“The dual pandemics last year, both a health crisis and a racial one, have shone a light on the ‘S’ pillar of ESG,” says Melissa James, vice-chairman and head of the ESG Center of Excellence for Global Capital Markets at Morgan Stanley. “Now, as a consequence, what we are seeing is that investors and companies both recognise how social factors such as diversity and inclusion and other things like worker health and safety can create material risks and opportunities for companies that need to be managed.
“This is a moment in time and many investors and corporates want to be part of creating lasting and meaningful change.”
This appetite for change is already translating into new sustainable finance approaches — both in investors’ ESG lenses and in ESG debt structures.
“We see the diversity and inclusion (D&I) space going the way of ESG more broadly,” adds James. “There will be a need for more data and disclosure around what people are doing so that stakeholders can measure and monitor performance against those goals. You need specific KPIs in the D&I space to ensure accountability towards goals and targets. After all, you get what you measure and that’s what we’re starting to hear from investors.”
Bond build-up
In turn, sustainability-linked bonds (SLBs) with KPIs tied to social goals — including specific D&I targets — are taking off. This development is taking place despite the European Central Bank (ECB) being limited to funding instruments linked to environmental KPIs only. Having begun buying euro SLBs this year under its Corporate Sector Purchase Programme (CSPP) and Pandemic Emergency Purchase Programme (PEPP), the ECB has quickly grown into the market’s dominant investor.
A euro SLB issued recently by Sweden’s EQT highlights the new trend. This features KPIs tracking greater gender diversity within the private equity investor and its portfolio companies, with percentages of both investment professionals and board members measured.
Along with SLBs, use of proceeds bonds tied to D&I goals are also gaining traction. “Both are excellent ways for investors and companies to signal their commitment to social impact,” James believes.
A recent landmark saw Amazon launch its first sustainable bond, for example. Proceeds finance social projects (affordable housing, upskilling) as well as environmental ones. The company’s sustainable finance framework specifically targets training expenditures “to populations that include the unemployed and underemployed individuals from underserved and underrepresented communities.”
Inclusive expansion Besides their involvement in ESG debt offerings, investment banks are trying to support and promote diversity and inclusion in further ways. These include initiatives like Morgan Stanley’s new Institute for Inclusion, which seeks to invest in underserved communities and support them philanthropically. It also aims to help Morgan Stanley attract diverse talent and improve its culture of inclusion. In addition, in November 2020 Morgan Stanley increased the use of D&I/minority-owned firms in its debt syndicates, with up to five firms among the lead managers and co-managers of its recent US debt capital markets offerings. This commitment represents “a significant change across investors, underwriters and issuers”, judges Cristina Lacaci, head of ESG structuring, global capital markets at Morgan Stanley. She points to “the willingness and desire of issuers to partner with D&I firms and for underwriters and investors to reaffirm our commitment to this space.” Moreover, Morgan Stanley recently launched a new share class product that it markets in the US in co-ordination with a D&I broker-dealer. The goal is “to provide our clients with the opportunity to align their investing with their values because we are seeing increased demand for impact or ESG cash management investments,” says Melissa James, vice-chairman and co-head of the ESG Center for Excellence for Global Capital Markets at the bank. Now the firm is looking to do more in the wake of these steps. “There are definitely other initiatives afoot,” James affirms. GC |
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This followed an earlier sustainable offering from Google parent Alphabet in 2020. Again, the triple-tranche jumbo funds both social and green investments. Besides affordable housing, small business support and pandemic recovery, eligible social uses of proceeds included the explicit D&I target of racial equity.
More should follow, James reports. “We are having conversations with a number of corporates around how they think about including social projects in their use of proceeds issuance. You’re going to see more of this.”
In addition, large US banks have become active issuers of social bonds. Like the tech titans, affordable housing has been the typical use of proceeds from these deals — such as a Morgan Stanley fixed-to-floating-rate structure in October 2020.
While corporate social bonds had been largely a US phenomenon, a recent landmark also emerged in Europe recently when French energy company EDF issued the first quasi-equity ‘hybrid’ corporate social bond. The deeply subordinated perpetual offering is linked to supporting small and medium-sized enterprises (SMEs) and regional and employment impact.
European banks such as the newly-merged CaixaBank (Spain’s largest lender by assets) has begun issuing social bonds to finance eligible assets.
These financings are meeting strong demand from buyers. “Investors are willing to reward companies for incorporating these features in their debt instruments,” James says. “We’ve seen it in the form of the sustainability premium that issuers are able to achieve in terms of lower coupons on their debt obligations.”
Moreover, demand is both growing and becoming more specific about KPIs. “Investors are asking for more of this type of issuance,” she judges. “We’re seeing specific reverse enquiries in some cases on what type of KPIs investors want to see.”
Capacity challenge
Even so, the further development of D&I financing still faces challenges. One is many companies lack sufficient expenditure to build frameworks and use of proceeds bonds around — a limitation that many observers see as supporting future growth of SLBs linked to issuer-level ESG performance rather than the project-level measurement of green and social bonds.
The capacity problem is not limited to social investments. Depending on sector and business model, companies may also lack environmental assets to finance — particularly if their uses of proceeds bonds are to reach benchmark size. “That has been a potential impediment,” James agrees.
A further issue has been uncertainty over social expenditures that companies would have made routinely as part of their corporate philanthropy efforts. “There has been some wariness on the part of corporates about designating certain investments as part of their framework,” she notes.
“I think they feel like you need something a little bit more programmatic and more concrete that’s outside of what you would be doing in the ordinary course.”
A further challenge is a perception among some investment grade corporate issuers that offering step‑up debt — the default SLB structure — signals potential weakness to investors. “In the investment grade market coupon ratchets have usually had a negative association,” James acknowledges. “Getting corporates in the IG space over that hurdle is one of the impediments to seeing more sustainability-linked issuance.”
In addition, the high yield market has been later to engage with ESG debt than its IG counterpart. James is optimistic, though. “I think that will likely evolve over time as well.”
Seeking stewardship
The rise of D&I concerns meshes with investors’ increasing emphasis on ESG stewardship — how effective and accountable companies are as stewards of capital from environmental, social and governance perspectives. “Institutional investors are coming up with their own assessment of companies based on how they think different ESG factors should be weighted within a particular sector and then more specifically within a particular company,” James believes. “You are going to have more investing along the lines of who’s a good ESG steward and who is not.
“They are looking at a whole range of ESG factors — not just environmental factors but also social and governance factors,” she adds, noting that governance is a particularly long-standing element within investment analysis.
She expects this approach to be refined over time. While this may not lead to widespread adoption of exclusionary screening, as commonly practised by European ESG investors, it is likely to bring “differentiation and discernment along the lines of ESG stewardship, broadly speaking, whether it be environmental or social.”
One dimension of this will be increasing focus on progress within ESG strategies. “No investor expects the company to be able to flip a switch and all of a sudden they are great environmental and social stewards. I think the market is sophisticated enough to realise that these things take time, that these changes are evolutionary — not revolutionary.”
This makes publicly announced goals and targets key. “Investors recognise that this is a journey that companies are on, and they want to be able to chart the company’s progress along that journey,” James adds.
She cites Morgan Stanley research that shows that alpha or total return is more highly correlated with rate of change on ESG measures than absolute performance. “Companies that are perceived to have a lot of potential upside and who are working towards capitalising on that upside are a really good ESG story even if they don’t start out in such a great place on day one. Similarly, if companies are perceived to have a lot of downside and are not doing anything to manage it, that would be a bad ESG story — even if they are starting out in a relatively OK place.” GC