Leading global asset manager Federated Hermes is looking at an old problem through a new ESG lens and is calling for weak covenants embedded in private equity buyout debt to be redefined as a governance issue.
Deteriorating covenants have been the scourge of institutional investors in recent years and are now as weak as they have ever been, as aggressive law firms paid for by private equity firms stripped investor protection from deals to compete for business.
A push to reframe the thorny problem as a "G" problem in the ESG spectrum could be a less contentious way of discussing covenants with sponsors, and coincides with other initiatives by trade associations, including the European Leveraged Finance Association.
"Of all the issues in leveraged finance, this is the most difficult," said Mitch Reznick, head of research and sustainable fixed income at Federated Hermes. "Covenant design and construction is a measure of how the shareholders balance the interests of all financial stakeholders. That's why it’s a governance issue."
Cash rich private equity firms have been slow to the sustainability party, but are facing increased pressure on ESG from their own end-investors and fixed-income investors after nearly a decade of excess demand in a bull market has allowed them to play hardball with investors chasing yield.
The push to reframe weak covenants as an ESG issue could prove to be an effective lever to bring private equity to the table, as investors continue to push for ESG disclosure and sponsors start to adopt their own corporate social responsibility programmes.
"Whilst covenants are, a priori, a governance issue, the momentum in ESG is an opportunity to reinvigorate the case for covenants that are amenable to the whole market,” Reznick said.
Federated Hermes is an ESG investor with US$575bn of assets under management following the combination of US investment manager Federated Investors and Hermes Investment Management in February.
Hermes has a more than 10-year track record in ESG investing and was seen as a world leader in the space by Federated Investors, which is currently integrating Hermes ESG factors into its products.
Federated Hermes identified US office-sharing start-up WeWork as an example of a governance problem in a paper titled "Do your ‘G’ work" written by Martin Jarzebowski, the fund managers' director of responsible investing in January. The report said that the company had taken its eye off basic governance matters. WeWork’s US$47bn valuation crashed after its public offering imploded last year.
The connection between covenants and governance is arising in ESG integration for more sophisticated investors, and the question of whether weak covenants are a credit or governance issue - or both - is being actively debated in credit committees.
Recent leveraged buyout loans, including a £1.3bn leveraged loan for UK forensic sciences group LGC, a £2.193bn loan for UK theme park and attraction operator Merlin Entertainments and an €820m-equivalent buyout financing for German insulation foam maker Armacell have all had weak covenants.
“Documents and covenants are at their weakest point that we've seen for a long time," said Jane Gray, head of European research at credit research firm Covenant Review.
Investors have been protesting about documentation and covenants for years, but have still been buying the deals, as excess demand and little supply has allowed private equity firms to push to secure maximum flexibility, which they say is their fiduciary duty to shareholders.
Fixed-income investors use ESG integration scoring to assess companies and draw a direct line from ESG issues to credit risks and spreads, and see favouring one set of stakeholders over others as a potential financial risk for the companies they invest in when rating for governance.
Funds are using ESG scores to inform investment decisions about how much of a credit they will take, and where they invest in the capital structure of private equity-owned companies, as ESG continues to filter into the leveraged market from its origins in the corporate investment-grade world.
“How companies score on governance can have an impact on how much default risk and volatility contribution we want in the portfolio associated with that single name," Reznick said.
"What you're trying to get out of governance is longevity, stable shareholders and the sustainability and viability of the business so that all stakeholders can benefit. Covenant structure gives a good indication."
ELFA has launched several initiatives to address ESG issues in the leveraged loan market, including a recent survey of 100 investors, which found that 72% are already addressing ESG considerations.
"We are providing investors with as many tools as possible to engage - that's ELFA's remit," said Sabrina Fox, executive adviser at ELFA. Reznick is also a committee member of ELFA.
ELFA is working on a standardised ESG disclosure and will hold an investor roundtable in conjunction with the UN-supported Princples for Responsible Investment in April to discuss the issue.