining an ongoing dialogue with our stakeholders, and, where appropriate and possible, providing our portfolio companies with incentives to improve their ESG profiles. This approach is designed to enable us to create positive difference while also seeking to deliver attractive risk-adjusted returns for our investors.
KKR’s Leadership in ESG
As a firm, KKR has made a commitment to the idea that the integration of ESG issues into investment processes can create shared value. In 2008, the firm began to formalize efforts to protect and grow value by considering broader stakeholder issues as an integral component of the investment process. In 2009, KKR became a signatory to the United Nations-backed Principles for Responsible Investment (PRI) and helped to develop the guidelines for responsible investing as a member of the American Investment Council. In 2013, the firm codified its global Private Equity ESG Policy, and in 2020, replaced this policy with KKR’s Responsible Investment Policy, which articulates KKR’s approach to the consideration of ESG risks and value creation opportunities into our investment processes. The firm’s commitment to ESG, and how it has been operationalized, is described in greater detail at https://kkresg.com.
The ESG Credit 2.0 Framework
Following a year of development and testing, our ESG Credit 2.0 framework has now been incorporated into our underwriting process across our Private Credit business.
Through the ESG Credit 2.0 framework, we will collect valuable ESG-related information about our investments that we believe will enable us to unearth trends, identify aggregate areas of ESG risk, disclose relevant metrics to investors, and potentially identify investments as relevant to future sustainability-focused investment strategies.
“Our investment teams are expected to implement the framework and incorporate ESG criteria on applicable transactions, proactively engaging with prospective portfolio companies and their owners”
–Ken Mehlman, Partner, Global Head of Public Affairs & Co-Head of Global Impact at KKR.
The ESG Credit 2.0 process, key features:01
Scoring an investment opportunity against our proprietary materiality-based ESG Scorecard;02
Analyzing whether companies provide sustainable solutions, e.g., advancing the UN Sustainable Development Goals (SDGs);03
Seeking out ESG due diligence and embedding ESG-related information rights in finance documents; and04
Looking for opportunities to include meaningful ESG metrics, ambitious ESG targets / key performance indicators (KPIs) and incentives into finance documents.
Before we undertake initial commercial analysis of an investment, we expect all potential opportunities to undergo a three-part, pre-screening process:01
While not an exclusionary list, each investment is expected to be checked against a list of critical ESG, regulatory, compliance, and reputational issues. The list includes key considerations that will influence KKR’s decision on whether to invest, and other considerations where additional scrutiny is needed before beginning significant commercial diligence.02
RepRisk is a global company focused on ESG data science and machine learning with a significant database covering many privately held companies. Its online platform scans publicly-available information regarding ESG controversies for both public and private companies. An “incident report” is produced and, where there are issues of concern, we expect these issues to first be satisfactorily diligenced in order for the investment opportunity to progress.03
Input from Internal KKR ESG Specialists
When there is a sensitive topic in an otherwise compelling commercial opportunity, our ESG specialists and the investment team will partner to work through any challenges.
Data-Collection and Engagement
From a sustainability perspective, we would like as many of our investments as possible to advance the SDGs, include impact theses, and be ‘transformative investments’, where relevant. Through the ESG Credit 2.0 process, we intend to collect data on investments that may contain these features. Whether a company does or does not include these features will not influence the investment decision for traditional Private Credit products. Separately, however, we will seek to incorporate ESG-considerations in the investment process through, among other steps, use of our innovative ESG Scorecard and, as appropriate, the incorporation of ESG features into loan agreements.01
Prospective companies that pass the pre-screening process are then analyzed against the SDGs. The objective is to understand whether companies are making a positive contribution to society / the environment, as indicated by the SDGs. We look to ascertain whether a company’s business model advances one or more of the SDGs, which broadly relate to driving solutions to mitigate climate change, benefiting communities and consumers, and/or driving a more sustainable future.
In order to make the assessment, we collaborate with a global NGO of sustainable business experts in an effort to bring both objectivity and credible third-party subject matter expertise. We have developed an iterative framework with the NGO designed to allow: first, the investment analyst to make an initial assessment; second, KKR’s ESG team to test that assessment; and third, if the investment analyst and KKR’s ESG team determine that an investment aligns with one or more SDGs, the NGO, as an outside consultant, to provide input on whether any of the SDGs are advanced. KKR’s ESG team ultimately makes the final determination as to whether any of the SDGs are advanced. This process and analysis may continue throughout the Underwriting process.02
We also look to identify and take note of companies that, while not necessarily advancing the SDGs, are part of another “impact” thesis. We are looking to identify companies backed by impact investors who are signatories to the Operating Principles for Impact Management, such that we believe there is a thoughtful and defensible sustainability thesis. Such investments may also be suitable for future ESG-focused strategies.03
Here, we seek to identify opportunities to finance sustainability-related transformation, including transition from “brown” to “green” (e.g. transitioning coal assets to renewable assets).04
Underwriting Engagement Process
In our credit underwriting process, we are striving to heighten our focus on ESG-related considerations and risk. We face a challenge in how to balance retaining our nimble underwriting approach, which we believe counterparties value, while aiming to devote greater attention to ESG topics. This challenge is probably best summarized as “taking complexity and creating simplicity”. We believe that the new ESG Scorecard, in addition to other tools assisting due diligence considerations, which include Investment Committee checklists and ESG-focused due diligence, strikes this balance.
A) ESG Scorecard
Our proprietary ESG Scorecard, in part informed by the Sustainability Accounting Standards Board (SASB), is a key component of our analysis and data-collection efforts. We developed the scorecard as a way to evaluate companies in which we are investing against materiality-based1 ESG criteria. Our analysts are expected to use the ESG Scorecard to provide an overall score for each applicable investment, allowing us to identify and monitor areas that have scored high or low and to revisit our scoring as facts and circumstances change. We also believe that analysis of data derived from the ESG Scorecards can provide investment insights.
Please access the Credit Viewpoints paper, Meeting the Call for Innovation in Leveraged Credit and Private Credit ESG for further details on the scorecard.
B) Investment Committee (IC) Checklist
To help ensure that we systematically address due diligence and credit quality, we encourage the use of an IC checklist. The checklist prompts investment teams to ask targeted questions – Have background checks been conducted on management? Have we used independent channel checks on key relationships? Is there a reputable auditor? And many more. We believe the questions on the IC checklist are important to commercial underwriting more broadly and that addressing such questions helps us to understand and assess if a company may have ESG issues.
C) ESG Due Diligence
Our intention is to ask our potential borrowers for ESG-related due diligence items. It is not always the case that ESG due diligence materials are provided by the borrower, nor do we believe the lack of such materials will necessarily impact our decision to invest. Often there will be ESG issues covered in legal or commercial due diligence reports, which is helpful. However, we believe asking for specific ESG due diligence items helps with providing additional insight into potential and existing ESG issues.
D) ESG Targets
We believe there is an opportunity to bring Sustainability Linked Loans to private markets, as we have seen occur in public markets.
We have worked to build an ESG-KPI framework for incorporating such features into loans that include incentives (e.g. margin, covenant flexibility, maturity extension, etc.) for achieving material KPIs and setting ambitious sustainable performance targets (SPTs) that are capable of being measured and reported. We have aligned our approach to industry-best practice standards (e.g., LMA’s Sustainability Linked Loan Principles) to help ensure that we are able to structure both “material” ESG KPIs and “ambitious” SPTs.
Given increasing global focus on reducing carbon footprint and increasing public focus on improving corporate diversity, equity, and inclusion, we think that the majority of these KPIs will relate to these topics. We believe our framework allows us to develop KPIs that target those issues most material to the portfolio companies and their sectors / industries. Our framework has received a second party opinion from Sustainalytics on its alignment with the Sustainability Linked Loan Principles developed by the Loan Market Association (LMA), Loan Syndications and Trading Association (LSTA), and Asia Pacific Loan Market Association (APLMA).
We are not taking the position that every investment we make must include ESG targets. However, whether or not we include KPIs in our loan documents, we think that engaging with our counterparts in these conversations may increase their focus on ESG issues and keep them alert to possible risks moving forward.
Having made the decision to provide financing to a company, we also focus on trying to reflect our ESG priorities in the finance documentation.01
ESG Information Rights
We typically look to include a contractual right that borrowers will provide us with copies of their ESG-related policies (e.g., employee health & safety policies) along with their anti-bribery and corruption policies. Failure to obtain these ESG policies does not prevent us from moving forward with a deal; but we would need to understand the company’s reasoning for not providing them.02
Document ESG Targets
Where we successfully establish KPIs and incentives to improve ESG in financings, we plan to document these as covenants so that we can hold companies accountable to the agreed upon targets.03
KKR ESG Questionnaire
Finally, we may ask the Sponsor to complete a tailored version of the standard LSTA questionnaire for Asset Managers, which has been customized to align with KKR’s Responsible Investment Policy.
Monitoring and Reporting01
Once an investment has been made, we aim to monitor ESG-related issues on an on-going basis and, where achieved, any on-going advancement of the SDGs or attainment of ESG Targets:
A) Credit QB
Our digital “quarterback” tool, which internally tracks the data from our credit investments, allows us to surface information from the ESG Scorecards and observe trends. It also provides an early warning system that may indicate where issues are likely to arise. Similarly, it can be used to track which companies are advancing the SDGs and the status of any ESG Targets that have been agreed to by borrowers.
B) Portfolio Monitoring Committee (PMC)
We plan to review company ESG Scorecards at least annually and expect our PMC to meet quarterly to review every credit in the portfolio – thus providing a formal opportunity to regularly assess any ESG risks or wins.02
We believe that the ESG Credit 2.0 process not only improves our Private Credit investing process, but also provides valuable data that we may share with our investors, depending on the relevant strategy, for example:
A) Scorecard Data
We will be able to report the data obtained from our ESG Scorecard analysis, including overall portfolio scores, breakdown by sector and split by Environmental, Social and Governance scores.
We will be able to report what % of a portfolio has been determined to advance the SDGs, which particular SDG target, and an estimation of the company’s impact based on the identified SDG contribution.
C) ESG Targets
We will be able to share which of our investments contain Sustainability Linked Loans. Below is an example of the types of ESG KPIs and targets that may be part of a Sustainability Linked Loan.
D) ESG Information Rights
We will be able to track and report deals where we did / did not obtain contractual disclosure of ESG policies.
KKR’s ESG Credit 2.0 framework represents a commitment to include ESG pre-screening, data-collection, engagement, measurement and (where possible) incentives throughout our Private Credit investment process.
In addition, the implementation of ESG Credit 2.0 means we can expect many new products we offer to be classified under Article 8 of the Sustainable Finance Disclosure Regulation, which applies to funds that promote environmental and/or social characteristics.
“We believe that our ESG Credit 2.0 process positions us well to continue identifying ESG-related risks and leaning-in to opportunities where we can be agents for change and partners in shared value through our Private Credit investing business.”
–Chris Sheldon, Partner, Co-Head Credit & Markets
Indeed, over the course of 2022, we hope to launch products supporting our European Direct Lending, Global Junior Debt and ESG Accelerator strategies – the latter being a new global cross-capital structure strategy focused exclusively on sustainable and ESG-focused Private Credit investments.
Finally, we recognize that this is a continually evolving area. We are committed to making progress, regularly critiquing and evolving our approach, and welcome as always questions, ideas and feedback from our investors.REFERENCES
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The information in this communication may contain projections or other forward-looking statements regarding future events, targets or expectations regarding KKR Private Credit and the funds or the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this communication, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.
Further, statistics and metrics relating to ESG matters are estimates and may be based on assumptions or developing standards (including internal standards and policies).
Similarly, there can be no assurance that KKR’s ESG policies and procedures as described in this report, including policies and procedures related to responsible investment or the application of ESG-related criteria or reviews to the investment process, including the ESG Scorecard, will continue; such policies and procedures could change, even materially, or may not be applied to a particular investment. KKR is permitted to determine in its discretion that it is not feasible or practical to implement or complete certain of its ESG initiatives, policies, and procedures based on cost, timing, or other considerations.
General discussions contained within this communication regarding the market or market conditions represent the view of either the source cited or KKR Credit. Nothing contained herein is intended to predict the performance of any investment. There can be no assurance that actual outcomes will match the assumptions or that actual returns will match any expected returns. The information contained herein is as of June 30, 2022, unless otherwise indicated, is subject to change, and KKR Credit assumes no obligation to update the information herein.