ESG considerations, such as a company's transparency in corporate governance, existence of an independent and experienced board of directors, a commitment to environmental protection and a track record of product safety, are integrated into DDJ's fundamental, bottom-up investment process. More specifically, incorporated within its bottom-up fundamental analysis of each fixed income investment opportunity, DDJ's analysts endeavors to identify material ESG factors that may contribute to financial downside (in particular, significant event risks that can negatively affect an issuer's creditworthiness and therefore its ability to meet its ongoing fixed income principal and interest obligations), as well as to assess whether or not market pricing adequately reflects those risks with respect to any proposed investment. If the DDJ research analyst, in consultation with the portfolio manager, believes that an identified ESG-related factor will have a material positive or negative impact on the business that may disproportionately change the risk/reward profile of such investment, DDJ will factor that assessment into its investment decision-making process (and, accordingly, may not make such investment on behalf of its clients). DDJ believes that integrating ESG factors into its investment process in this manner allows for deeper insight into critical risk factors, including exogenous factors not typically exposed in a traditional business analysis model, ultimately resulting in sounder investment decisions on behalf of its clients. In addition, DDJ also seeks to identify issuers that exhibit positive ESG factors or improving ESG trends that DDJ believes have not been identified by the broader market. DDJ seeks to improve the overall ESG profile of a portfolio by identifying investment opportunities with an attractive risk/reward profile (including, without limitation, opportunities where positive ESG factors are not fully reflected in the then-current valuation). When ESG considerations are taken into account in the investment decision making process, DDJ compares ESG factors on an industry relative, not absolute, basis.
DDJ will account for any material ESG factors uncovered as part of DDJ's due diligence process in connection with DDJ's fundamental analysis and its overall assessment of the risk/reward of each investment opportunity. Depending on the nature of the ESG factor, DDJ will incorporate such assessment in determining a business's overall valuation. As a result, such assessment could result in a less favorable (or, if the ESG factor is value-accretive, more favorable) loan-to-value profile (thereby affecting the risk/reward of the investment opportunity).
When examining ESG-related risks, DDJ believes that the magnitude and source of risks vary from one sector to another and oftentimes from one issuer to another; however, certain risk themes oftentimes emerge in issuers within one sector or across several sectors. For example, in the Basic Materials and Energy sectors, DDJ is focused on Environmental factors affecting all issuers, including (where applicable) the consequences of the ongoing switch by utility providers from legacy fossil fuels towards cleaner and more renewable energy sources. In addition, the increased viability of renewable energy sources has caused DDJ to conduct a careful review of fossil fuel dependent companies in these sectors. Meanwhile, in the Healthcare industry, DDJ is focused on Social issues, particularly the risks associated with high-cost service providers and with pharmaceutical companies dependent on high-cost drugs.
Importantly, ESG integration does not occur only when evaluating new investment opportunities. DDJ believes that the continuous monitoring of existing positions is the best way to monitor existing ESG factors as well as identify new ones before they materialize. If the risk/reward proposition for any name changes in an adverse due to ESG-related developments, DDJ will determine if such changes warrant divestment from the applicable portfolio.
To further enhance the quality of its ESG-related research, DDJ licenses third-party ESG data from a leading provider of such data for thousands of companies worldwide. Such information includes both industry-wide and company-specific research reports. In addition, the vendor provides ESG ratings for a broad list of corporate credit issuers, including many portfolio holdings of DDJ's clients. DDJ's research team can access such ESG ratings within DDJ's trade order and portfolio management system. Although DDJ does not use these ratings to strictly include or exclude an investment from client accounts, DDJ does instruct its analysts to incorporate such information in their fundamental research process in an effort to better understand the topical ESG-related factors as well as the relative value among existing and prospective investment opportunities.
DDJ believes that issuer engagement as a debt-holder tends to be more indirect when compared to that of an equity owner. While an equity owner can ultimately vote (and replace) the members of an issuer's board of directors, the opportunities to actively engage as a fixed income investor tend to occur around events such as new debt issuances and corporate restructurings. In such cases, depending on the size of the DDJ position relative to the total class of debt, DDJ may be able to exert some degree of influence over an issuer, particularly with respect to governance and reporting issues. DDJ believes that adherence to strong governance principles is an important feature of the companies in which its clients invest. DDJ's active approach to fixed income investing generally includes frequent interaction with company management, as DDJ seeks to keep an open line of communication with respect to actions that could negatively impact the investment made by DDJ on behalf of its clients. While DDJ does not always agree with the policies implemented by an issuer's management, DDJ believes that remaining active and engaged will typically result in more constructive, long-term relationships surrounding topical issues, including governance concerns, and that such an approach ultimately benefit its clients. In the event that issuer engagement is not successful, and DDJ does not believe that it can advocate for practical change, divestment may be warranted, depending on the nature of the ESG factor and the corresponding effect on the investment's risk/reward profile. DDJ has actively engaged with management of its portfolio companies since the inception of the firm and expects that it will make an effort to increase ESG engagement over time.