In this view from the Secured Credit desk, Elissa Johnson, Portfolio Manager within the Secured Loans Team, outlines the team’s environmental, social and governance (ESG) philosophy, as well as the ratings and trends within the Secured Loans Fund, explaining why there is more than just a ‘green’ colour in the portfolio.
- We believe the rigorous application of ESG principles can improve risk‑adjusted returns over the long term and company engagement is an integral part of successful investing. Our investment process encompasses a full assessment of ESG risks for every borrower we review.
- As ESG‑related disclosure improves from both borrowers and private equity sponsors, we see a future where the cost of capital will increasingly differentiate between companies addressing ESG risks and those that do not.
- We do not just pick the ‘easy’ ESG‑related loan investments. Our portfolios seek to maximise risk‑adjusted returns for investors over the medium term. Finding investments with ESG risks where we think improvement is likely and capital costs could improve in the future is simply good loan portfolio management in our view.
How green is the portfolio?
Looking forward, as ESG‑related disclosure improves from both borrowers and private equity sponsors operating in the European loans market, we see a future where the cost of capital will increasingly differentiate between companies addressing ESG risks and those that do not.
Here, we set out the ESG profile of the Janus Henderson Secured Loans Fund and analyse the trends of some of the ESG issues we have identified.
Our ESG philosophy
Our ESG philosophy is built on the belief that rigorous application of ESG principles can improve risk‑adjusted returns over the long term and company engagement is an integral part of successful investing.
ESG considerations are fully integrated into our fundamental bottom‑up investment process. While ESG is one of the many factors we consider in our research, its considerations can be the overriding factor in determining the final credit recommendation (where there are material risks and the trend is not improving). In the loans market, where we are private‑side investors, we engage regularly with both management teams and sponsors — including on sustainability issues — as part of our detailed fundamental analysis and ongoing borrower monitoring.
Each investment is allocated an ESG rating. Chart 1 highlights the key criteria for formulating our ESG assessment.
Chart 1: key criteria for formulating our ESG assessment
Source: Janus Henderson Investors, as at March 2020
The primary analyst for each loan investment is responsible for selecting the ESG rating. This is discussed and reviewed by the credit team before being formally assigned to the loan. The ESG rating is subject to active monitoring and review, in exactly the same way as we assess and review all other factors that form part of our ongoing loan investment thesis.
Chart 2 illustrates the split of the Janus Henderson Secured Loan Fund by its ESG ratings. As can be seen, the vast majority of the portfolio is rated green; ie, there are no material ESG risks and the companies within have stable or improving ESG profiles.
Chart 2: rating split for the Janus Henderson Secured Loans Fund
Source: Janus Henderson Investors, as at 31 January 2020
The chart also shows how 4% of the fund is invested in loans, which have an internal ESG rating of ‘yellow’, while 15% is invested in loans with an ESG rating of ‘orange’. This is a consequence of our investment process, which does not seek to avoid companies with material ESG risks. Instead, we seek to identify investments where the company is improving its ESG profile, which we believe will, in time, reduce the cost of capital for the company and as such lead to excess returns on our investment.
What is orange?
The split of the fund’s orange ESG investments by sector is shown in chart 3.
Chart 3: ‘orange’ ESG investments in the portfolio, by sector
Source: Janus Henderson Investors, as at 31 January 2020
Chemicals - Unsurprisingly, we have assigned many chemical companies an orange ESG rating. The chemical industry has obvious environmental risks linked to site and ground contamination and water pollution, as well as having typically heavy carbon footprints through the supply chain. Regulatory risk is also a factor for the chemical industry as operating performance in terms of health and safety may impact on operating permits.
However, many chemical companies are recognising the ESG impact of their businesses and attempting to reduce the use of fossil fuels, not just through power supply to plants or improved efficiency, but through research and development (R&D) into non‑fossil‑fuel-based chemicals.
For example, Perstorp is working to assess the potential for recycled methanol and Inovyn has announced a world first in a bio‑attributed PVC, manufactured from a renewable feedstock (biomass) enabling a 90% greenhouse gas saving. The product is expensive but Inovyn report that they are seeing very strong demand from customers given the product’s green credentials.
Leisure - Within the leisure sector we have gaming credits which are rated orange. While these entities operate in licenced jurisdictions, the pressure from social factors for increased regulation is a key risk in certain jurisdictions in our view. Our investment risk analysis assesses diversification across regulatory jurisdictions, as well as which forms of gaming the business is exposed to, as these can provide some mitigation.
Food and beverages - Within the food and beverage sector we have assigned an orange ESG rating to a global food manufacturer.
The company discloses on its website that it is aiming to use 100% sustainable palm oil (only) by 2022. This is behind other global and regional food manufacturing groups, who are already using 100% sustainable palm oil (through their supply chain). We think this exposes the company to potentially material consumer risk and also regulatory risk, as part of government actions on climate change linked to reducing deforestation. In addition, its products, which are largely highly calorific, could be at risk of regulation on fat or sugar content (in the way that the UK introduced the sugar tax in 2018). We continue to engage with the company to gain confidence in its path to its stated ESG goals, noting the geographic diversity and scale of the group, which should help mitigate risks from these factors.
Engagement remains key
It may seem counter‑intuitive to our philosophy towards ESG investing that we have any credits with a yellow ESG rating in the portfolio (non‑material ESG risks and a deteriorating trajectory, top left corner of the quadrant in chart 1). In fact, we hold two loans currently assigned a yellow rating.
Both companies have the same ultimate parent company and ownership structure but are funded on a ring‑fenced basis. Historically, we have seen the parent unexpectedly request the payment of dividends from a subsidiary (with the entity having to raise debt, in order to do so) and that entity receive material pushback on additional debt-raising. Its initial reporting was also less transparent than expected. Therefore, when the second ring‑fenced entity from the group approached the loan market with a business profile that we liked, we engaged extensively with the lead syndication banks on documentation protections to restrict the flexibility of the borrower. Once these were secured, we invested in the loan.
We have engaged extensively with the parent, and both borrowers, and are confident that future disclosure and credit trends will improve. We cautiously assigned a yellow rating to both ring‑fenced entities. However, if disclosure and governance improves as we expect going forward, we will re‑examine the yellow rating with a view to move the company to a green ESG rating.
Conclusion: not just green
Our bottom‑up fundamental based investment process encompasses a full assessment of ESG risks for every loan and floating rate note (FRN) borrower we review. We do not just pick the ‘easy’ ESG‑related loan investments but will consider every loan, and seek to engage with management teams and owners to ensure ESG risks are minimised and that companies look to improve their ESG metrics over time.
Third party data providers do not provide significant coverage of the European loans market. For example, Sustainalytics only covers around 20% of the loans in our fund, which is not surprising as they have a focus on public companies or companies with public securities, given the disclosure required to undertake their research. Third party data, while a useful sanity check, cannot be the sole basis of ESG risk assessment for loan investors today. Real time monitoring of portfolio risks remains as relevant for ESG as it does for traditional credit metrics such as operating profitability, cash flow, interest coverage and leverage.
Our portfolios seek to maximise risk‑adjusted returns for investors over the medium term. Finding investments with ESG risks where we think improvement is likely and capital costs could improve in the future is simply good loan portfolio management in our view.