A few years ago, sustainable investments were niche products, but today impact investing is booming: the market expanded1 by more than 40 per cent last year to USD715 billion. And it’s clear that investor appetite for environmental, social and governance (ESG) assets is continuing to strengthen. So why have we not solved the world’s problems yet?
The issue seems to lie in channelling capital to companies and projects that contribute to solving the world’s problems but whose growth is limited by access to external financing. Such investments are not easy to find and can be risky. Standard Chartered believes that innovative financing techniques will play a key role in addressing these issues as they are aligning purpose and profits more effectively, while providing investors’ with more granular visibility into the impact of their projects.
Pooling assets to spread risk and make them more easily marketable is just beginning to take off in ESG investing. Bespoke securitisation structures, where assets are placed into a legal vehicle that issues bonds, require innovative thinking. They are an attractive way to offer different levels of risk and potential return to investors, who can pick and choose depending on their risk appetite and the desired level of credit quality.
As a means to attract institutional capital to projects who have a deep environmental and social impact, asset-backed securities (ABS) and collateralised loan obligations (CLO) – which are backed by pools of loans, are standard financial vehicles which have become important enablers of impact investing.
Pooling assets offers bespoke solutions
These tools offer institutional investors access to investments they would never normally be able to consider, due to their size or absolute risk levels. In the same vein, they are an effective way to channel capital to impact projects and deals in regions that struggle for investor attention.
“This is a fast-paced, fast-changing world,” says Mark Freydefont, Head of Capital Markets Solutions at Standard Chartered. “The wall of money being raised shows the potential of structured finance to deliver returns and move the needle in terms of making a difference where it’s needed most.”
Even so, the securitised asset market remains small relative to the flood of green funding, while incorporating sustainability principles has become a fundamental requirement for most fund managers. Structured ESG financing has lagged behind, in part because of a lack of availability of collateral that meets the impact requirements and also due to a lack of standardised frameworks and ways to measure effectiveness.
Blended finance, the bringing together of private and public investors and different forms of capital to support development, helps to channel capital to where it’s needed most, as it may, for instance, serve as an effective catalyst to enable transactions, where equity returns would not otherwise be commercially viable. The blended finance2 approach allows investors with different objectives to invest alongside each other, opening up investable opportunities for institutional investors who may have returns as their main motivation, second to social impact, or may be interested in both.
Challenges faced by impact investing
While fundamental shifts are in train, as the financial community reassesses how, why and where it channels capital, applying ESG principles remains challenging3 because of the complexity of the structures, the lack of data for each part of the transaction and the lack of an agreed lexicon for discussing and assessing progress as well as few benchmarks for assessing credit risk.
Securitisations often involve multiple parties and assets bound together in the legal structure. There are many parts in the chain, from the initial originator who structured the assets, to the sponsor, who selected these underlying assets, to the trustee and the entity who maintains the assets, to the ratings agencies.
With high levels of due diligence needed along every part of the chain, there can be differences of opinion with regard to the level at which the ESG lens should be applied. While industry bodies agree that there’s a need for robust ESG guidelines in structured finance, no ESG reporting standards4 have been developed so far and data can be scant or hard to compile.
Improving metrics is of vital importance as this will help convince institutions to back impact investing. Investors want to see deep impact, and when they are assured their money is going to make a difference, they are more likely to fund projects that might not otherwise be funded.
A blended approach can benefit everyone
Bonds that raise funds to support the livelihoods of women are a remarkable showcase of success, representing returns for investors, creating deep impact, and driving real change in people’s lives.
The Impact Investing Exchange (IIX) issued a series of women’s livelihood bonds (the latest one towards the end of 2020, raising approximately USD 30 million5) structured as a CLO of loans made to underlying microfinance institutions and in support of enterprises owned or run by women in emerging markets. These bonds use elements of blended finance to increase their impact, with a focus on transparency from start to finish: measurement at every level, starting from initial assessments and when the loans are made.
While the first issuance was a landmark, what makes these projects easier to sell to institutional investors is repeating the process, gaining traction and growing the market gradually over time. Working hand-in-hand with ratings agencies to develop credit risk assessments and standards will be a key part of driving this forward and will pave the way for larger-scale projects to come.
Impactful securitisation is the future
There is no doubt that ESG and impact investing have captured the imagination of the securitised finance world. More than USD 1 trillion worth of structured finance6 will probably be issued in 2021, according to S&P Global Ratings, and investors will increasingly demand ESG data as a precursor to their involvement.
A recent survey conducted by Fitch Ratings7 shows that 84% of polled CLO managers have a stated ESG policy, with 60% part of an organisation that is a signatory to the United Nations Principles for Responsible Investment (UNPRI). Managers reported generally sparse ESG information for leveraged loan issuers, but highlighted steps taken to improve the information gap. Survey respondents believe that their credit analysts are in the best position to assess ESG impact, with larger institutional firms with substantial resources more likely to have specialised teams to facilitate consistency of their ESG approach across their organisations.
Around eight in 10 securitisation issuers currently incorporate ESG into their overall business practices, according to the Structured Finance Association8 and half of the responders that did not have those practices in place already have plans to do so.
With the momentum harnessed in the right way, structured finance offers the potential to bridge funding gaps9, channel capital to where it is needed most and help developing nations to rebuild their economies. Securitisations composed of different tranches can give funding access to smaller ESG projects that become part of larger asset pool, and they allow investors to choose the level of risk that fits their requirements.
It also offers a chance for institutional investors to align profits with purpose, orientating the aims of developing countries alongside those of financial markets. Structuring creates a broader, deeper pool of opportunities, which ultimately will lead to more development projects getting off the ground. There’s already evidence linking impact investing and profitability, with the two best performing US equity funds in 2020 focused on clean energy.10
“Securitisation techniques can really make a difference here,” concluded Mr. Freydefont. “Not only do they have a positive aim, they also offer great returns and access to profitable projects that were previously out of reach.”
This article is based on themes discussed during a panel discussion at Standard Chartered’s recent Global Credit Conference: Opportunities from Disruption. View the recording.