The quiet revolution of sustainable private debt

Private lenders are increasingly becoming key drivers of sustainable practices

In my previous article, we explored sustainability as a powerful lever for value creation in private equity. However, that conversation is incomplete without addressing the debt side of the equation. A quiet revolution is underway as private lenders increasingly become key drivers of sustainable practices. While private debt was a later adopter of ESG principles compared to public markets or traditional banks, its unique structure offers profound advantages for integrating sustainability, particularly in emerging markets and the mid-market segment.

Why private debt is uniquely positioned

To understand this shift, it's helpful to consider the evolution of private debt itself. It has transformed from a ‘lender of last resort’, to ‘opportunistic gap filler’ to now the mainstream strategic partner to borrowers. While ESG integration in private debt was viewed sceptically, unlike equity investors, private debt managers were assumed to have limited influence over portfolio companies, especially in non-control lending structures. However, this view has been systematically overturned.

Unlike large banks that often treat sustainability as a broad risk and compliance function across massive portfolios, private debt funds typically operate through bespoke, hands-on partnerships. For many of these funds, ESG is not a checkbox exercise but a core component of their investment thesis and active engagement strategy for a concentrated portfolio of companies.

This leads to a fundamental distinction between the roles of private equity and private debt in ESG. As owners, private equity firms create value through active management throughout their investment lifecycle. In contrast, private debt funds are lenders. Their approach is inherently risk-based and protective of borrowers’ credit quality. Their primary influence is exercised at the point of covenant negotiation, using ESG criteria to assess risk, and through ongoing monitoring and pricing incentives. Their value creation is tied to the stability and reduced risk of their loan portfolios.

The compelling case: how strong ESG performance mitigates risk

The logic behind this risk-based approach is powerfully supported by data. Studies show that strong ESG performers demonstrate up to 30% lower default rates¹, pointing to a direct mitigation of financial and operational risks.

This is where Sustainability-Linked Loans (SLLs) become a key instrument. A SLL is a loan where the interest rate goes down if the borrower hits pre-agreed ESG targets (like cutting carbon emissions or improving diversity) or goes up if they miss them, tying financing costs directly to sustainability performance. Think of it like a ‘discount for doing good’ or a ‘penalty for falling short’.

The rationale is clear: a company with robust ESG practices is proactively managing a wider set of risks, avoiding fewer ‘blind spots’. For instance, a manufacturer with weak environmental controls is far more vulnerable to a catastrophic ‘tail risk’ event like a chemical spill, which could trigger a liquidity crisis and default. Conversely, strong ESG management leads to tangible benefits that strengthen the balance sheet, including significant cost savings from energy efficiency, enhanced operational resilience, and a more transparent supply chain. For example, companies focused on environmental metrics (energy, water, waste) often uncover significant cost savings; companies that often engage more deeply with their suppliers to ensure ethical and sustainable practices are met, would have more resilient and transparent supply chain, less vulnerable to disruptions.

However, correlation does not equate to causation, some may argue that ESG is a proxy for better management overall, yielding similar beneficial results, and it’s almost impossible to attribute a particular financial improvement to the ESG performance solely.

The implementation gap: why adoption is still nascent

Despite the compelling case, a significant gap exists between intention and action. While over 70% of private debt funds now use ESG criteria, only about 20% tie pricing directly to performance globally². Having worked with lenders and borrowers across the ESG maturity spectrum in the EU mid-market segment, two primary barriers to wider SLL adoption emerge:

1. Misaligned incentives: the financial incentive - often a modest 5 to 20 basis point interest rate discount, is frequently deemed too small to justify the administrative burden. For a borrower with no existing ESG framework, the cost of setting up data collection, KPI tracking, and third-party verification can easily outweigh the potential savings.
2. Perceived greenwashing and lack of expertise: the absence of standardized SLL terms fuels concerns that these loans are merely public relations exercises. Without clear strategic benefits or internal ESG expertise, borrowers are often hesitant to commit to binding sustainability KPIs they fear they cannot meet.

While the EU's robust regulatory framework, including the EU Taxonomy and SFDR, has established it as the most mature and active SLL market, this very framework presents a dual challenge. Its complexity and ongoing revisions, such as the current ongoing SFDR update, have led many market participants to adopt a 'wait-and-see' approach due to the prevailing uncertainty. The very regulation driving adoption is also a barrier. The complexity of the EU Taxonomy and fear of "greenwashing" accusations make lenders and borrowers exceedingly cautious. They are afraid of structuring a loan that might later be deemed non-compliant with evolving standards.

On the other hand, the U.S. sustainability landscape is very different, characterized by a lack of comprehensive federal regulation and significant political polarization. Unlike the EU, there is no overarching federal mandate, though the SEC's climate rules represent a step in this direction. Such political environment has fuelled an ‘ESG backlash’ in recent months, prompting some companies to scale back on their public sustainability commitments. Consequently, many companies are wary of high-profile SLLs to avoid alienating certain investors or triggering backlash in states with anti-ESG laws.

The gap between the intention and action for SLLs is a classic case of a great idea meeting complex market reality. For SLLs to bridge the gap between ambition and reality, the market must overcome key hurdles: standardizing KPIs, lowering verification costs, clarifying regulations, and stabilizing the political climate. As these pieces fall into place, the promise of SLLs will finally translate into widespread adoption.

The future: five trends shaping sustainable private debt

Looking ahead, several key trends will accelerate the integration of sustainability in private debt, some may be viewed as challenges or opportunities, depending on if you see the glass as half empty or half full.

1. The regulatory clarity: as regulations like the EU's CSRD, SFDR and EU taxonomy are being revised and updated, there will be a clear divide: companies that genuinely embed sustainability into their strategy will enjoy cheaper capital, while laggards will face a ‘brown discount’ - a cost of capital penalty that is set to grow exponentially.
2. AI-powered data and monitoring: the game-changing potential of AI lies in real-time ESG data tracking and consolidation. This may be the key to reduce data management and verification costs for both the lender and the borrower. But lenders may need to integrate this continuous data stream into their monitoring, moving beyond annual reviews.
3. Capital gap for transition: there will be growing demand for capital to fund transitions, particularly for mid-market companies in traditionally ‘brown’ sectors that need support to adapt because of the withdrawal of traditional bank lending, for example, based on major banks’ commitment to reduce O&G and Power sectors financing exposure by 2030, while some smaller players in those sectors are in most demand for low carbon transition financing.
4. ESG as a core deal team competency: the true differentiator for private debt funds will not be the size of their internal ESG team, but the ability to weave ESG analysis seamlessly into the core skills of every investment professional and throughout the firm.
5. From risk mitigation to impact creation: the private debt leaders in the space, such as Tikehau, are already active impact participants. They are deploying capital into thematic impact strategies and building sophisticated Impact Measurement and Management systems. This final step transforms private debt into a powerful tool for addressing global challenges, building a compelling case that measurable impact is synonymous with superior, lower-risk returns.

Conclusion: greater implementation of ESG by private lenders will unlock the full potential of sustainable private debt to generate both financial returns and meaningful impact

The quiet revolution of sustainable private debt is reshaping the lending landscape, proving that financial returns and meaningful impact are not mutually exclusive. As private debt funds move beyond risk mitigation to embrace active stewardship, their hands-on, covenant-driven approach is unlocking tangible ESG improvements - particularly in underserved markets where capital and guidance are most needed.

The data is clear: strong ESG performance reduces default risk, enhances operational resilience, and lowers long-term borrowing costs. Yet for SLLs to realize their full potential, the industry must bridge the implementation gap - aligning incentives, standardizing frameworks, and leveraging technology like AI to streamline data collection and monitoring.

Funds that integrate ESG into their core investment DNA - not as an afterthought but as a lever for value creation - will differentiate themselves as partners of choice. Ultimately, private debt’s evolution from passive lender to proactive catalyst signals a broader shift: finance is no longer just a tool for profit, but a force for systemic change.

References

¹Moody’s ESG & Default Risk Study (2023)
Several Moody’s Investors Service studies have found that higher-rated ESG borrowers exhibit materially lower default rates than peers, with the gap widening in high-risk sectors. Sector Breakdown: Oil & Gas: ESG leaders had 50% lower defaults than laggards. Consumer Goods: 25% lower defaults for high-ESG firms.

²Prequin ESG in Alternatives 2023

Authors

Claire Zheng

Claire is a Visiting Fellow at the Centre for Business, Climate Change and Sustainability in the University of Edinburgh Business School