Beyond Green: Governance taking greater role in ESG evaluation

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Rob McDonough believes in green.

As an Angel Oak Capital Advisors executive he plays a role in seeking the highest possible return for clients. But McDonough is also delivering on another promise to patrons of the $10.6 billion fixed-income specialist: “ESG”-eligible assets.

McDonough is director of Angel Oak’s ESG – environmental, social and governance – initiatives, with the task of aligning Angel Oak’s company-wide investment strategy with impact investing guidelines. In particular, McDonough closely works with one of the firm’s niche funds that specializes in buying banking-sector debt bonds. For the past five years, he had advised on analyzing and choosing bank assets that meet the criteria for its five-year-old, ESG-centric Angel Oak Financial Income Fund.

“We get very specific data during the due diligence process around the kind of environmentally sustainable things that they were doing,” McDonough said in a December interview. Institutions which have lent to renewable energy projects, or have invested in paperless internal operations and moved into LEED-certified buildings get Angel Oak’s attention.

“We’ve probably looked at 500 banks very closely. We’ve invested in about 200 at this point. So we say ‘no’ to more banks than we say yes to.”

Angel Oak’s results so far: The fund has earned an annualized return of 5.27% as of year-end 2019, ranking it fifth among nearly 500 short-term bond funds tracked by Morningstar.

For 2020, there’s a further growth stage in ESG that McDonough envisions for the bank sub-debt fund. As more banks each year are aiming to meet sustainability or community reinvestment needs of their local areas, said McDonough, “the real differentiating factor is the strength of their management."

“Most people look at the CAMELs components – the capital asset quality, management, earnings and liquidity,” he said. “But we really focus our efforts in our due diligence on getting to know management and understanding their strengths. That’s their governance component.”

The additional attention to governance, or how an organization handles areas such as financial strategy, risk management, compliance and diversity, is by no means confined to Angel Oak. For years, environmental and social criteria were the dominant ESG factors for many investors. But as certain institutional investors seek to pursue ESG-related mandates, governance is coming to the fore.

“Environmental consideration may be really much more important to a family office or a foundation, whereas a pension fund may be more concerned about governance issues,” said Guy Benstead, a portfolio manager for Shelton Capital Management.

However, the attention to governance comes with a significant hitch: There’s far less consensus on what counts as ESG-qualifying governance than there is about the other two pillars.

Most often governance has been associated with organization structures that could pertain to investor concerns like board independence. But governance issues are also absorbing areas of, for example, how well an organization is prepared for regulatory compliance or its operations are adapting to key market business strategies.

No greater example may be on display in the asset-backed world than how well (or not) issuers are preparing for the upcoming demise of Libor benchmark rates that price floating-risk assets.

Issuers who have not applied a “fallback” alternative rate in the absence of the London interbank offered rate could find themselves disfavored by funds and institutional investors who consider the lack of planning a potential governance risk.

“Right now it’s not impactful item to our ratings or ESG scoring,” said Roelef Slump, a managing director in Fitch’s residential mortgage area. But “over the course of this year, I think it’ll become increasingly clear whether or not it should be an elevated item impacting ratings and elevated ESG scoring.”

Governance issues are becoming a greater part of responsible investing guidance for private residential mortgage-backed securities, too, as that market continues to increase in size. Issuers are being expected to demonstrate strong reps and warranties, origination/aggregation and servicing practices and quality third-party due diligence in their documentation.

Rising priority
Governance has often been the third cog in ESG investment strategies, both in the acronym and in investment priority. In a 2018 biannual study, the non-profit US SIF Foundation reported that institutional investors in the three prior years had incorporated social and environment responsible investing criteria into approximately $8.7 trillion in assets, compared to $3.49 trillion for governance-related measures.

But as more ABS investors and issuers strive to make assets and deals meet ESG criteria, governance is getting more attention. The cessation of Libor at the end of 2021, for instance, is growing more urgent for holders of floating-rate assets of bonds and loans.

Likewise, online marketplace lenders may face increased regulation and legal exposure for the cross-state loans as industry volume continues to escalate. While it is uncertain if they will gaining or strengthening exemptions from state usury and consumer protection laws of a borrower’s home state, S&P Global Ratings said regulatory and business-practice factors will remain “key considerations” in rating marketplace lending securitizations.

For Angel Oak, assessing the operational and management strategies of the banks may become more crucial considering an 18% surge in 2019 community bank merger and acquisition activity, according to data from Compass Point and S&P Global Market Intelligence,.

Banks offering subordinate debt bonds often target the newly raised capital proceeds as dry powder to finance deals or positioning their balance sheets to be acquired, said McDonough. But if they have shortcomings in governance – compliance, risk-laden loans on the books, or a shortage of directors with sector expertise in local industries – then placing and adequately pricing the sub-debt bonds becomes a tougher sell.

“We do look at the way that management is able to communicate their strategy to us and how they’re going to deploy this capital into that strategy,” said McDonough.

In October 2019, Fitch Ratings introduced what it called ESG “relevance scores” into its ratings coverage for structured finance and covered bonds. (The agency had previously launched them for credit ratings analysis in corporate loans and public finance earlier in the year.)

The new guidance was constructed to create scores, on a 1 to 5 scale, assessing the impact that ESG factors would have on issuers and debt vehicles. For structured finance, this introduced ESG relevance scores into Fitch’s coverage of residential and commercial mortgage-backed securities, as well as asset-backed securities portfolios.

The scores are observational only, so they won’t impact credit ratings, but will provide some transparency to investors as to how environmental, social or governance factors might play into a portfolio’s performance. For nearly 2,200 Fitch-rated RMBS transactions, the agency found one-fourth had “elevated” ESG factors of 4 or 5, indicating they ESG is potentially a key driver of future performance – and a window into potential upgrades or downgrades on credit ratings to come.

“For U.S. RMBS, we had about 22% elevated scores; this is at the higher end of U.S. asset classes, followed by CMBS with 16%,” said Slump. In most cases, governance factors were the most influential, taking into account the business practices of lenders and deal sponsors, the representations and warranties offered to investors, due diligence, and servicing performance. Not all the elevated scores represented negative credit implications for deals, either; some bore positive attributes for deals because of the strong credit attributes and performance of most post-crisis deals.

CLOs
Structured credit transactions, such as collateralized loan obligations, have not yet been included in Fitch’s ESG scoring expansion.

But again, few CLO managers have issued deals where ESG factors have been front and center.

U.K. private equity firm Permira has sponsored green-friendly euro-denominated CLOs which meet the European Commission’s ESG criteria for institutional investors. U.S. manager Sound Point Capital Management last year refinanced an outstanding 2016-vintage CLO deal with a newly installed ban on tobacco industry assets in the collateral pool.

But more asset management firms are planning ESG-friendly CLO deals. LibreMax Capital currently has an ESG-centric CLO in the warehouse ramping phase, with plans to issue a transaction sometime during the first quarter, according to LibreMax executive David Moffitt.

Moffitt, the head of tactical investment opportunities and CLO management, said the firm is meeting institutional investor demand for platforms making socially responsible investments, in turn driving managers and issuers to those standards.

“I think investors look at the upside of being involved in socially responsible investing, as something that’s worth an additional cost,” Moffitt said. “And I think what it will do is push companies in a direction where they would want to be included in the broader portfolios of ESG-eligible asset management platforms.”

But what constitutes an ESG-eligible deal is up for question in the U.S. Generally portfolio managers will derive at least half the revenues from so-called clean businesses, and avoid assets involved in oil and gas production, military weaponry, gaming, tobacco and payday lending, according to several industry observers.

But to be an ESG-eligible CLO, investors would also demand the deals meet governance criteria on the green assets. Stan Renas, a partner in law firm Katten Muchin Rosenman. Investors and ratings agencies would insist on knowing what levels of transparency, management organization, and internal controls are in place with the debt issuer. “How much independence does the board have from the CEO and the other officers of the organization?” Renas said.

“While you’d expect it to be defined by those eligibility criteria as opposed to some sort of numerical determination, the rating agencies could conceivably attempt to quantify governance based on a numerical scale,” Renas said.

“Rating agencies are trying to figure out what people need to be looking at. That’s still unknown,” said Shelton Capital’s Benstead. “There’s still a lack of uniformity in the application of these criteria, but there’s a lot of work being done on it.”

Future performance
At an early December symposium in New York, the Structured Finance Association gathered nearly 200 asset managers and investors to discuss trends in ESG investment strategies. According to the SFA, nearly $11.6 trillion – or $1 of every $4 invested in the United States – was made under ESG criteria.

That was a 44% increase since 2016, the SFA stated. But that didn’t silence all the doubters in attendance.

At the SFA conference, an individual investor questioned why to date “there really has not been an outperformance of securities with ‘so-called’ better ESG factors, than those that didn’t,” said Slump.

In other words, if there’s no economic benefit to ESG criteria, the call for sustainable investing amounts to little more than good intentions.

But Fitch doesn’t think about “good and bad ESG,” he added. “We’re thinking about whether the ESG factor is a credit component or not; also the credit environment has been very favorable for most mortgage credit over the past number of years.”

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