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    Structured Insights: responsible investment in structured credit

    Structured Insights: responsible investment in structured credit

    October 26, 2021 Structured credit

    ESG risks in structured credit markets are complex. Insight is tackling them head-on, and encouraging transparency on ESG issues across structured credit markets.

    Summary


    Responsible investment challenges in structured credit

    Environmental, social and governance (ESG) risks bring new challenges to structured credit investors that public equity and fixed income investors do not face.

    • Analyzing and measuring ESG risks for structured credit securities can be complex, with many different potential ESG risks to consider (see Table 1, overleaf)
    • There can be many stakeholders in the lifecycle of a structured credit asset, as underlying asset pools may change over time. For example, the ESG rating of a special purpose vehicle can vary as mortgages are replaced and the environmental quality of underlying houses changes
    • There is a lack of standardization and depth in the ESG reporting which issuers complete. It can therefore be difficult to access relevant and comparable data

    Insight is supporting a responsible approach to structured credit

    We believe Insight is leading efforts to encourage issuers to consider and disclose ESG risks in structured credit markets.

    • ESG factors are an important part of the rigorous fundamental analysis undertaken on originators. This includes detailed due diligence both prior to making an investment, as well as on an ongoing basis
    • Proprietary questionnaires aim to help us better understand the ESG risks. We have developed them for a range of sectors and we have more in development. Of the questionnaires we issued in 2020, ~75% elicited responses from public ABS issuers, and 100% for private structured credit transactions (eg direct lending)
    • We have been working to highlight the need for enhanced ESG reporting. We have engaged with the International Capital Market Association (ICMA) to encourage local regulators to support greater transparency

    Case study: improving governance in a private bridge lending deal

    In 2021, Insight performed due diligence on a senior note proposal. It was sponsored by a large US investment bank and backed by a pool of residential and commercial properties originated by a specialist bridging finance lender.

    Insight’s due diligence on the lender revealed its specialist capabilities and performance to be compelling, in our view. However, our ESG scoring output flagged ‘room for improvement’ within governance.

    Independent bridge lenders tend to be small (with portfolios no larger than $200m) as scaling up is challenging given the short-term nature of the loans. Meanwhile the compelling returns on offer (which can be up to 9% to 10% on an annualized basis for loans maturing in just a few months) can make a small-scale business model viable.

    This means originators typically have small teams and tend to rely heavily on key management and their founders, concentrating control of the business and policies around a few key individuals.

    Insight worked with the lender and the US bank, advocating for the inclusion of an independent director on the board to improve governance, impartiality, risk management and diversity of control. The originator agreed to seek an independent board member.

    How Insight evaluates ESG risks

    ESG risk varies given the nature of the asset. How we evaluate and respond to ESG risk varies depending on the type of asset.

    Residential and consumer

    For securities based on underlying pools of consumer loans (such as credit card debt or auto finance) and residential mortgages, originators vary in their ability to provide ESG data on the underlying assets.

    • We issue a proprietary questionnaire focusing on ESG risks to all originators of securities based on consumer loans or mortgages that helps to supplement our existing due diligence framework and issuer engagement.

    Commercial

    Commercial deals include those secured against aircraft, media rights or the longstanding commercial real estate (CRE) market. CRE loans are typically issued on a small number of commercial properties. This means it is can be more straightforward to assess relevant ESG risks. For example, environmental audits on large buildings are typically available for review.

    Commercial mortgage-backed securities (CMBS) are similar, although may be based upon a larger pool of commercial mortgages which increases the complexity of any analysis and increases the challenges in getting appropriate ESG data on the underlying pools. There are exceptions, with ‘green’ CMBS starting to come to market and offering environmental data on the underlying assets.

    • For CRE loans and mortgages we review ESG disclosures on the underlying assets which are typically extensive and incorporate this into our investment analysis.
    • We have developed new questionnaires for CMBS and CRE originators and are sending these out as new issues come to market.

    Secured corporates

    CLOs purchase a pool of senior secured bank loans, made to sub-investment grade businesses. They issue debt in tranches, with differing risk/return profiles derived from the seniority of the claim on the cashflows generated by the underlying loans.

    The structure of CLOs means investors usually depend on the originator to provide data on underlying loans, and ESG data is typically limited.

    • Our focus is typically on governance for the CLO manager. We intend to encourage greater ESG disclosures across CLO issuance, following the progress we have made on consumer and commercial loans. When we review CLO managers, we ask specifically about ESG factors, and whether they have a relevant policy integrated within their credit process. We also aim to discuss examples of loans they have rejected due to ESG concerns. We also assess the underlying loans within the CLO, which will include analysis by our loans team, where appropriate, which incorporates ESG considerations where possible.

    Esoteric structured credit

    Many companies seek to borrow money from non-bank lenders. Such loans are typically illiquid and therefore offer higher yields than more liquid assets, all else being equal.

    For any esoteric structured credit deal, such as direct corporate lending, we ask borrowers to provide information on ESG risks to which they are exposed, and how they manage them. If a borrower does not provide this information we decline the loan. Credit analysts and portfolio managers therefore have clear incentives to ensure that borrowers provide the necessary information on ESG factors.

    Table 1: ESG considerations within structured credit market segments1

     

    Environment

    Social

    Governance

    Residential and consumer

    • Energy efficient buildings
    • Electric vehicles in auto sector
    • Strong consumer protection practices
    • Appropriate arrears/default process
    • Strong underwriting process
    • Quality of collateral info
    • Originator's risk process
    • Back-up servicing arrangements
    • Sponsor equity (risk retention)

    Commercial

    • Energy efficiency is positive for real estate values
    • Corporate team analyze key tenants
    • Real estate usage (limited control)
    • Corporate credit analyst team analyze key tenants against ESG criteria
    • Sponsor business plan/spending covenants
    • Back-up servicing agent outlined
    • Sponsor analysis
    • Sponsor equity (risk retention)

    Education and Communication

    • Analyze each underlying loan, including: carbon emissions, raw material sourcing and waste
    • Analyze each underlying loan, including labor practices, safety and data security
    • CLO manager ESG process
    • CLO manager investment process and government structure
    • Key-man risk
    • Sponsor equity (risk retention)

     

    Seeking ESG disclosure improvements

    In 2020, we engaged with selected issuers to explore the potential for improved ESG disclosures for securities based on consumer loans and mortgages. We sought to consider how we might encourage the wider industry to move forward on these issues.

    These engagements highlighted a number of key challenges:

    • Some issuers faced technical challenges in obtaining data across the pool of assets, in particular energy certificates within residential mortgage pools. Originators that have gone through several historical mergers and acquisitions have client information spread across legacy systems.
    • Some issuers, despite our engagement, were less willing to bridge these data gaps. One major European auto manufacturer, despite emphasizing its ESG credentials at the corporate level, said the lack of demand from investors meant it would not consider incorporating ESG disclosures in its asset-backed securities issuance in the short term.

    Global initiative for enhanced ESG disclosures

    Although we continue to engage with originators more widely, we recognized that by engaging with other asset managers we could accelerate this process. We therefore raised the issue with the Asset Management and Investors Council (AMIC) at the ICMA and proposed a joint initiative with other major global asset managers to agree and develop key performance indicators on ESG issues and to engage with local regulators on these topics.

    An initiative focusing on this issue was announced in March 2021. The key priorities include:

    • standardization of ESG disclosures
    • annual reporting of material ESG risks
    • ESG support for market participants
    • creation of ‘green’ standards
    • increased collaboration between industry and regulators

    Table 2: Insight questionnaire example – key areas covered by our proprietary ESG questionnaire for consumer loans3

    Environment

    Social

    Availability and disclosure of environmental metrics Do affordability checks account for socio-economic circumstances?
    Building energy efficiency and environmental stress testing Have inadequate practices led to legal proceedings?
    Is the impact of environmental regulations on loan recipients measured? Consumer practices for arrears and foreclosures
    Is carbon impact part of the origination practices? Frequency of defaults/foreclosures

    Corporate Governance

    Product Governance

    Board independence and diversity Is the origination team's compensation structure linked to volumes?
    CEO pay structure Comparison of origination process against industry standards
    Independence of risk and audit committees Do affordability checks include change of borrower circumstances?
    Separation of Chair and CEO roles Are lending policies reviewed regularly?

     


    Contributors:

    Shaheer Guirguis, CFA
    Head of Structured Credit

    Jeremy King, CAIA
    Head of Business Development

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