The ESG Growth Story by Scott Avila and Gary Lembo

ESG is a hot topic for investors, consultants and regulators: profitable and politically-charged investment opportunities will be plentiful; some via value-added restructurings.

 

It’s certainly true to say that a discussion of Environmental, Social and Governance (ESG) factors means different things to different investors. Confusion still reigns over definitions, compounded by a lack of standardized metrics, varying state and federal regulatory frameworks and uncertain transparency protocols. ESG can sometimes feel like the Wild West in North America; (Europe is very much a different ball game for ESG investing). But define it as you will, ESG has become a core requirement of many of the most high-profile and influential investment portfolios and the space has seen sustained growth and popularity with fund managers and lenders, significantly reshaping capital markets. Investors, corporations, and governments have increasingly recognized the importance of considering environmental impact, social responsibility, and strong governance in their decisions.

A lot has changed in 20 years. Talk of philanthropic “CSR” initiatives in annual reports, once seen as nice-to-have and a nod to sustainability, has evolved to see rigorous ESG disclosures as a fundamental factor in debt and equity asset allocation across all industries. ESG strategies have moved from a niche approach to a major force in the investment world. Paladin recognized this shift in attitudes early on and has been building an expertise in supporting value creation for investors from ESG opportunities that have had subpar performance, as well as in other cash-flow rich ‘sustainable’ sectors, such as renewable energy, recycling, and recycled materials.

The growth in ESG capital allocation, and the corresponding percentage of ESG investments in any funds AUM (Assets Under Management), has been gathering pace year-on-year, driven by a number of factors, from societal awareness and regulatory incentives to better ESG data and a paradigm shift from shareholders and consumers and investment professionals in wealth management.

Global sustainable investment assets under management increased substantially from $22.9 trillion in 2016 to over $35 trillion in 2020, making up over a third of total professionally managed assets globally.

However, ESG also remains a noisy and politically charged space to navigate. Complaints of woke capitalism and greenwashing are mixed in with anti-ESG state lawmakers negating federal incentive schemes, all clashing with growing demands for more sustainable investment in positive change. The passion for and against ESG spans the political divide in the same way climate change is argued and debated from all sides.

The fact remains that the sector is attracting increasing funding, and this is only set to continue. As a result, there are ever more opportunities for successful restructurings and profitable turnaround scenarios. In particular, the regulatory incentives and inherent ESG requirements defining fund allocation have resulted in cheaper capital and lower costs of borrowing. All striving towards higher returns and a dynamic investment landscape.

Paladin on the frontline

We’ve been on the frontline of complicated middle-market ESG deals, turnarounds, and restructurings—from wind and solar power to recycling specialists and innovative recycled products. As we’ve built value for clients, we have learned a lot.

TPI Composites

As the global leader in composite wind blades, TPI Composites recorded $1.76 billion in net sales and produced more than 8,800 wind blades in 2022. Paladin worked closely with TPIC in 2022 to implement a number of restructuring initiatives designed to improve profitability and increase margins as it faced numerous challenges in the wake of the pandemic, from exiting the Chinese market (due to US import tariffs), rising costs, and supply chain disruptions. A true success story.

SolarReserve

SolarReserve set out to be an innovator in the US renewable energy space, developing utility-scale power with Concentrated Solar Power (CSP) and Photovoltaic (PV) technology. Paladin supported SolarReserve through a successful Chapter 11 process in 2019 as a result of liquidity issues stemming from design and operation problems with their Nevada plant and an ultimately risky international market expansion strategy. In the dynamic solar sector, Paladin has also worked with Ivanpah and Conergy (at one time, one of Europe’s largest solar companies) to navigate major restructurings.

One sector where Paladin has built an exceptional track record in recent years is in recycled materials and sustainable building products.

 

CalPlant

CalPlant created the cutting-edge “Eureka™ MDF”, the world’s first no-added-formaldehyde, rice straw-based medium density fibreboard. Filling for Chapter 11 in October 2021 due to a liquidity crunch, Paladin managed the process of entering a voluntary Plan Support Agreement leading to the successful liquidation of its assets.

CarbonLite

Paladin also supported CarbonLite’s voluntary Chapter 11 bankruptcy. Once one of the world’s largest suppliers of post-consumer recycled polyethylene terephthalate (“rPET”), or recycled plastic bottles, used by the global beverage industry, Paladin conducted a complex four-part asset sale to individual purchasers totaling $230m to return value to debtors. And Columbia Pulp, one of North America’s first producers of wheat straw pulp, used as sustainable feedstock for paper and packaging products, entered a debt restructuring in 2022 to recoup $240 million in secured debt.

Time to look forward, not backward

Capital allocation will continue to support the burgeoning ESG sector, even as it encounters failures and changing regulatory environments and incentive structures. The same dynamics played out in the healthcare and technology sectors in the last few decades. With this influx of capital comes huge potential, offering unique opportunities to private equity investors and credit funds with an aggressive ESG appetite.

The 2022 Inflation Reduction Act (IRA) represents a monumental investment in the nation’s energy transition, which envisages 3x more clean energy on the electric grid by 2030, and capital continues to flow from this landmark legislation. The ESG space will only benefit from the SEC firming up standards, guidelines, and clarity on disclosures and metrics, which is expected to be published imminently. The effect should be to increase confidence in capital markets and promote more efficient valuations.

Because of partisan divisions, about half the states enact provisions to block efforts to invest in state-run investment accounts with an ESG lens.

2024 will be critical to defining the state and federal incentive structures. Because of partisan divisions, about half the states enact provisions to block efforts to invest in state-run investment accounts with an ESG lens. High-profile Republican figures who are part of the GOP presidential primary, including Minority Leader Mitch McConnell and Florida Governor Ron DeSantis, have campaigned against ESG investment strategies, which right-wing media outlets vocally support.

Across all restructurings, no matter the sector, we have noted that embedding ESG improvements in a business plan can increase valuation and reduce the cost of borrowing for distressed companies (indeed, KPMG also found that 70% of U.S. CEOs said their ESG programs improved overall financial performance). Increasing ESG disclosure facilitates investor sourcing of ESG ideas in turnaround situations. ESG data availability for leveraged issuers is improving, driven in part by regulation. These regulatory tailwinds are expected to continue, creating opportunities for credit managers. Lenders’ support for debt restructuring is often predicated on corporate governance improvements - recruiting board members with the right experience is the priority, and at the same time, there may be an opportunity to enhance focus on diversity.

Focusing on specific sectors, investor appetite for distressed renewable energy assets appears to have generally increased and investments in climate technology are still increasing, defying wider capital market headwinds. We also predict that private equity will continue to invest capital in solar as the sector offers impressive turnaround opportunities and long-term cash flow potential. With inflation stabilized, debt markets will seek the most resilient business models, so environmental services M&A should be a beneficiary and the recycling industry is likely to be among the first to recover (albeit with debt financing at less issuer-friendly terms than in 2021 and early 2022).

We also predict that private equity will continue to invest capital in solar as the sector offers impressive turnaround opportunities and long-term cash flow potential.

Companies need help to pass on the increasing costs from supply chains and transportation in the green building space, squeezing margins and creating the right conditions for Chapter 11 filings. However, attractive investment opportunities remain in various construction-related verticals, such as green procurement software and emerging building materials, with further innovation expected. Private equity has increasingly sought out “PropTech” ventures, especially green PropTech – technologies designed to improve the environmental performance of buildings.

Green bond issuances for buildings reached over $11 billion in 2022, a 55% increase from 2019, which should be set to continue, alongside investment in low-carbon construction technology, which surpassed $2 billion in 2022.

 

As ESG investing gains more prominence, the profound shift in how ESG companies operate (and restructure) and generate a return for investors will undoubtedly guide the allocation of capital. Credit investors will be able to price the sustainability of ESG projects into bond prices, while equity investors can identify companies poised to generate long-term equity returns. And at Paladin, we’re ready to help maximize returns.

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