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Special Report: As It Matures, ESG Permeates the Entire Investment Universe

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Demand for sustainable investing is ubiquitous – across every market, from every type of institutional investor, even if not with the same fervor. Harnessing the right data remains a key to evolving and diverse ESG investment strategies, which themselves are driven by distinct and innovative investment philosophies and processes. In this special report, we look at the latest trends in sustainable investing, including ESG in emerging markets and structured credit.


Promoting Sustainable Finance

The Sustainable Investment Forum North America 2019 takes place in New York on September 25. As the event drew near, II caught up with Leon Saunders Calvert, Head of Sustainable Investing & Fund Rating at Refinitiv, to discuss how Refinitiv is promoting sustainable finance.

Let’s start with some background on Refinitiv and your role there?

Refinitiv is one of the world’s largest providers of financial markets data and infrastructure, formerly the Financial and Risk business of Thomson Reuters. I head up the Sustainable Investing and Fund Ratings businesses. One of the key assets I am responsible for is our global database of corporate disclosure on Environmental, Social, and Governance (ESG) metrics. We aggregate, normalize, and create analytics to disseminate the data to the institutional finance community, including the world’s largest asset managers and asset owners, many of whom use it at the core of their ESG investment allocation models.


How do you see the investment market changing now that sustainable investments are firmly increasing each year?

There is a maturity taking place in the market in which ESG factors are becoming fundamental to all investment allocation decisions rather than being seen as an alternative asset class. So, yes, sustainable investments are rapidly increasing each year, but more than that, we are starting to see the mainstreaming of sustainable investing where sustainability factors inform the basic institutional investing processes.

The regulatory overhang on the market, the increasing influence of Millennial investors and employees, the need for active fund managers to find sources of competitive advantage to drive alpha, and the general growing awareness of climate challenges and need for related action, all contribute to a growing trend which ensures it is not simply a zeitgeist issue.

What are some of the challenges in promoting sustainable finance?

There is still a general perception that investors need to sacrifice returns to invest in sustainability despite various analytics to the contrary. But broader resistance associated with promoting sustainable investing is decreasing rapidly based on the growing awareness by consumers and investors alike. The challenges instead become the lack of transparency and analytics associated with sustainability related data and benchmarking.

At Refinitiv, we strive to be the industry standard for ESG-related corporate disclosure data. This helps to create transparency and auditability in the space. In our scoring system, we penalize companies for non-disclosure with the view to promoting superior standards of reporting to better inform investors. We want the supply to meet the demand, and drive transparency around what has historically been an opaque area.

What is the importance of events such as the Sustainable Investment Forum for businesses interested in investment?

Driving awareness around sustainable investing continues to be critical, especially as sustainability means so many different things to so many people. Creating a community of leading professionals in the financial markets to enable and facilitate dialogue on how to think about this space, what problems to solve, what order to solve them in, sharing of best practices, and establishing the elements which are clearly in the common good and need to be addressed in unison – all of these extremely valuable. Corporations and the financial community have to fill in some of the holes left by today’s politicians around climate and other critical issues, so the process of knowledge-sharing and outcome focused goal-setting through the Sustainable Investment Forum is something Refinitiv fully supports.

Take a deeper dive into the latest trends in corporate sustainability, including the transition to low carbon economies.


Why Responsible Investing?

“There is no business to be done on a dead planet.” – David Ross Brower

Only 15% of the world lives in developed countries, yet these countries represent over 40% of the world’s GDP. However, this is likely to be transformed in the near future. Various estimates predict that by 2030, the middle class will reach 5.6 billion people, which translates into 2 billion people with increased purchasing power – 87% of whom are Asian. India and China combined will represent 66% of the global middle class in just over a decade.1


Most of the emerging countries see the developed markets as an aspiration and understandably want to be part of the growing middle class. At BMO, we consider this a great opportunity. We love talking about the low penetration of various consumer products and long-term secular growth prospects as these markets grow in wealth and size. While the narrative of investing in the emerging markets sounds promising, there is a simple question that investors often forget to ask – what is the negative impact of these positive improvements? We know from the evolution of the developed world that our benefit has come at a cost to the environment. As it stands, we remain the largest environmental offenders from a per capita perspective. Reflecting on the per capita element, the fact that by far the majority of the world’s population resides in the emerging markets and wants a higher standard of living will inevitably worsen the environmental crisis we face.

Get to know the team involved in a remarkable collaboration around responsible investment.

Emerging markets must leverage resources

Emerging markets will require more energy output as they become more power-hungry, leading to more power plants fueled largely by coal given its abundance and low cost of extraction. The inevitable result is larger carbon emissions and air pollution. These consumers will also require more factories, producing short-lived consumer products that will lead to plastic and other types of waste that are likely to end up polluting land and oceans or in our food systems through microplastics. This is just the tip of the iceberg for the environmental damage that is taking place as billions move closer to becoming middle-income citizens.

For us it is clear that the developed world cannot expect the emerging world to curb its middle- class aspirations in exchange for cleaner water and air. A new approach is required, one where economic progress is not solely calculated based on traditional revenue or EBITDA metrics, but also on whether companies are operating in a sustainable2 way to actively minimize their negative impacts, while providing products and services that are improving the quality of life for the masses.

Specifically, for the BMO Responsible Global Emerging Markets strategy, we look for companies that have a positive impact by either solving, or being positioned to benefit from, the sustainability challenges in emerging markets.

China no longer a sleeping giant

In our investment universe, we regularly observe some emerging nations that go two steps forward and one step back in terms of economic development, while others have progressed more steadily — among the latter group is China. China as a nation has done a tremendous job of lifting its large population into the middle class from poverty. China today leads the world in the number of internet users and college graduates and is working to land a person on the moon. It is fair to say China is no longer the sleeping giant portrayed by Napoleon Bonaparte. This success has a cost, though. The ecological environment of this 1.4 billion-strong nation, who today eat three times as much meat as in 1990 and consume five times more dairy than in 1995, is faced with declining farmland, where 20% of what remains is polluted and there is visible air pollution in cities.3 Many other challenges are highlighted regularly in the media.

While it is easy to be pessimistic about the future of China with all the negative news that is regularly flagged to us, we remain optimistic that over time China will overcome these challenges. There is a lot of progress that often doesn’t make front-page news. For example, China spends three times more on renewable energy than the U.S. It is also by far the largest investor in this field globally, with renewables expected to reach 35% of China’s energy mix by 2030 – up from 12% just 4 years ago.4 82% of Chinese consumers are willing to spend more on healthy food and beverage products, much higher than the global average of 68%.5To keep the “social contract” between the leadership and the people intact, there is a requirement to change and improve. We are already seeing this and are likely to see more. In other emerging markets, we are seeing countries heavily investing in renewables, banning plastic bags, implementing a tax on sugar – basically taking the social cost from the public and forcing it into the accounts of the corporates. We welcome this and, equally, we demand our companies to prepare for and, where possible, benefit from these challenges.

Learn more about BMO’s Emerging Markets and Responsible Investing capabilities at bmogam.com.

1 https://ec.europa.eu/knowledge4policy/foresight/topic/growing-consumerism_en: “middle class” defined as earning $11 to $110 per day, can expect to live a decent life and have escaped extreme poverty. They are also known as the ‘consumer class,’ the group whose demand powers most economies.

2 Avoidance of the depletion of natural resources in order to maintain an ecological balance.

3 Coal is still around 2/3 of the energy source for China.

4 Source: U.S. Energy Information Administration and https://asia.nikkei.com/Spotlight/Cover-Story/China-s-renewable-energy-surges-after-state-backing

5 https://www.nielsen.com/cn/en/insights/news/2018/nielsen-report-ten-trends-of-chinas-consumer-market-in-2018.html

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What to Expect in ESG’s Time of Transition

The past year has marked a time of record inflow into funds and products that promote good environmental, social, and governance (ESG) practices at investee companies. But legislators and other market movers are still underestimating the impact of such factors on the long-term health of not just financial markets, but wider society and the planet as a whole.


“Companies increasingly are able to quantify their actions on ESG issues, but not many can turn this information into what it means to the business financially,” says Elena Philipova, Global Head, ESG Proposition, at Refinitiv. “In turn, this means that companies and investors are not monetizing the full values of the sustainability business case. That said, I expect many improvements in that regard, powered by continued innovation, stronger regulation, and tougher systematic market risks hitting closer to home.”

A mainstream movement

For Cyril Blanchard, Refinitiv’s Market Development Manager in Continental Europe, the progress made over the last year is cause for celebration. He points to moves such as Amundi’s decision to generalize its ESG criteria, or the fact that 253 new companies signed up to the UN’s Principles for Responsible Investment in 2017, according to the organization’s 2018 annual report, representing the addition of $82 trillion of managed assets.

The European CFA Institute conference held in Paris in November 2018 was also a landmark moment. “ESG was one of the main topics on the agenda,” Blanchard says. “Some 56 percent of attendees reported that they now consider ESG a mainstream practice and not an alternative asset class anymore.”

This mainstream move is a trend that many predict to continue, including Birgit Hermle, Market Development Manager in Continental Europe for Refinitiv. She believes ESG factors will become a top priority for asset managers across the spectrum.

“There will be no investments made in companies who don’t fulfill the set environmental requirements for investment, for the reason of reducing risk,” she says. “There may even be transactions which lead to disadvantages for minority shareholders.”

This refocusing from asset managers will be somewhat led by Millennials, who are more switched-on to environmental and social issues than their predecessors. As the intergenerational transfer of wealth switches capital over to such investors, asset managers will correspondingly increasingly focus on ESG issues.

Shareholder rights

Barnabas Acs, Market Development Manager in Europe North at Refinitiv, predicts that Northern Europe’s focus will be on “higher activity in shareholder rights management,” particularly how ownership information, activist investor data, and ESG metrics are handled.

“There’ll be more scrutiny of the public and regulators,” says Acs. “ESG factors will increasingly be used to support wealth management decisions and transparency.”

Paul Hewitt, Refinitiv’s Market Development Manager in APAC, currently sees similar forces in the East. Since the Japanese Pension Investment Fund, otherwise known as the Government Pension Investment Fund (GPIF), signed up to the UN PRI in 2015, inflows into responsible funds in Japan have accelerated: in the last year, the value of ESG-integrated funds in the region has grown by 182%.

“It’s very difficult to make generalizations regarding Asia, as each market has its own priorities and is at different stages of incorporating and integrating ESG considerations,” Hewitt says. “But the rise of index funds is driving the importance of corporate governance. These funds are in for the long haul with companies, and are seeking greater voting rights and increasing board engagement to drive sustainable long-term growth.”


ESG investment products

An increasing number of private asset managers are taking green issues more seriously, and new ESG products are also expected following innovations such as Credit Agricole’s green bond emission, introduced in 2018.

Acs also points to more “thematic” products, such as resource protection funds or diversity and inclusion-focused instruments, coming to the fore, along with further refinements of existing sustainability staples like fund ratings and the quality of ESG data.

“In Canada we are seeing a trend where asset owners are becoming even more sophisticated with their in-house sustainability talent,” says Hugh Smith, Market Development Manager in Americas at Refinitiv. “This has created the need for more raw, transparent, auditable ESG data – rather than ESG ratings or opinions provided by a third party – so that can derive their own opinion about the sustainability of a holding or potential investment.”

Demand for data is also trickling downstream from asset owners to asset managers hoping to win their mandates, and then on to corporations hoping to attract investment from asset managers, and to sell-side research houses hoping to engage with their buy-side counterparts.

“If the industry and practice of ESG investing is to continue this evolution, real quality has to be driven from within — starting with the availability of quality, independent data by which accurate and important investment decisions can be made,” says Philipova.

Learn more about how to build sustainability into your investment strategy with data and services covering thousands of companies.


In Emerging Markets, Context is Everything

Experience matters, perhaps more in emerging markets and sustainable investing than in any other aspect of asset management. The core of the team led by Maria Negrete-Gruson, Portfolio Manager, Sustainable Emerging Markets Strategy at Artisan Partners, has been investing together for nearly 20 years. In that time, a philosophy has emerged that stresses the context of sustainability in emerging markets, along with a focus on the progress made by companies on their individual journeys. The result is a compelling and original approach to sustainable investing in emerging markets. II recently spoke with Negrete-Gruson about the team’s singular approach.

II: As a firm, Artisan is particularly focused on ESG strategies and opportunities in emerging markets (EMs). Why is that?

Negrete-Gruson: We’ve been building our EM strategy for a long time, and we’ve always wanted to offer a broader perspective on sustainability in the specific context of emerging markets. From that perspective, we feel that ESG isn’t only about “do good now.”

ESG is essential – almost existential – to a lot of the opportunities in emerging markets. Given the needs in EM countries and the importance of long-term investing, our approach has always been that of bottom-up investors with a long-term horizon. Having clarity and a strategy about what type of opportunities are sustainable has always been important to us.

You mentioned the specific context of emerging markets. What is the context you use to frame ESG opportunities in EMs?

Negrete-Gruson: In short, we don’t think you can simply apply a developed market perspective to what are the right practices and approaches to ESG in EMs.

You’re not a big fan of ESG ratings. Why is that?

Negrete-Gruson: They fail to capture what is actually happening in emerging markets, where things are evolving and moving rapidly. So, to create categories of “good” and “bad” isn’t appropriate in EM, because it doesn’t take a long-term view, and the truth is that these companies are evolving, positively or negatively, constantly.

The second problem with ratings is how the metrics are developed. It can’t be all about a single opinion or definition. We must acknowledge where emerging markets are coming from, and reward positive change.

It sounds as if rather than worrying about ratings you’re concentrating on the evolution of EM companies?

Negrete-Gruson: Exactly. It’s a journey for businesses in EMs, and a journey for us, too, which is why we reject permanent exclusion lists or criteria that are set in stone in terms of good or bad, or emission standards. The journey is about factually assessing where the companies are coming from – where they started, and whether their sustainability-related behavior is improving.

For example, a company could have a mixed track record, but we see it’s transforming in a way that will lead to a more constructive future. From that perspective, there is a reward for us as investors. Even if we just narrow it to governance – perhaps a company that never paid dividends establishes a dividend policy – there is reward in that. As citizens of emerging markets, these companies are evolving from the reality of EMs of the past, and that progress has a very positive impact for the company and the community. We look to identify that positive change and reward it, and to penalize negative change.


Can you give an example of journey and context compared to a company being simply good or bad?

Negrete-Gruson: Some investors will say they don’t want fossil fuels in their portfolio – period, end of story. We would never say that. We would all prefer a world in which fossil fuels didn’t exist, but the reality of the journey of India or China includes setting priorities. Do you want no emissions, or do you want electricity for hospitals and schools? It’s not the activity itself, but rather how companies go about the activity. If you feel a company operates responsibly in regard to its community and environment, and you can quantifiably measure that, that’s where the focus should be. It might sound like a strong word, but it’s hypocritical to sit in New York, for example, and say companies in EMs should be doing this or that. Developed economies became developed based on doing the very things they say EMs shouldn’t be doing. You can’t just tell EMs to go ahead and develop, feed your population, give them access to education and healthcare, but don’t use any of the tools you have at your disposal – which, by the way, happen to be the same tools developed countries used. On our team, we are trying to identify progress toward positive change within the context of reality.

When it comes to the ESG, there is a lot of focus on the “G.” Is that because it’s already a basic part of assessing the value of a company?

Negrete-Gruson: Yes, and that’s one of the challenges. Over the years, as fundamental investors, we have become quite good at identifying the “G” – the quality of the exposure, quality of communication, and so on from EM companies. But it’s a mistake to ignore “E” and “S” simply because we cannot quantify them – that excuse is no longer valid. Based on the staleness of the data that are available, and the bias that goes into how ESG ratings are developed, we developed our own way to quantify “E” and “S” in an incident-based manner. Rather than importing scores or ratings, we get access to the incidents experienced by a company.

How does your proprietary assessment work?

Negrete-Gruson: We don’t concern ourselves with the stated policy of the company because it’s relatively easy for any company to put policies on paper. But how do you execute? How do you prove that these policies are being enforced? That is the tricky part. We can’t walk away from that, but we also can’t only listen to what companies say. Instead, we look at what companies have done. It’s not your policy on sexual harassment, but rather how many times have you been sued for sexual harassment? It’s not your policy on the environment, but how many oil spills have you had? To measure change, we look at the number of incidents a company has had historically, how many incidents it had three years ago, how many incidents it has had recently.

We are not necessarily aiming to have a portfolio of companies that have had no incidents. We’re looking for companies that show improvement by, for example, reducing the number of incidents in a given time frame. In contrast to that, if a company has had no incidents historically and suddenly they start to pop up, we’re measuring that, too. There is a lot of information in that history. Usually when an incident happens, it’s not the first time. Companies demonstrate patterns of behavior; we’re trying to identify improvement or deterioration in those patterns.

Is there a qualitative component of your assessment as well?

Negrete-Gruson: Yes, based on our interactions with the company. We match the quantitative incident-based scoring with our qualitative assessment, and based on that we create a score for a company which has an effect on our target price for the stock. Incidents are captured as soon as they occur and are immediately incorporated into our target stock prices.

As many emerging markets move toward being technology- and service-driven economies, and less commodities based, will that affect your ESG strategies?

Negrete-Gruson: EM economies and investment opportunities will always include the extractive industries – that’s the reality. Appropriately and sustainably utilizing their natural resources is part of the path a country needs to follow to develop. So, that is part of emerging markets – but only part.

We’re also seeing companies in EMs producing microchips and processors for devices that are used in developed markets and also adopted in other EMs. Alibaba is a good example. They initially developed technology in China, but it has transformed the way commerce operates in other emerging markets, as well as its own. The impact that type of transformational technology has on emerging markets is very important, but it doesn’t eliminate the important roles of other industries that are still very relevant in EMs and very necessary in the process of development.

And what about the service-driven aspects of EM economies?

Negrete-Gruson: The consumer staples story of multinationals penetrating emerging markets is played out and has been replaced by meeting the desires of an emerging middle class in EMs. These are people who, for example, are looking for their first international vacation. There is a whole crop of opportunities in companies that specialize in services for people who, for the first time, are starting to use their leisure time and their disposable income to travel. There are companies doing this that are very indigenous – very much EM companies. We have businesses in our portfolio, from China and Brazil, that specialize in those services.

I would also include casual dining in the same category. As middle-class households emerge and change, perhaps the mother works, and casual dining becomes more frequent. That’s an opportunity that’s not exclusive to multinationals – local companies could have a greater edge into capturing and understanding what consumers want and offering these types of services to the population.

Are there particular sectors within emerging markets that you feel merit special attention for ESG strategies going forward?

Negrete-Gruson: It’s almost ironic that a lot of the industries that have a bad reputation from an ESG perspective represent some of the best opportunities. Industries and companies and even regions in emerging markets that have historically poor sustainability track records can be the greatest delta for positive change.

Russia is a good example. Everybody knows the social, the environmental, and governance horror stories of the past. But our experience and our long trajectory with that country tell us there are real forces of change happening there, and in many cases exemplary change. Investors might have ignored these companies in the past, but they might present a great opportunity for transformation going forward. There is often opportunity in places that, from the top, might appear among the more unappealing options at first glance.

Are negative screens valuable in emerging markets investing? Find out.


ESG’s Role in Evaluating Structured Credit

Applying ESG considerations to equity and standard fixed income offerings becomes a little bit easier with each passing day. In the world of securitized credit, however, it’s still a very new concept. However, as II discovered in its conversation with Jose Pluto, Senior Structured Research Analyst and Portfolio Manager, Sustainable Fixed Income Strategy, Aegon Asset Management US, there can be tremendous value in doing so. Pluto has been instrumental in formalizing Aegon AM US’ ESG integration approach for structured securities and was a key architect of developing the proprietary sustainability assessment process for structured securities. In this conversation, Pluto shares his perspective on a corner of ESG integration that is, for the most part, new territory for investors.

In your experience, do investors tend to think of securitized credit in the context of ESG?

Jose Pluto: Generally not. Formally incorporating ESG considerations is comparatively nascent in the securitized space. Unlike equities or corporate bonds, where there are more standardized metrics such as the Sustainable Accounting Standards Board’s Materiality Map and independent research providers such as MSCI and Sustainalytics, ESG is a much newer, less evolved topic in the securitized world.

What are the potential benefits for investors?

Pluto: ESG analysis provides a systematic way to incorporate what we believe are investment best practices. Simply put, we see it as good old-fashioned credit work. Systematically integrating ESG factors can help uncover risks and opportunities that could impact collateral, structure and/or issuer performance and ultimately, portfolio performance. To give you some context, at Aegon AM US our structured finance research process is built around answering two basic questions: Can this business or issuer create value for its stakeholders? And is the value that’s created appropriately distributed amongst the business, the customer and bondholders? We believe ESG considerations are integral to answering those questions.


Data is a focus of almost any ESG investment discussion. Is quality data regarding securitized loans more or less difficult to access?

Pluto: It’s not necessarily harder or easier, it’s just different. There aren’t industry standards around ESG-related data for securitized credit. Assessing ESG factors for securitized assets requires a more creative approach relative to corporate bonds given the lack of third-party ESG metrics and research. In traditional credit markets, for example, a large portion of the issuers are public companies that have ongoing quarterly public filing requirements. Many issuers have active ESG engagement efforts and have reporting that can be mapped to established ESG frameworks. And a pretty good portion of that universe is also covered by third-party dedicated ESG research providers.

In contrast, securitized issuers tend to be private companies, so for the most part third-party ESG research is not available. With securitized, you’re generally looking at a dedicated collateral pool that’s been transferred into a securitization vehicle. An abundance of information about that securitized vehicle is released at issuance in the offering documents, including very detailed information about collateral composition, structural features and the roles and responsibilities of transaction participants – in a way, you’re much closer to the assets. Particularly in consumer-related ABS, CMBS and RMBS, this data can be very granular with information available right down to individual obligors and loans, with different data fields from which you can glean insights about the type and nature of the origination, the collateral’s consistency with the sponsor’s stated value proposition as well as identify potential ESG-related opportunities and risks.

You mentioned the environmental aspect of applying ESG to securitized is quite nuanced. How so?

Pluto: Many approaches, such as UN PRI, frame the environmental part of ESG in the context of how a business is exposed to climate change and what it is doing to adapt. For securitized, this is a useful starting point, but there are more nuanced environmental-related considerations that can impact investment outcomes and vary by collateral type, structure and issuer. We seek to answer two main questions: are there potential environmental concerns, or opportunities, around the sponsor’s business model that could impact performance? And ultimately, are there mitigants in place to help address these risks? For example, the collateral, borrower or business in a securitization may be exposed to rising insurance coverage costs from increased frequency of stronger storms. In certain situations, the collateral or structure could also have exposure to natural disaster risk such as hurricanes, earthquakes, wildfires and volcanoes that may not be insured. Additionally, some business models such as railcar leasing may have man-made environmental risk that can impact collateral performance.

Agency credit risk transfer (CRT) deals are one example of a securitization structure that can allow natural disaster exposure to manifest itself in credit performance in a way that bondholders may not fully appreciate. Government sponsored entities (GSEs) often engage in CRT transactions to sell portions of the credit risk in their mortgage guarantee portfolio to private investors. However, Agency CRT transactions don’t scope out natural disaster-related defaults from other types of defaults – they’re treated as a traditional credit default. Natural disasters such as hurricanes are typically accompanied by an uptick in delinquencies and defaults by borrowers, and you can imagine why – homes are destroyed and storm victims might not have adequate insurance coverage, or they might have had wind coverage, but not flood insurance. In 2017, when Hurricane Harvey hit Houston, the fifth-largest metro area in the U.S., according to Bank of America research, for most of the outstanding CRT deals, anywhere from 2% to 4% of the of the loans included were exposed to mortgages on homes located in the five metro areas in Texas that were most impacted by the storm. With Harvey, the uptick in delinquencies led to near-term price dislocation in certain subordinate CRT bonds as investors realized the risk and repriced these transactions to reflect the increased potential for losses.


And what are some nuances around social factors?

On the flip side, environmental considerations can lead to attractive investment opportunities. Solar panels and generating electricity using photovoltaic cells is one of the cleanest, most renewable sources of electricity at the moment. Growth in the renewable energy sector has given rise to a new form of securitized investment opportunity – solar ABS. From an environmental perspective, solar ABS, which are securities collateralized by consumer receivables originated by solar energy companies, provides potentially attractive opportunities for consumers and investors looking to support the renewable energy movement.

Learn more about opportunities in solar ABS.

Pluto: Social considerations for securitized assets span a broad spectrum of areas including regulation, product design, origination and servicing standards and customer satisfaction that can impact the collateral, the structure and the issuer. The primary areas of focus are on the origination and servicing practices, product design, the transaction’s structure and incentives as well as evaluating the business along dimensions such as customer satisfaction and regulatory compliance. First and foremost, we seek to establish whether the business provides the borrower with a product that provides utility and value. We look to assess incentive structures, evaluate where these could create a systematic adverse relationship between the business and its customers and determine what mitigants are in place to manage these risks. And we review the business and management team to establish what prior controversies or specific regulatory concerns might exist that could be detrimental to credit performance.

Consider for example student loan refinancing ABS. Historically student lending in the U.S. was concentrated among a few lenders providing limited, very expensive options. More recently, new finance companies have emerged that allow borrowers who have become established in their careers and demonstrated consistent creditworthiness to reduce their debt burdens by refinancing at lower rates that better reflect their improved post-graduation credit profile. This product design lowers the ultimate cost of education ex-post, helps minimize exposure to the much-publicized problems with student loan debt and provides investors with a potentially attractive structured credit investment opportunity.

How do you assess governance factors?

Pluto: Governance factors are a critical component to assessing the credit profile of a securitized deal. Offering documents govern the transaction’s economics and determine transaction participants’ roles, rights and responsibilities. Among other things, these documents spell out how cash flows are divided among investors, structural credit protections, collateral inclusion criteria, borrower servicing standards, reporting and disclosure requirements as well as investor protections such as representations and warranties - backstops where the issuer attests to the collateral being originated in conformance with applicable underwriting standards, laws and regulations. We look for a deals with a strong alignment of interest between the collateral performance and the sponsor’s economics, as well as seek to understand transaction processes and procedures. We also evaluate non-structural aspects that could impact the transaction such as the issuer’s ownership structure (are they publicly traded or privately held?), management’s business acumen and issuer’s communications and disclosure track record.

There must be some unique characteristics related to ESG regarding the various types of securitized loans such ABS, CMBS, RMBS, yes?

Pluto: The securitized world can be segmented into two broad buckets – consumer-oriented, such as auto loans, solar, student loans and residential mortgages; and commercially-oriented, such as commercial mortgage-backed securities, and ABS on assets like transportation equipment and cell towers.

On the consumer side, social and governance factors are generally the most relevant. From a regulatory perspective, customer-facing businesses will generally face a bigger burden to show that they acted fairly, and in the customer’s best interests. We look for aspects of the business’ operations and practices that create a systematic adverse relationship with the borrower. That includes evaluating everything from the origination model and how the value proposition is disclosed to the borrower, to servicing - the backend customer service and collections activity, to late stage default management, foreclosure and repossession practices.

And what about on the commercial-facing side?

Pluto: For starters, commercial-oriented securitized loans tend to involve more sophisticated borrowers, but ESG-related considerations are still very relevant. Environmental concerns are very relevant – as mentioned earlier adverse environmental exposures can increase operating costs. Additionally, trends such as energy efficiency could lead to positive business outcomes for businesses such as data center operators and cloud computing equipment makers – several of which have used securitization financing. Governance factors are again a major consideration. It is especially important to focus on the alignment of interests between different parties to a transaction. The evaluation should cover the originator - the entity producing the collateral that is going into the deal, the servicer who is responsible for collecting payments and managing the transaction and the sponsor - the party who ultimately holds the junior-most equity risk in the deal. For example, if the captive finance operation of a major industrial company originates and securitizes loans for financing their customers’ purchases, they will typically hold the most subordinate credit risk in the transaction. But in other structures such as aircraft ABS, you may have an entity originating lease receivables and selling them to a private equity fund, for example, who in turn uses securitization to get leverage on that pool of assets. Despite selling the lease receivables, the aircraft lease originator, may be kept on as the transaction servicer; an entity that is first in line to be paid from any deal cash flows and has little-to-no credit exposure. The result is that there are multiple entities with unclear motivations and asymmetric access to information about transaction economics, holding different parts of the transaction, being paid with different priorities in the waterfall. As such it’s important to understand what the set of incentives for each of those entities might be and how potential conflicts might be mitigated.

What qualities are important when searching for a strong partner for ESG-based securitized credit investing?

Pluto: We believe assessing ESG factors in securitized bonds requires a research-intensive approach to dissect the plethora of available information and distill it into actionable investment recommendations. A long track record of fundamental credit work – detailed reviews of collateral pools, transaction structures, and issuers – is evidence of the experience required to more fully understand the potential ESG and non-ESG risks within securitized credit. Furthermore, a manager with experience that goes beyond the traditional well-trafficked benchmark sectors and has participated in new sectors across the credit spectrum through multiple business and market cycles, may be better positioned to identify and analyze ESG-related risks.

Looking for insights on nearly every aspect of ESG? Here they are.


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