The complexity of secured assets is a major barrier in accessing the desired levels of disclosures. Although environmental audits can make ESG risks relatively easy to ascertain for a single property, it is significantly more difficult to determine the risk on a pool of assets. There are often many stakeholders in the supply chain, and underlying asset pools may change composition over time.
For example, the ESG rating for a special purpose vehicle can vary as mortgages are replaced and the environmental quality of the underlying houses changes. Furthermore, ESG risks can vary significantly depending on the types of assets held.
The material ESG risks and how they are assessed vary given the nature of the asset: The structured credit market encompasses a variety of instrument types, including securitizations of consumer loans and residential mortgages, commercial real estate loans and of commercial mortgages and collateralized loan obligations.
For securitizations of consumer loans (such as credit card debt or auto finance) and residential mortgages, the key ESG risks include consumer protection and energy efficiency. For a pool of consumer assets, there is environmental risk in the underlying assets including the efficiency of residential buildings and fuel efficiency of vehicles. Social risks include how the originator handles consumer protections and cases of arrears or default. Due to the complexity of structured credit, managing governance risk is especially important. For residential and consumer loans, a strong underwriting process, servicing and adequate risk retention are all essential.
In commercial real estate, loans are typically issued on a single commercial property. This means it is relatively straightforward to ascertain relevant ESG risks as environmental audits on large buildings are typically available for investors to review. Social risks in commercial real estate mainly relate to property usage, while governance considerations include covenants, servicing and a firm business plan.
However, commercial mortgage-backed securities, which derive returns from an underlying pool of commercial mortgages, face similar challenges to other pools: multiple stakeholders and the evolving nature of the pools make it challenging to derive clear ESG data on the underlying assets. As with residential mortgage-backed securities, direct engagement with the originator can help to address these challenges.
Collateralized loan obligations are a particularly challenging asset class in which to analyze ESG risks. The structure of CLOs means investors usually depend on the originator to provide data on underlying loans, and ESG data is typically limited. CLOs purchase a pool of senior secured bank loans, made to subinvestment-grade businesses. They issue debt in tranches, with differing risk/return profiles derived from the seniority of the claim on the cash flows generated by the underlying loans.
Due to the lack of data, it can be challenging to ascertain the environmental and social risks inherent in the underlying loans. Therefore, the focus is typically on the governance arrangements for the CLO manager. When reviewing CLO managers, one should ask specifically about ESG factors and whether they have a relevant policy integrated within their credit process, as well as aim to discuss examples of loans they have rejected due to ESG concerns. For credit-sensitive tranches, a loan-by-loan review and analysis that incorporates ESG considerations should be conducted where possible.
Direct lending will have varied ESG risk factors depending on the purpose of the loan. However, the direct connection between the investor and the borrower allows for greater transparency. Investors can request bespoke reporting and disclosure on a variety of ESG risk factors.
