CLO Investors Flexing ESG

The heat is on in the debate over ESG (environmental, social, and governance) investing. Some believe that considering ESG risk factors in investment decision-making is part of an investment professional’s fiduciary duty and others believe that ESG investing is just a form of “Virtue Signaling” that adds unnecessary cost related to data collection and reporting that hurts the investor’s total return. ESG factoring has traditionally been more associated with equities; however, they are becoming more relevant to fixed-income investments, including collateralized loan obligations (CLOs).

CLO investors are clapping back at the “Never ESG” opponents forcing change in CLO loan eligibility. These large CLO Investors, including insurance companies, pension funds, and sovereign wealth funds, wield the most influence in determining ESG integration. And despite no specific regulation requiring ESG disclosure, Investors believe that ESG considerations are important in assessing the creditworthiness and long-term sustainability of the underlying borrowers in the loan pool.

To quickly review, CLOs are structured financial products backed by a pool of loans made to various corporate borrowers. The loans can be for multiple purposes, including acquisition financing, leveraged buyouts, or refinancing. The cash flows from the loans, interest and principal payments, are sold to investors via a special purpose entity (SPE, the CLO) which is typically divided into different tranches, each with different risk and return levels.

CLO ESG Considerations

CLO Managers, mainly at the direction of investors, are implementing negative screening strategies of responsible investing (prohibition of certain loans). Some of the most popular are:

Environmental: The impact of the underlying loans on the environment may be a consideration for investors. For example, loans to companies in industries with high carbon emissions, such as fossil fuels, may be seen as having a negative environmental impact. A prohibited loan may include a loan made to a company that produces or trades in:

1. Thermal Coal Mining.

2. Speculative extraction of Oil & Gas.

3. Items banned by applicable global conventions and agreements: hazardous chemicals, pesticides, and wastes, ozone-depleting

substances, endangered or protected wildlife, or wildlife products.

Social: Investors may consider the impact of the underlying loans on society. For example, investments in companies with a history of labor violations or human rights abuses may be regarded as having a negative social impact. A prohibited loan may include a loan made to a company that produces or trades in:

1. Opioids.

2. Tobacco, Vape, THC.

3. Palm Oil.

4. Pornography and Prostitution.

5. Predatory Lending.

6. Private Prisons.

7. Firearms and Controversial Weapons of War.

Governance: Investors may consider the governance practices of the companies the loans are made to or of the CLO collateral manager. This may include the manager's approach to ESG considerations, as well as their risk management practices and transparency.

Transparency includes the disclosure of ESG considerations in the loan inclusion process and information on the companies and industries in which the loans are invested.

ESG Mega Trend

The ESG movement is in full gear so, barring explicit language prohibiting the use of loan proceeds, many asset managers voluntarily disclose ESG information about the companies in the loan pool to investors in their CLOs. This can include information on environmental impact, labor practices, and corporate governance, among other factors. Some asset managers also proactively incorporate ESG criteria into their underwriting and credit analysis processes.

In addition to CLO Manager ESG risk underwiring, some rating agencies are starting to consider ESG factors in their assessments of CLOs. For example, Moody's includes ESG considerations in its credit analysis of CLOs and assesses the potential impact of ESG risks on the creditworthiness of the underlying loans.

Investors should note that ESG considerations may not be reflected in traditional credit ratings and that additional due diligence may be required to evaluate the ESG risks and opportunities associated with investing in CLOs.

ESG is Here to Stay

Our understanding of ESG risks and opportunities continues to improve as data collection and management costs drop and the standardization and quality of data improve. Therefore, it's essential to continue to test each ESG strategy to identify which generates the greatest financial return and positive social and environmental impact.

One thing is for sure, no matter how hard the opposition tries to put the toothpaste back in the tube, ESG investing is here to stay.