ESG in Aerospace & Defense Lending
ESG in Aerospace & Defense Lending
Environmental, Social, and Governance (ESG) has become an increasingly significant influence on investment decisions for both equity and debt investors in private markets. The term “ESG” can be applied to a host of wide-ranging considerations – inclusion, environmental impact, and workforce/labor relations to name a few. ESG is also a term that seems to have, in part at least, subsumed SRI, or socially responsible investing. Some would say that ESG evolved from SRI, which began back in the 1960s. Regardless of which acronym is chosen, it is undebatable that the LP community, including investors in private credit funds, is driving a significant shift in investing. The ESG push is particularly prevalent amongst pensions and sovereign wealth funds, which have expanded their considerations beyond a primary focus on climate change.
Aerospace & Defense represents a huge portion of the economy (including nearly $1 trillion in total domestic revenue and over 6% of total U.S. exports) and it has long been one of lenders’ favored industries. Acyclical demand and long-term programs tend to provide lenders comfort in underwriting A&D-linked businesses. However, as ESG has become more impactful to lenders, A&D (more specifically, defense) has become more of a controversial investment. The sector is broad, including clothing, vehicles, food, services, aircraft, etc. and the supply chain is even more expansive, consisting of component manufacturers, assemblers, and other service providers. Each of these companies, at times, seeks to access the capital markets, often in conjunction with M&A or an LBO.
Recent experience suggests that the debt capital markets remain open to companies with defense exposure. While most lenders don’t explicitly exclude these borrowers, the proverbial bar has gotten higher in recent years. It can be particularly difficult to source debt capital for borrowers that are directly linked to weapons and munitions. That said, appetite often depends on the extent to which the prospective borrower’s products are finished goods as opposed to components or subassemblies. The line gets blurrier, however, when the borrower is only partially linked to weapons and/or munitions, and the analysis is both quantitative (what portion of the borrower’s business is linked) and qualitative (to what extent are the products finished, what are the products, how are they used, etc.).
Further, most lender fund documents do not strictly prohibit these investments, and there is often room for interpretation. In this way, it is critical when a borrower is presented to potential lenders, these concerns are addressed directly and with sufficient detail to allow the investment committee to make a quick and accurate decision about the level of interest and adherence to internal protocol. Temptation may be to avoid the topic with lenders, but Configure suggests the opposite approach, particularly with ESG-sensitive topics, as these issues can be binary in response. Either a lender can get comfortable with the relevant issue, or they cannot. Additionally, lenders generally err on a more conservative interpretation of ESG requirements. It is in no one’s interest – not the private equity sponsor, the borrower, nor the lender – to spend time evaluating a potential lending relationship only to discover a binary, gating issue after several days (or weeks) of work.
Importantly, these ESG-sensitive borrowers can also introduce additional logistics in lender evaluation. Specifically, lenders sometimes are required to screen A&D opportunities through additional committees prior to committing the time and resources to pursue. At times, lenders may be required to include major LPs in the decision as well. For this reason, Configure will deliberately construct a detailed memo with the relevant credit considerations, including the ESG-related considerations. In combination with a few discussions with lenders, this allows lender deal teams to quickly get in front of the “ESG committee” and to accurately present the opportunity internally.
ESG is here to stay, and deservedly so. This is a movement that adds complexity for many A&D borrowers and sponsors, and managing that complexity is critical to achieving optimal terms and execution.