This Kroll Bond Rating Agency (KBRA) report is a follow-up to a research publication on KBRA’s general approach to incorporating environmental, social and governance (ESG) factors in our credit rating process across corporate, financial and government (CFG) ratings, which we describe as ESG Management.
While our previous publication provided a broad overview of KBRA’s ESG Management approach (summarized below), this research report focuses on the potential influence of ESG topics on KBRA’s rating analysis of asset managers and investment funds. It is important to note that this research is not a methodology. KBRA’s cross-sector ESG methodology can be found here.
Overview of KBRA’s ESG Management Approach
KBRA believes that ESG issues are best examined through the lens of active risk management. Under our ESG Management framework, we seek to understand how an issuer or transaction identifies, addresses, and mitigates relevant ESG risks or capitalizes on ESG opportunities.
KBRA believes that credit-relevant ESG risks and opportunities are unique to every rating and issuer. Our approach to evaluating the management of ESG issues is a bespoke and dynamic process.
KBRA does not deploy subjective value-based ESG scoring rubrics.
KBRA understands that better quality ESG-related disclosure is needed to understand an issuer’s exposure to credit-relevant ESG issues.
Our direct dialogue with management teams enhances our understanding of credit-relevant ESG issues, while also improving the quality and consistency of ESG-related disclosure.
Consistent with how we assess default and recovery risk, we view the management of ESG factors as a dynamic process, rather than a point-in-time judgment.
In addition to the unique ESG risks related to each specific debt issue or issuer, KBRA’s analysis of ESG Management typically includes a review of broadly relevant topics such as climate risk, stakeholder preferences, ESG reputational risk, and cybersecurity.
We believe the risk management framework should be comprehensive, yet also dynamic and flexible enough to accommodate evolving factors, including ESG considerations.
KBRA’s ESG Management Framework for Asset Managers and Investment Funds
Some ESG factors can have a clear, identifiable impact on credit ratings, and these are incorporated in KBRA’s rating analysis. However, KBRA believes that the relative ability of issuers to identify, disclose, and address a broader array of ESG factors that may be less direct or immediate is an increasingly important credit consideration.
As part of our due diligence process, KBRA evaluates, where relevant, the overall effectiveness of the issuer’s risk management framework to determine whether it adequately captures and addresses the plausible risks to which the entity is exposed. When relevant, we may analyze the management team’s awareness of existing, emerging, and potential risks, and the processes in place for identifying, assessing, and responding to relevant ESG risks and opportunities, as well as how these functions compare to peers.
Given the wide range of assets and structures within the asset management and investment fund sectors, the ESG factors that KBRA considers to be most relevant will vary depending on the transaction being evaluated. KBRA approaches ESG considerations in the ratings of asset managers and investment funds with three levels of analysis, where relevant. In the first level, KBRA examines the asset manager’s ESG priorities and how these may positively or negatively impact their ability to continue to attract capital. For example, KBRA may evaluate how the asset manager demonstrates its commitment to the various ESG priorities of their potential limited partnership (LP) investors and other relevant stakeholders. In the second level, KBRA examines the ways that ESG priorities influence how the general partnership (GP) screens investment opportunities. We may also seek to understand how ESG investing approaches, such as inclusionary or exclusionary screening, are used in their investment decisions. In the last level, KBRA analyzes how the GP manages the underlying portfolio assets. For example, we may ask about goals related to greenhouse gas (GHG) emissions, employment and board diversity, and cybersecurity risks, among other potentially relevant topics.
Environmental Factors
Environmental factors have the potential to affect some asset manager and investment fund ratings, but their relevance can vary depending on the characteristics of the underlying collateral, the structural features of the rated debt, and/or qualitative aspects of the transaction. In KBRA’s Level 1 assessment, where relevant, we analyze how the asset manager prioritizes environmental considerations in its own operations and how its environmental strategy affects its ability to attract capital. As the effects of climate change increase in severity, it is important to understand the level of exposure an entity has to climate transition risks relating to the global shift to a low-carbon economy, such as increases in global emissions regulation. We may evaluate the asset manager’s GHG emissions levels, the policies or targets it has in place to reduce emissions, and how the manager monitors and reports this information. Increasingly, asset managers are setting net-zero carbon emission targets, which may have a positive effect on their access to capital and, therefore, creditworthiness. Where appropriate, we also analyze the asset manager’s exposure to physical climate risks such as hurricanes, sea-level rise, and wildfires.
It is also increasingly important to evaluate the level of exposure that an investment fund’s assets have to both physical climate risk and climate transition risk, including the potential for stranded asset risk. In our Level 3 assessment of rating investment funds, we may evaluate the percentage of assets that are directed toward carbon-intensive industries versus the assets held in renewable energy, energy efficiency, and other projects related to climate mitigation. Where relevant, in our Level 2 assessment, KBRA also analyzes how the GP monitors and measures its portfolio’s exposure to climate change risk.
The topics KBRA pursues related to environmental factors can vary widely, but typical guiding questions include:
Does the asset manager/GP have climate-related goals or targets in place for itself and underlying assets? If yes, what are they? If no, why not?
How does it measure progress toward its stated goals?
What level of exposure does the collateral pool have to physical climate risks (hurricanes, floods, droughts, wildfires, etc.) that could potentially have a financial impact?
What level of exposure does the collateral pool have to transition risks that could potentially have a financial impact, including potential regulatory changes?
What is the fund’s exposure to stranded asset risk?
What is the fund’s exposure to a potential international carbon tax, cap-and-trade program, or other regulated carbon pricing scheme
Does the asset manager/GP calculate carbon or GHG emissions for itself and across its assets under management? If so, what were the annual emissions levels and how did they calculate them? If they did not calculate them, why not?
Are there internal or independent auditors to verify their emissions reporting?
Are there any self-initiated or third-party required plans to reduce them?
Social Factors
An analysis of social factors, especially stakeholder preferences, is often a key part of KBRA’s assessment of ESG issues. In KBRA’s Level 1 assessment, where relevant, we analyze how the asset manager incorporates stakeholder preferences into their decision-making process. These stakeholders may include LP investors, the asset manager’s employees, and relevant regulatory bodies, among others. With the growth of dedicated ESG and sustainability funds, we may analyze if the asset manager is facing pressure from its investor base to create or invest in these types of funds or plans to in the future. KBRA also evaluates how the asset manager minimizes the risk of greenwashing[1] in its funds, investments, or assets, which is becoming a key reputational risk and is incorporated into the Level 2 assessment, where appropriate.
KBRA often analyzes how the issuer aligns its own internal policies and procedures with investor expectations and preferences on ESG issues. We may inquire how the issuer measures and reports ESG information to satisfy the needs of its investors and other stakeholders. Similarly, for the Level 3 assessment, KBRA may evaluate the monitoring process accounts for stakeholders’ ESG preferences at the GP, LP, and asset levels.
Where relevant, under the Level 1 analysis, we may also consider how the asset manager approaches diversity and inclusion related to employee stakeholder pressure and employee retention. This may include an analysis of anti-discrimination policies, prioritization of employee engagement and retention, and employee training programs, among other considerations. We may also inquire how the asset manager supports or invests in the communities in which it operates and whether this affords a competitive advantage with regards to reputational risk.
Typical guiding questions include:
Who are the asset manager/GP’s key stakeholders (regulators, investors, employees, etc.)? What risks or opportunities do these stakeholders pose to the issuer?
Do the preferences of key stakeholder groups pose risks to long-term operational and/or financial stability?
Has the asset manager/GP or any affiliate ever been involved in any ESG-related controversies, litigation, misconduct, penalties, incidents, or cybersecurity attacks that may have implications on stakeholder/reputational risk?
What were the ramifications? What were the lessons learned?
Governance Factors
Governance is a key component in KBRA’s Investment Fund Debt Global Rating Methodology and Asset Manager Global Rating Methodology. Typical governance analysis includes a manager review and an assessment of the legal framework that may direct a manager’s actions in each individual transaction. With the increased rise in ESG investing, asset manager and investment fund’s governance frameworks have received increased scrutiny, particularly in how the various facets of ESG factors intersect with company operations and/or asset allocation. KBRA’s rating process will continue to incorporate an assessment of governance structures but, where relevant, we will also include a specific line of inquiry to highlight explicit strategies or programs to address ESG issues.
In the Level 1 assessment, where relevant, KBRA evaluates how ESG-related risks and opportunities influence the asset manager’s strategy and financial planning. We may seek to understand the asset manager’s oversight of ESG issues, for example, if it has a separate committee to oversee ESG policies and procedures, and how it reviews and monitors ESG-related compliance. As ESG reporting and disclosure becomes increasingly mainstream, we may evaluate how the asset manager discloses relevant ESG information, how it ensures this disclosure is reliable, and if it uses internal or independent auditors to verify its ESG reporting. We may also analyze how the asset manager or GP approaches conversations with portfolio companies on strategy alignment related to ESG goals. For example, if the asset manager has ESG goals in place, it may be important to engage in conversations with portfolio companies on topics such as executive compensation tied to sustainability goals, whether the company has dedicated sustainability or ESG-focused staff and resources, if the portfolio company is actively trying to meet the goals of the Paris Climate Accords and/or transitioning to a low-carbon economy, among other potential topics.
Understanding the asset manager’s cybersecurity measures is also an important part of KBRA’s Level 1 assessment. We evaluate issuer’s cybersecurity policies and how the implementation process is documented. We also analyze if the asset manager follows an internationally accepted security standard such as ISO 27001, SSAE-18 SOC reporting, NIST’s Cybersecurity Framework or CIS Top 20 Controls, and whether it is audited to this standard on a regular basis.
In assessing Level 2, KBRA may evaluate how the GP makes investment choices based on multiple ESG criteria. With the rise of ESG investing, GPs are increasingly applying various ESG-related investment strategies to screen investments. This includes approaches such as exclusionary screening (meaning that the GP will not make investments in certain sectors such as fossil fuels or tobacco) or inclusionary screening (meaning the GP seeks out investments with positive environmental or social impact such as renewable energy). Other ESG-related investing strategies include thematic investing, impact investing, and norms-based screening, among others.
For Level 3, where relevant, it is important to understand how the fund manager responds to ESG concerns that affect margins and valuations at the asset level. KBRA may also evaluate the procedures to ensure underlying portfolio companies have appropriate codes of ethics, appropriate corporate governance practices, and other ESG priorities that are consistent with the priorities of the investment fund or asset manager.
Guiding topics for governance-related issues may include:
When and how do ESG-related risks and opportunities influence the issuer’s strategy and/or financial planning?
Describe the issuer’s process for identifying, assessing, and responding to ESG-related risks and opportunities.
Describe how the asset manager/GP is preparing for anticipated social, technological, and other demographic changes associated with the shift toward a low-carbon economy.
How does the issuer or fund track and report ESG-related information?
Does the asset manager/GP have a cyber risk management program?
Do they assess their threats and vulnerabilities and determine acceptable risk thresholds?
Do they manage risk by prioritizing and structuring their information security program based on the cyber threats most relevant to them?
Conclusion
ESG factors are complex and dynamic, and some are likely to become more relevant to credit over time. As the world moves toward a low-carbon economy, ESG issues will continue to evolve as shifts in public sentiment and regulatory action influence changes in supply and demand. As we develop and advance our understanding of these complex topics, KBRA aims to understand, identify, and disclose an issuer’s unique ESG risk exposure and its relevance to credit. We will continue to communicate these findings in our rating, surveillance, and research reports as we gather data on relevant ESG considerations for our rated universe .
[1] Greenwashing refers to the process of falsely labeling or misrepresenting products or investments as “green” or “sustainable” when they have little positive environmental impact.
Contacts
Chelsea Nguyen, Director
+1 (646) 731-1251
Ashley Phillips, Senior Director
+1 (301) 969-3185
Pramit Sheth, Senior Managing Director
+1 (646) 731-2330
William Cox, Senior Managing Director
Global Head of Corporate, Financial, and Government Ratings
+1 (646) 731-2472
