How GPs and LPs can drive net zero leadership in private credit

Private credit is growing in popularity. Does this change the ability of credit investment teams to engage with companies on Carbon reporting and how does it impact transparency around emissions disclosures?

Sonia Rocher: At BlackRock, we have seen demand for the asset class really grow. Our latest global private markets survey showed that 52% of institutional clients want to allocate more to private credit.¹Separately, we see more clients considering sustainability and climate in their overall asset allocation to reflect their investments beliefs. These allocations can be broadly within private markets but also include specific investments that contribute to their net-zero targets.

Different segments of private credit can offer client’s alignment. When it comes to net zero in direct lending, reporting is definitely a challenge but also offers an exciting opportunity. The mid-market companies we tend to invest in are typically in very early stages of thinking about net zero.

As a lender, we work with a range of companies- some who are looking to or have decided to be part of the transition to a low carbon economy. We can work with these companies as they start their journey towards achieving Paris agreement targets by setting a strong foundation for potential future growth and success.

Historically, reporting in private markets has been a challenge but a lot of work has been done to help address the gap and to improve data collection. For example, there is an industry-led initiative on independent disclosure projects in partnership with UNPRI.

We are also seeing a growing trend towards more solutions for asset managers to help align client portfolios to net zero. The IIGCC framework on private debt is a good example of progress being made here.

Alex, how does this play out from an LP’s perspective?

Alex Owen: We have observed a similar trend. Private credit has become increasingly popular. Based on conversations I have had with managers, European LPs have really driven managers to sophisticate their approaches to net zero alignment (with Carbon reporting being a step on the way).

At Brunel, we allocate to private credit for the general benefits the asset class brings to a portfolio (attractive income and return, low defaults, diversification etc), but when talking to managers, we make it very clear that climate is a priority for us. So, while this is a mainstream allocation, we expect the direct lenders we select to make progress on net zero in their mainstream direct lending portfolios.

Alex, at Brunel, you have quite ambitious targets around net zero. How do you put these into action within your private credit portfolio?

Alex Owen: Given that net zero strategies in private credit are still very much evolving, we view this as a two-phase project over the medium term.

The first step is to ensure our managers have robust and improving measurement methodologies, making use of estimated emissions where needed (though we fully understand the limitations of this).

The second step is to encourage our managers to move from simply measuring and reporting on emissions to achieving net-zero alignment across their portfolios. Right now, there are great credit managers who are making progress on the first step and over the medium term we expect them to make progress on the second.

Sonia, how are you working with LPs on their transition strategies?

Sonia Rocher: First, I should stress, at BlackRock, we are a fiduciary to our clients. Different LPs and respective geographies have varying expectations from what they want their allocation to deliver. Some allocate to private credit traditionally, while others have a specific net zero targets / allocations.

As Alex mentioned, LPs will have their short-term expectations and medium-term goals.

The importance lies in being transparent about what can or can’t be done and how a filter might impact the investment universe. It’s about dialogue and partnership to find solutions. The partnership between GPs and LPs can impact our engagement formulation and help lead to innovative solutions.

Alex, do you think the relationship between GPs and LPs has an impact on the effectiveness of engagement?

Alex Owen: That is right, from talking to many private credit managers, I noticed that the more sophisticated managers handle restrictions better, leading to a less narrow universe and better ESG outcomes. Allocating only to assets like software borrows isn’t good enough.

Alex, what is the role of LPs in pushing for better standards at the companies they invest in?

Alex Owen: As a LP, your real influence on portfolio companies is through the GP you select and making your objectives and outcomes clear. Our capital makes a difference and we trust the GP to engage and be good actors in the space. The direct lending universe is deep and asking your managers to do more and choosing those that actively listen and implement what you ask for is an important selection factor.

Sonia, a lot of the companies you invest in are SMEs. What are the challenges and opportunities in implementing net zero strategies at that level?

Sonia Rocher: Mid-market companies tend to be at the early stages when it comes to thinking about the transition and what it means for their business. For instance, the recent BCG-Argos survey, reports c.15% of companies have embarked on their decarbonisation journey, which is much lower than larger counterparts. Yet, 85% know it’s important and believe it’s critical to consider. When it comes to our portfolio, Two-thirds have shared they want to engage but need guidance.²

Like Alex mentioned, the first step is to have reporting in order. Carbon emissions can be idiosyncratic and it’s essential to help companies understand what decarbonising their business means. New regulations (like CSRD) require carbon footprint reporting and are a great tailwind.

The gap for SMEs is help – resources, best practises, and support to help these companies decarbonise. Some initiatives, like moving location for clearer grid energy can switching their grid offer quicker wins. Others, like redesigning plastic-based products to use more sustainable materials are multi-year projects.

Does this process also come with higher upfront costs?

Sonia Rocher: That is an interesting question, there is often a perception that decarbonisation means costs and capex. However, we find when you get into the details and the opportunities decarbonisation can offer it can be a business enabler. Mid-market companies are often part of a larger companies’ supply chain. These companies are already in the process of reducing their Scope 3 emissions and need to pick companies with carbon reduction plans or ones that have lower emissions. Thinking about net zero could actually help these smaller companies win new business.

Operational initiatives can also lead to cost savings. For instance, an IT company in our portfolio has four decarbonisation pillars, all leading to cost savings, from right-sizing office space to more transport fleets. These benefits are often underestimated.

How do you source the companies that are the most willing to adapt?

Sonia Rocher: Engagement and knowing your companies are crucial, especially since flagship private credits don’t usually have sustainability filters. Fortunately, as senior lenders, we have direct dialogue with the CEO or CFO which helps identify if a company is serious about decarbonisation.

Sonia, would you be able to share any example of how you and the team have been putting this into practice?

Sonia Rocher: Yes, we recently worked with a company wanting to progress to net zero. We connected them with a carbon reporting provider, and after a few months, they had their Scope 1, 2, and 3 emissions report and gap analysis.

We identified they were using two offices powered by non-renewable sources, which resulted in a much higher carbon intensity compared to their sector benchmark. They realised their leases were up for renewal and are now relocating, reducing emissions by half, aligning with the benchmark, right-sizing offices, and introducing huge cost savings. 

It is often forgotten, but it’s important to note mid-market companies play a key role in the energy transition, accounting for about 50% of GDP and 40-50% of emissions³. Investing in infrastructure and new technologies is essential, but SMEs also need to move forward and use this infrastructure and new technologies. As direct lenders, we are in a unique position to help these companies accelerate their journey towards a low-carbon economy.

Alex, any words of advice for your peers looking to invest in private credit?

Alex Owen: Communicate your interest in carbon integration early in due diligence. Good managers, such as BlackRock, are doing excellent work in this space. We use the Net Zero Investment Framework to guide our thinking across asset classes, we would hope this help managers to avoid a plethora of different LP asks. Helpfully, NZIF private credit guidance has just been released, to further stimulate progress in the market⁴.

The universe of good credit managers is large enough to select those strong on carbon and broader ESG issues. As a significant institutional investor, you can shape behaviours positively. Not only can you select top-performing managers, but you can also help those behind in this space improve if you are clear and thoughtful in your requirements.

As an LP, you don’t have to take a manager’s base offering as the only option; be willing to have the dialogue to ask if they can improve it. 

For this interview, net-zero and targets referenced are as defined by the UN and Paris Agreement.

As defined by the UN, net zero means cutting carbon emissions to a small amount of residual emissions that can be absorbed and durably stored by nature and other carbon dioxide removal measures, leaving zero in the atmosphere.

The 2015 Paris Agreement, which is a legally binding international treaty on climate change with an objective to limit global warming to well below 2º C, preferably to 1.5º C. The Paris Agreement recognises that not only do governments play an important role in those efforts, but achieving net zero by 2050 requires the investment community (both asset owners and asset managers) to allocate capital towards technologies, companies or countries that are fundamental for the transition.

Sources
¹ BlackRock, Global Private Markets Survey 2023.
² Argos - BCG Mid-market Climate Transition Barometer (2023) and BlackRock as 31 December 2023.
³ Cambridge Institute for Sustainability Leadership (CISL), Financial innovation for SME net zero transition: Role of banks and buyers 17 January 2023.
⁴ IIGCC Resources | Net Zero Investment Framework

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