Pierre Klemas, Chief Sustainability Officer at Stirling Square Capital Partners
Interviewed by Vincent Lemaître, Tikehau Capital and Marie-Laure Mounguia, EY on 11th October 2023
1. How do ESG ratchets fit into the overall ESG strategy of your investments? Do you systematically include ESG ratchets in the transactions?
ESG ratchets have seamlessly integrated into our overall sustainability strategy. In my first year with Stirling Square, we have incorporated ESG ratchets into every acquisition, and several previous deals also feature them. Initially, it was not a practice we actively promoted, but rather one that lenders gradually introduced, and we readily embraced. It has now become a standard practice for us, and we anticipate that future deals will invariably include ESG ratchets.
While we endorse and fully support this practice, we also prioritise empowering the portfolio company to define its ESG objectives and targets. We encourage these ESG KPIs to be closely aligned with the core business activities and to extend beyond mere margin adjustments, supporting broader value creation.
The early-stage establishment of ESG criteria is a pivotal catalyst for transformation. It initiates productive dialogues that lead to the identification of quantifiable ESG commitments with the portfolio company’s management, particularly with the CFO and the CSO. We consider these mechanisms as the starting point of our portfolio engagement program, setting the foundation for meaningful and impactful ESG initiatives throughout our ownership.
2. Are these ratchets a trigger in the choice of the debt provider(s)?
At present, I do not consider ESG ratchets to be the primary determining factor when selecting debt providers. The responsibility for selecting debt providers lies with the investment team, and their decision is influenced by a range of factors related to the financing aspects of the transaction. My involvement typically occurs at a later stage, where we delve into the specifics of the ESG indicators, their definitions, and the establishment of both realistic and ambitious targets. This is where my expertise becomes valuable, as I work in close collaboration with the portfolio company and the deal team to shape the ESG aspect of the transaction. In the end, the decision regarding the choice of a debt provider rests with the deal team and the management of the company.
3. Would you say that your investment team can select a debt provider based on its ability to negotiate ESG ratchet or based on its ESG expertise?
To reiterate, our investment teams typically do not select debt providers based primarily on their ESG capabilities. This decision is primarily influenced by a range of financial considerations, as the ESG ratchet margins, at present, are not significant enough to be a top priority in the decision-making process. However, I would like to note that in my four years of experience with ESG ratchets, I’ve observed a significant enhancement in the expertise and expectations of lenders.
In the current landscape, deal teams and portfolio companies are increasingly required to engage their ESG experts to address the technical aspects necessary for meeting ESG criteria. This collaborative effort has the positive effect of raising the overall ESG expertise within all involved parties. It also holds the potential to become a distinguishing factor between debt providers in the near future as ESG continues to evolve and gain prominence in the financial industry.
4. Do you have preferred KPIs? Do you have in your overall strategy some priorities that you want to push to the target company and that will be a big discussion with the lender?
Certainly, within our portfolio engagement program, we adopt a collaborative approach with the company’s management to establish a robust sustainability roadmap. This roadmap is underpinned by well-defined actions and KPIs that are diligently monitored throughout our ownership. The specific KPIs selected are derived from in-depth materiality analyses and are tailored to focus on value creation. Given this approach, ESG KPIs can vary significantly from one company to another, as each has its unique characteristics and sustainability priorities.
Nevertheless, we do place a strong emphasis on climate action and DE&I as overarching themes that align with our ESG policies and broader public engagements. It is worth noting that these dimensions are commonly recommended by lenders. However, we remain flexible, and there have been instances where KPIs related to energy efficiency, training, customer satisfaction, and other material factors have been incorporated into ESG ratchets. Our ultimate aim is to ensure that the selected KPIs are both meaningful and aligned with the company’s specific circumstances and objectives.
5. Have you observed any differences in the terms and conditions of SLLs compared to traditional loans, and how do these differences impact your investment strategy and returns?
I believe that a loan with an ESG ratchet essentially starts as a traditional loan. From the perspective of an investor, the core financial aspects remain largely unchanged. However, the distinguishing factor lies in the additional ESG dimensions introduced through these ratchets. This involves close collaboration with the ESG teams of the lenders, portfolio company and us.
As of now, the additional bps attributed to these ratchets typically range from 2.5 to 15 bps. However, I share the sentiment that these numbers may not yet be substantial enough to make a significant impact or differentiation for lenders. We do hope to see an increase in the significance of these bps over time, making ESG ratchets a more material element of our investment strategy. It’s a part of the evolving ESG landscape we are closely watching and working to further integrate into our approach.
6. If we skip the financial part, do you believe that, at least for the ESG strategy, the ESG ratchet help making an improvement at the level of the target?
We have been actively engaging with our portfolio companies through our established program, regardless of the presence of an ESG ratchet in the deals. In cases where there was no ESG ratchet, we did not observe significant changes in our approach. This is primarily because we have a well-defined ESG agenda and program that we rigorously adhere to. However, it is essential to acknowledge that the introduction of an ESG ratchet can be particularly beneficial, especially for less mature funds or companies.
From my perspective, ESG ratchets are valuable as they create an additional layer of accountability and engagement, involving the CFO and often leading to more interactions with senior management. This dynamic, in my view, is a positive development, particularly at the scale we operate. When ESG ratchets are in place, I find myself in more frequent discussions with CFOs, which I find truly fantastic. It becomes an opportunity for dialogue and education to further raise awareness and support for ESG initiatives. In many cases, especially in mid-cap companies, having a dedicated ESG professional in-house is still uncommon. It becomes a part of our transformative journey when we acquire companies, with a clear understanding of the need to meet specific ESG targets.
7. Do you have other way to make sure that CFO or the C-Suite of your target company is involved in ESG when you invest? If you don’t have an ESG ratchet, how do you make sure that it’s in their business plan?
Certainly, ensuring the active involvement of the CFO and the C-Suite in ESG initiatives is crucial for us. We have established a dedicated sustainability engagement programme that comes into play when a company enters our portfolio. This program follows a well-defined process. We initiate contact with the CEO and the executive committee where we introduce our programme and initiate a materiality analysis.
The CFO is an integral part of these discussions and interviews as well. This approach has been consistently applied since my arrival and is implemented across all our portfolio companies. As a result, all our portfolio companies now have a sustainability roadmap in place. We actively encourage them to present updates on these roadmaps at the nearest board meetings, which culminate in a comprehensive annual meeting. This ongoing engagement is a critical component of our strategy, regardless of the presence of an ESG ratchet.
When an ESG ratchet is incorporated, it adds an extra layer to our interactions. By aligning the ratchet’s indicators with our existing roadmap, the process becomes more streamlined and integrated into our program. The only additional element introduced by the ratchet is the need for evidence. We often provide a compliance report conducted by a third-party to substantiate that the targets have been met. While this does add some administrative work, it is in line with our commitment to transparency and accountability.
It is worth noting that the application of CSRD is already driving broader changes. Companies are increasingly required to communicate their targets, audit their data, and publish their findings. This evolving landscape further highlights the potential importance of ESG ratchets in the future, which we hope will become a more substantial aspect of the loan process as they gain greater prominence.
8. The last question is the crystal ball question which is about future development. What do you see as an evolution for the mechanism? You say there will be some interaction between CSRD and this type of mechanism…
The future of this mechanism holds exciting potential. In particular, I anticipate a growing synergy between this approach and the forthcoming CSRD. Currently, a significant number of midcap companies are not obliged to publish comprehensive sustainability reports. However, I foresee a considerable shift in this landscape. Companies will increasingly be compelled to enhance their transparency and reporting, expanding beyond workforce-related aspects to cover their entire value chain. This expansion will encompass topics such as supplier practices, biodiversity conservation, pollution control, water management, and the promotion of circular economy principles.
This evolution represents a significant change in the ESG reporting landscape. I envision that new deals in the era of the CSRD will be intimately tied to the quality and depth of information disclosed by companies. As a result, lenders are likely to raise the stakes when it comes to ESG ratchet components. These components could evolve to become material, impactful, and strategic elements on the agenda, far beyond the typical 2.5 basis points today. We hope that in three years, the conversation around ESG ratchets won’t be considered a “nice-to-have” but rather an essential and value-driving aspect of financing deals.
This transition holds immense potential for the ESG landscape, fostering greater value creation through sustainability practices. We eagerly await how this shift will manifest in our new deals and are hopeful that the associated margins will indeed increase, spurring greater engagement and progress across all ESG teams and industries. This, in essence, is what propels positive change in the world of sustainability.