Letter number 145 of October 2022

  • NEW

News : How high will green and sustainable finance go?

As we do it regularly we organised an event for the publication of the latest edition of the Vernimmen.


 For the 2022 edition, Victoire Aubry (CFO and member of the Executive Committee of Icade) and Philippe Zaouati (CEO of Mirova) did us the honour of taking part in a round table discussion on the theme "How high will green and sustainable finance go? "


After Victoire Aubry provided a quick recap of the characteristics of products currently available on the market (green bonds, social bonds, sustainability-linked bonds[1], green loans[2]), the discussion focussed on the necessary standardisation and credibility of issues in a crowded market:


Philippe Zaouati: It has to be said that there are different levels of conviction, and of credibility. This is typically the case with green and sustainable bonds, where we have a market that is gradually being structured, but not quite keeping pace with innovation. What I mean is that, initially, there were green bond issues, then this market was structured with standards and labels guaranteeing that these were bona fide issues. This was the work done by the ICMA, with the green bond principles, which from the outset tried to structure things well by explaining what it meant to "earmark" the bond, in what is known as the "use of proceeds" of the bonds: what is the money going to be earmarked for, and what will this money be used for? This has been very well structured by ICMA, which has done the same thing with social bonds.


Then, beyond that, regulatory work was done. In particular by the European Union with the green bond standards, which have added elements of taxonomy to the ICMA structure, i.e. the definition of what is green. The problem is that innovation moves faster than EU standards, and so hot on the heels of green bonds, we had social bonds, then came sustainability-linked bonds, etc. We therefore have a lot of innovations coming onto the market that don't necessarily follow all of the recommendations under the standards that have been set.


Take the example of sustainability-linked bonds. This involves issuing bonds on more favourable terms if a number of targets are met. Consider a company that wants to reduce its greenhouse gas emissions by setting a target: "I want to reduce them by x%, and if I meet this target, I'll get preferential terms." The problem is as follows: is the reduction that has been set as a target sufficient and in line with targets such as those of the Paris Agreement for example? It's possible that a company will set very positive targets, but it's also possible that it will let woefully inadequate targets in relation to the climate trajectory we want to set.


Today, some standards are beginning to emerge in this area, such as science-based targets: targets based on science that tell a company whether its targets correspond more or less to a particular scenario.


What does this mean for an asset manager? This means that we cannot rely totally on innovation and the market today: there is a real need for analysis. It should be based on standards, on green bond principles, but it also requires an in-depth analysis of investors according to their objectives. If we as asset managers set the bar high enough, it means that some issues will not be eligible for our portfolio.


Vernimmen Co-Authors: ICADE Santé issued a social bond for € 600 million in 2020: would you do it again? What type of investors did you encounter on this occasion?


Victoire Aubry: Yes, this was a flagship issue. The notion of greenwashing is important. ICADE issued a green bond in 2017, and we havn't reissued any since for reasons of strict compliance with the constraints of the green bond principles, where we have established selectivity criteria for our major assets. This is why we worked on our health activity, which is essentially social in nature since we finance the construction of nursing homes and private clinics, so we considered it important to be part of the social bond principles too. We're very scrupulous and adhere to extremely rigorous criteria, which is why we try to limit any overly automatic standardisation of significant volumes of portfolios. We have to pay very careful heed to these performance criteria. So yes, we issued this social bond in 2020, which enabled us to broaden the profile of investors who subscribed to our issue.


In six years, it's interesting to see how things have evolved. I think the share of CSR (Corporate Social Responsibility) funds at the time was between 5 and 10% of the subscribers at most. We met with traditional investors who told us that they had €5-10 million to invest in CSR projects, but they did not have a very proactive policy. When we issued our social bond in 2020, I think the share of CSR funds in the broad sense was between 30 and 40%. This shows how far investors had come between 2017 and 2020. What's interesting is that even institutional investors are invited to subscribe to bonds with a sustainable connotation. So, of course, this broadens the range of potential investors for us, and therefore the success of the programme.


Vernimmen: Do you think there should be a premium for sustainable investment? In other words, should the investor be satisfied with a lower return, and should the issuer benefit from a lower cost of financing in order to be virtuous?


Victoire Aubry: In 2017, it was more complicated: there was no price incentive and there were tight constraints. This made it possible to bring together, within the company, the financial teams and the business teams, since the issue had to be constructed by analysing the characteristics of the assets in depth. So, it was an interesting experiment at our level, but I do think it's a question of balance between supply and demand. We shouldn't think in terms of incentive or price: I think that today there's more demand for sustainable bonds, so by necessity, as there is more interest in our CSR-labelled issues, this enables us to pull the price down and exit under better conditions. It more of a consequence of the success of this market. I don't believe that it should be systematically valued as such.


Philippe Zaouati: People have been trying to tell investors for years that they can invest in sustainable assets and get the same or even better performance than they would if they invested in other assets. That's how we attract them. I'm often asked if this is true. The answer is yes: there are many advantages, it's a way of analysing the market that enables us to be relevant and to go after the right investments. If we assume from the outset that sustainable investment will underperform and that we'll have to pay more, we may not find many investors. Hence the interest in turning the situation around: demand must be created to improve the situation. However, the only way to imagine this premium would be to introduce regulatory and tax benefits associated with these products. In this case, we'd have a premium, but it wouldn't be the investor who paid it: it would be financed by the general interest. This would be worthwhile if we consider that climate is a systemic risk for the financial system.


Another way of answering the question is to ask one: For a company, what is the point of issuing a green bond? Is the only interest for a company the opportunity of borrowing at a lower cost? Stabilisation of its investors (who would better understand the company's targets) is often cited. Personally, I fundamentally believe that issuing green bonds is only of interest if it is a tool that enables the company to step up the pace of its transformation. A company that does not want to transform itself, that has not set itself very high targets for sustainable transformation, will not see the point of issuing a green bond. On the other hand, for a company that has set itself high targets, issuing a green bond can have an extremely strong impact. Transformation can only be successful if the financial side is aligned: by aligning its financial management, by sharing reporting sources and KPIs across the company, by aligning the whole company with its targets, it will accelerate its transformation.


Victoire Aubry: It is sometimes frustrating to see that a lot of things are done on the assets side, but on the liabilities side we struggle to keep up because of a field of constraints. Avoiding greenwashing remains fundamental, but I think the last few months have been very positive: things are becoming more structured and standardised. I hope that we'll standardise sustainability-linked bonds.


Vernimmen: Victoire, in your investment decisions, how do you link financial and non-financial criteria?


Victoire Aubry: We have a very active CSR policy within ICADE. We find this reconciliation dynamic at two levels. The first is that in all our investment files, there are our usual criteria (IRR, P&L, rate of return, profitability, etc.) and also CSR criteria that have the same weight as the financial criteria. In our choices, the CSR label is absolutely essential. At the very least, if this is not the case at the time of investment, we assess the potential for transformation and our ability to bring it up to the best CSR market standard. Today, our investment criteria are scrutinised through this prism.


The second level is that all our criteria include investments, amounts and costs that track the improvement of the energy performance of our assets. How does this translate? Over the last four years, we have spent over €65 million on our office assets deploying photovoltaic panels on roofs for example. These are no longer costs for us: they are part of the quality standards of our assets. When people talk to me about "the costs of CSR investments", I say that they're not costs but opportunities. Why? Because we're convinced that tomorrow our products will be more attractive by being of the highest standard. We've seen that after the Covid crisis, our tenants are now demanding buildings with very high energy performance: not only do we no longer have a choice, but it's also an opportunity for us to develop the attractiveness of our products of tomorrow, and consequently our turnover, and consequently our profitability.


Vernimmen: Philippe, do you think that Europe will be able to set its own environmental standards or will it have to be part of a wider scheme?

Philippe Zaouati: Setting standards is a matter of sovereignty. For financial standards, Europe has long since capitulated: it's the IFRS that sets the global standards. In theory, Europe has the power to accept or reject IFRS, but in practice it has always accepted them without saying a word. This means that we end up with standards that are not at all controlled at a European level.


We now have the problem of "extra-financial" standards, i.e. the way in which companies will structure their reporting on environmental and social issues. We need to move to extra-financial accounting, which is not at all standardised today: we're therefore at the start of a battle of standards. At a European level, we have a number of initiatives such as the taxonomy or the work on the recasting of the Non-Financial Reporting Directive (NFRD) into a Sustainability Reporting Directive (SRD), which will provide a precise definition of the indicators that companies will have to present to the market. The European institute working on this is called EFRAG. Europe is therefore in the process of building up the resources to achieve this extra-financial standardisation.


The problem is that at a global level, the same work is being done. In Glasgow at COP26, the IFRS announced the creation of the ISSB (International Sustainability Standards Board), whose purpose is to produce these environmental and social standards at a global level. So, Europe is defining its own standards, but will it have to submit to international standards?


Some may question whether the issue is relevant. It is in fact of paramount importance since the European and Anglo-American visions are very different. Europe is based on the principle of double materiality - we analyse things in both directions - first we study the impact that nature may have on the company (the extra-financial risks borne by the company): how can the climate have an impact on the company's profitability? Then we look at the company's impact on the climate. So, it's a very different philosophy. Double materiality will be at the heart of the standardisation battles in the coming months. I think that Europe could emerge victorious because it has a global standardisation capacity. For example, when Europe legislated via the UCITS Directive in the late 1990s to clearly define what an investment fund is, it practically became a global standard. This is also what is happening in the area of data protection with the GDPR: here too, a European standard is gradually becoming a global standard.


So, we can see that the European capacity to standardise things is there and we're going to have to use it for extra-financial standards.


Vernimmen: Victoire, we believe that you're working on taxonomy reporting, can you tell us more?


Victoire Aubry: Yes, this is an innovative approach driven by Europe and should be welcomed. I believe that the financial and non-financial worlds will be parallel tomorrow. This is confirmed when we see that listed companies are now obliged to draw up extra-financial reports as thick as financial reports.

The reporting of the taxonomy is interesting because it invites us to reconcile the extra-financial with the financial and thus to begin to respond in part to the financial translation of the extra-financial. What exactly will happen from 2022? All listed companies will be required to report on the eligibility of our assets. We must ask ourselves what in ICADE's activity is eligible for the taxonomy. In addition, it will be necessary to identify the assets that are aligned with the criteria of the taxonomy in terms of turnover, OPEX (expenses) and CAPEX (investments). This is going to be exceedingly effective as companies will have to report their green activities in terms of turnover. This first translation will be imposed from 2023 on the 2022 accounts. This is a major step forward.


Vernimmen: Philippe, what do you think of the evolution of the criteria developed by Danone, for example, in terms of carbon EPS, or by Kering in terms of its environmental income statement?


Philippe Zaouati: These measures are taking it to the next level. We're no longer dealing here with extra-financial reporting that will be added to financial reporting: it's a vision that tries to mix things together completely. The idea is that the accounting vision, which guides us and structures the life of companies and capitalism in general, no longer corresponds to reality because, for example, a company could destroy its environment, deforest and destroy natural capital in order to carry out agricultural activities. However, this destruction does not appear in its accounts.

So, if we want to account for this, we now no longer refer to externality but to capital destruction. Can we imagine an accounting system that will reflect these phenomena? This can be translated as follows: "If at the end of your activity you return the natural environment to its initial condition, you don't have to mention any degradation in your accounts. If this is not the case, this means that you have used natural capital, so you will have to record this loss linked to the use of the natural environment in your accounts." There is some interesting work in this area that is going in directions that are ambitious, to a lesser or greater degree.


Danone's approach is simple: we do all the traditional accounting, then at the end we take into account the carbon impact we have in the EPS. It's an end-of-pipe process. There are also more ambitious things, such as Alexandre Rambaud's Ecological Accounting Chair and his CARE model. It goes much further: it's an alternative accounting model. Although we may be a long way off in general, there are still many companies that are trying certain initiatives, such as that of the WWF, which has launched a lab with dozens of companies with the aim of testing these different tools. Who knows, maybe this will be the accounting of tomorrow?


Vernimmen: What are the barriers to green finance? I'm thinking, for example, of the fact that less attractive returns may deter investors. What is it that could prevent green finance from replacing "traditional" finance?


Victoire Aubry: There are barriers. The first is rigour. We have to be very rigorous to avoid greenwashing. But this implies meeting a certain number of criteria which are sometimes restrictive for a financial director. We lose all flexibility in the financial management of our company, which is the opposite of agility. Structuring should be accelerated, the definition of extremely rigorous frameworks should be accelerated, but they should be made less restrictive.


Today, the bond market is worth around €330 billion and of this €330 billion, €90 billion is made up of sustainable bonds (70% green, 20% sustainable, 10% social). This means that two thirds of the volume of funding today is still not sustainable. So, there's plenty of room for improvement, and we need to find a framework that reconciles the agility of financial management with rigour so that investors can be sure that they're in line with their criteria.

Philippe Zaouati: I'd like add to what Victoire's just said. I think that today, green finance is about tools that have enabled the reallocation of capital towards what we think is virtuous: green bonds, responsible investment funds, etc. This part has been working rather well given that this reallocation has begun. The ecological transition is being financed to a greater extent. This reallocation is working because there's a lot of innovation, because there are places to invest.


What isn't working so well, however, is that the financial system has moved very little. We still have the same accounting rules, so whoever destroys the natural environment can continue to do so. The financial system remains very short-termist and this hasn't changed much. Green finance will really be established when we shift the fundamentals of the system, such as banking regulation or the way the ECB finances green bonds in its monetary policy.


Furthermore, it's imperative to avoid generalised greenwashing. If one third of the bond market is already green, not to mention the many companies claiming to have an ESG approach, then this means that we likely have a financial market that is already 50% or even 2/3 green. Is this really the case when we have seen no significant reduction in CO2 emissions? Reality is therefore at odds with these figures.


Today, a large proportion of institutional investors invest passively, i.e. they just copy the market, and accordingly they don't take positions and don't really think. If you look at the commitments made by major global asset managers like BlackRock, even among those strong enough to stop investing in coal, you will see a systematic footnote: "For all our investments, except passive management." Their argument is as follows: "For passive management, our hands are tied." This is one of the obstacles to green finance.


Vernimmen: How can banks support SMEs in a CSR approach?


Victoire Aubry: There is a certain degree of complexity in the extra-financial approach today. Some time ago, I attended a CSR roadshow with my CSR manager and noticed that some investors were very focused on CSR. In a traditional roadshow, even financial directors or investors don't have the technical skills to explain these issues to SMEs. Fortunately, we are starting to see traditional investors looking at CSR issues and trying to really understand what the company is doing with its CSR policy. Banks have a fundamental role to play in supporting small businesses that do not necessarily have the time or skills to tackle these highly technical issues. This technicality is another obstacle: we need to "de-jargonise" and simplify extra-financial information, while remaining rigorous. It's not easy!


Vernimmen: How far will green finance go? There are concerns about a type of "green bubble". With the taxonomy coming up, I wanted to ask you if companies claiming 40% (or more) of their activities as taxonomy eligible are really virtuous. Is there not a risk of investors concentrating on 'virtuous' stocks and perhaps problems of capital allocation beyond the moral issue?


Philippe Zaouati: I have the impression that there are bubbles elsewhere than in the green area: Facebook, Google, not to mention all the start-ups that become unicorns in a few slides! Personally, I think there is a bubble today. With the money being poured in by central banks, there is a structural asset inflation bubble. We're in a new economic system, with asset price inflation, but without price inflation[3]. This is a new phenomenon, linked to the dumping of a large amount of money which creates consequences in terms of increasing inequality: it's the asset holders who are becoming richer and richer because of this inflation of asset prices.

With regard to the "green bubble", the problem is simple: will this influx of capital occur at the same pace or at the same rate as the growth of this "green" area, and therefore of innovation? It seems to me that this is the case at the moment. There is so much development in renewable energies, clean mobility, the circular economy, innovation is so powerful that we're able to accommodate quite large financial flows. It is possible that bubbles may appear due to the difference in the pace of growth of green and the inflow of capital into green, but this is specific to each financial matter!


In terms of the taxonomy, we have to make sure that it is understood that no one is going to ask anyone to have 100% of their assets invested in the taxonomy. That's a fantasy. No one will require this, or if they do, it won't work. Today, the taxonomy only includes the "climate" part but does not yet take many parameters into account, which explains why a company active in water purification is not yet eligible for the taxonomy because it has no climate impact!


These criteria will be added as they become available. The taxonomy represents 3% of the economy today, which is tiny. This means that we have identified the 3% of the economy that is really climate friendly and aligned with what we want to do. For an investor like Mirova, 12% of our entire portfolio is aligned with the taxonomy. On our "Europe environment" portfolio, dedicated to the environment, we are increasing to 25-30%. So, you can't ask anyone to be 100% aligned! Let's not make the taxonomy say what it doesn't mean. It's a target, it's the 'dark green' part of the economy, it gives a useful definition to the market, but it's not where we're going to put 100% of our assets, at least not in the short term.


Victoire: I'm a corporate finance person and I'd like to come back to the subject of standards. Philippe, you explained double materiality very well. Is there still hope that the ISSB (for example) will move towards taking into account the environmental impact of the company? I don't see how it could miss this measure.


Philippe Zaouati: We can only but hope!


[3] Please note that this round table took place in November 2021.


Statistics : Investments coming out of a downturn typically generate better returns

This general rule is clearly identified in the following graph which shows how the year in which the LBO is made has a considerable impact on the rate of return that will be achieved. Thus an investment made at the height of the TMT bubble in 2000 yields an IRR of 11%, compared to 25% in 2001, 40% the following year and 47% at the bottom of the stock market in 2003.

This graph has been produced by Bain in its midyear private equity report for 2022.


Research : Bankruptcy, a good experience for directors!

With Simon Gueguen, lecturer-researcher at CY Cergy Paris University

Academic literature on finance has often focused on the character traits of managers and their impact on operational decisions on investment or financing[1]. However, few studies have looked at the experiences of directors during their careers, which can affect their behaviour. This is the case with bankruptcies, a rare and therefore inevitably significant experience. Three US researchers[2] studied the impact of directors' experience of bankruptcy on company policy and in particular on risk taking. Their results show that a director who has experienced bankruptcy has a positive influence on the risk level of the company.


The empirical study focuses on a sample of US companies between 1994 and 2013. Then Gopalan et al identified 718 firms (sample analysed) that share at least one director with the 261 firms that experienced bankruptcy over the period. The method used (difference-in-differences) measures the impact of this event (a director of the company goes bankrupt) on the company's risk-taking, by comparison with a sample of comparable companies not affected by the event (control sample).


The first (and most important) result concerns the level of debt. Gopalan et al look at net financial leverage, the ratio of net cash debt to total assets. This ratio increases by 4.1% for the sample analysed in the year following the relevant bankruptcy. Accordingly, it seems that the experience of bankruptcy encourages a director to encourage greater risk-taking. While it may seem paradoxical, this effect is better understood when looking at the results in detail. The increase in risk-taking is mainly observed when the director experiences a "soft" bankruptcy, without litigation, without excessive cost, and with a resumption of activity. In the case of hard bankruptcy, especially leading to liquidation, there is no effect on risk taking. In fact, it seems that directors tend to be overly fearful of bankruptcy, and that experiencing bankruptcy reassures them when the consequences are not too serious. Gopalan et al also show that the observed increase does not lead to excessive risk-taking.


For the sample, the increase in net leverage is largely due to a reduction in equity issuance. Capital increases decrease by 7.7% for the treated sample compared to the control sample; this results in a reduction in cash holdings, thus an increase in net leverage. Gopalan et al verify that the volatility of cash flows as well as the stock price also increases, a natural consequence of increasing leverage.

In this kind of work, a major concern of researchers is to deal with reverse causality. In this case, one could imagine that managers wishing to increase risk-taking would voluntarily choose directors who might share this desire. Here, the directors in the sample analysed have been on the Board for an average of six years. And the increase in risk is only observed when there is a trigger (a director goes bankrupt). Reverse causality is therefore very unlikely.


Experiencing bankruptcy is inevitably a significant experience for a director. On average, directors who face this problem receive fewer offers as a result, and their careers may be affected. One could therefore expect an increase in risk aversion on their part. In fact, the fear of bankruptcy is present even outside such an experience, and this is one of the reasons why companies appear to be under-leveraged compared to theoretical predictions. Directors who experience a "soft" bankruptcy share their experience with companies and are willing to take more risks.


[1] See, for example, "Funding choices: a question of personality?" Vernimmen Newsletter No.73, March 2013.

[2] R. Gopalan, T.A. Gormley and A. Kalda (2021), "It's not so bad: Director bankruptcy experience and corporate risk-taking", Journal of Financial Economics, Oct. 2021, vol. 142.


Q&A : What is a continuation fund?

One of the main constraints of private equity funds is the fund lifespan. Typically, a fund will have a lifespan of around ten years, which may be extended by a few years if liquidation of investments is not completed (this period being specified in the fund's constitutive documents and the contract signed with the fund providers – the Limited Partners). The purpose of the fund's finite lifespan is to give investors the prospect of exiting.

The life of the fund can be broken down into:

·       fund establishment and fundraising;

·       years 1-4: investment phase;

·       years 5-9: harvesting phase;

·       years 10-12+: possible extension phase.

If an investment is made at the end of the investment period, the pressure to dispose of it will come only a few years later. This can be very frustrating for the fund's management and investment team who will see that there are still opportunities to increase value. Furthermore, while the pressure to sell will become very strong in the final years of the fund's life, the timing may not be optimal (bad economic climate, major investment that has not yet borne fruit, etc.).

Some funds have chosen to get around this timing constraint by offering evergreen funds, i.e. funds with no limit on their lifespan. Investors then exit on the secondary market (some funds are even listed on the stock exchange to facilitate this secondary liquidity) or through redemption by the fund, which retains a small liquidity cushion to offer an exit (this will necessarily be limited in size). However, a listed evergreen fund will rarely be listed without a discount on its net asset value.

Other private equity teams manage the end of the fund's life by creating bridge vehicles that will acquire the fund's remaining investments and carry them through to disposal. These are continuation funds. Investors in the original fund are then offered the opportunity to participate (or not) in the continuation fund, alongside third-party investors who may be approached.

Continuation funds may acquire one or more assets of the original fund. This will optimise value creation and the ultimate exit.

An independent expert is required to issue a fairness opinion on the sale price of the stake. The fund management team (which is the same for both the initial and continuation funds) will have a conflict of interest as they need to safeguard the interests of investors in the initial fund by maximising value, but they also need to safeguard the interests of investors in the continuation fund by minimising the purchase price!


New : Comments posted on Facebook

Regularly on the Vernimmen.com Facebook page[1] we publish comments on financial news that we deem to be of interest, publish a question and its answer or quote of financial interest.

Here are some of our recent comments.

150% above break-even in the automotive industry!


This is the performance posted by Stellantis on the occasion of the publication of its half-yearly results. Given the cyclicality of results in the automotive sector, as this graph shows,



 such a situation makes it possible to withstand a drop in sales of up to 60% while remaining profitable. This is all the more remarkable given that Stellantis is mainly present in the mass market segment (Peugeot, Citroën, Fiat, Chrysler) and not very much in the luxury segment (Maserati, DS). It is true that the all-time high of 14.1% for the operating margin is also impressive.


Hats off to Mr Tavares and his teams.


[1]  Like it here