Fiona Hagdrup is a fund manager, leveraged finance, at M&G Investments
The ‘green’ finance revolution is under way, with sustainable debt issuance continuing to set new records as sustainability becomes an increasingly critical factor for stakeholders and companies seeking to raise capital.
The loan market leads the way for sustainability-linked issuance, a financing form that began in 2017 and had reached $140bn (£101bn) by the end of 2019, when it emerged as an ESG instrument also in the bond market. More recently, there has been a flurry of new loans and bonds in the sub-investment grade corporate world arena carrying sustainability-linked pricing mechanisms, including in the European leveraged buyout (LBO) market. Indeed, a quarter of the leveraged loans issued in the first half of the year have incorporated sustainability criteria1. What do investors make of this latest evolution in the leveraged finance market? Is the level of scrutiny from market participants sufficient and are sustainability-linked loans (SLLs) here to stay?
What are sustainability-linked loans?
SLLs are similar to sustainability-linked bonds (SLBs), being loans linked to pre-determined sustainability performance targets (SPTs) and associated key performance indicators (KPIs) or third-party ESG scores/ratings. A SLL’s proceeds may be used for general corporate purposes, unlike the dedicated use-of-proceeds instruments, green or social loans (whose proceeds are ring-fenced for specific purpose).
Until 2020, SLLs had been solely the pre-serve of investment grade issuers and almost entirely provided by banks. SLLs first emerged in 2017 and predated their bond market equivalent, SLBs – and have dominated the issuance picture ever since. S&P Global Ratings expects global SLL and SLB issuance to exceed $200bn (£145bn) this year 2. More recently, the feature of linking a coupon to an ESG KPI has spread to the leveraged finance market, now accounting for more than a third of corporate loans in Europe and a grow- ing portion of high yield bonds. Unlike its bond market equivalent (whose coupon adjusts only upwards, should targets not be met), the SLL’s interest rate is adjusted up or down, depending on whether the borrower meets its specified target(s). Let’s explore some of the key terminology associated with SLLs in the LBO world: Margin ratchets: SLLs are typically structured linking performance according to stipulated targets, to a margin ratchet based on chosen KPIs, intended to incentivise the borrower’s achievement of ambitious, pre-determined sustainability performance objectives. Depending on their structure, margin ratchets effectively reward borrowers for their achievements (margin decreases) and hold borrowers to account if progress reverses (margin increases). In some cases, sustainability- linked margin ratchets can be based on several KPIs with each KPI, in turn, having an independent margin ratchet that is tested annually and subject to the borrower delivering certain information to its lenders to show that the underlying KPIs/targets have been met, if specified in the transaction terms.
The fact that the ratchet is designed to work both ways, i.e. to penalise (as well as reward) if the company does not hit one or more KPI or does not provide the requisite information, is an important feature and could help to ensure that credibility and integrity around the use of sustainability-linked loan pricing ensues. However, with a pricing incentive comes the need for careful scrutiny of the KPI. KPIs: Key performance indicators included in such deals can be focused on sustainable elements of pre-existing company targets, although have thus far mostly tended to be ‘green’ or environment-focused. That said, there have been instances of ‘social’ targets, with some deals having been tied to a company’s goals around diversity or staff-training hours. A business could target a measurable reduction in CO2 emissions, or have other selected KPIs, based on the sustainability objectives of the business and the industry in which it operates.
Due to the varied nature of this market, linking financing-cost to KPIs is not standardised yet but, according to global law firm White & Case, discounts are typically set at a maximum of 15 bps in total3 even where multiple KPIs exist and are achieved. Indeed, a company may choose to link its financing to more than one such measure, with between two and five targets being worked into the ratchets.
What would we expect to see incorporated in such deals?
It is hoped that the advent of SLLs in the leveraged finance market will herald wider commitment on the part of the borrower/private equity (PE) sponsor to ESG disclosure and a means of raising profile of climate-related issues, rather than be a ploy to reduce the costs of the transaction based on hand-selected, peripheral targets that add little to material risk-chang- ing and fail to demonstrate significant sustainability performance improvements over the life of the instrument. Given the boom in SLL issuance this year and the relative infancy of the market, the credibility of the KPIs used in SLL instruments has unsurprisingly come under the spotlight. There have been a handful of deal examples where the inclusion of ESG-linked contractual provisions, have already been called out by the market for lacking ambition, inviting broader con- cerns about greenwashing.
According to S&P Global Ratings4, some of the key challenges facing sustainability-linked debt instruments relate to metric comparability, relevance and ambition, with proceed use also cited as a consideration given there are no restrictions on how capital raised can be spent. These challenges emphasise why vigilant lenders must remain alive to potential green-washing risks.
The loan asset class is well adapted to engagement with borrowers/sponsors. The direct, contractual nature of the loan permits more frequent interaction between stakeholders, and there are certain things that lenders can look out for when performing due diligence and deeper evaluation of a borrower’s businesses prior to investment. Yet, a lender must be able to carefully assess the KPIs to determine the expected impact of each, whether they are ambitious enough (or would have been achieved anyway during the normal course of business) and are achievable in the right timeframe. There must also be adequate oversight of KPI measurement and reporting.
In summary, the key components of SLLs are:
- Relationship to a borrower’s overall sustainability strategy – KPIs should be relevant, core and material;
- Target-setting – appropriately ambi- tious SPTs should be set and be capable of being measured and externally verifiable;
- Reporting – clear communication plan for progress;
- Review – third-party review and verification.
Market standards and principles
The sharp increase in the volume of SLL deals across the syndicated loan market this year against a backdrop of incoming ESG and sustainability regulation, especially in Europe, has also led to some market self-examination of standards.
The updated Sustainability Linked Loan Principles (SLLP), developed by the Loan Market Association (LMA) in conjunction with the Loan Syndications and Trading Association (LSTA) and Asia Pacific Loan Market Association (APLMA) originally in 2019, seek to further promote the transparency and integrity of the SLL product, by tightening the language regarding the selection of key KPIs and scope of SPTs. The amendments have also underscored the need for independent and external verification of a borrower’s performance level against each SPT for each KPI.
M&G was involved with and supports such guidance, being supportive of the development of ESG instruments in the loan market. At the same time, we want to further ESG disclosure and efforts via credible KPIs, ones that are based on valid and stretching company targets.
Embracing sustainability
For some PE sponsors, who have fully embraced ESG and long advocated good practice and disclosure across all ESG areas when it comes to their portfolio companies, ESG has become part of their value creation ambition. Principles for Responsible Investment (PRI) membership per- vades the sponsor universe just as it has become a sine qua non for the asset management community.
The size of the PE industry, its long-term view and the characteristics of its business model, mean that it has a clear role to play in influencing private companies towards the effective management of ESG risks. Limited partners will also continue to apply pressure to their general partners in this regard. With rigorous scrutiny from private debt stakeholders too, there is a common collective objective.
Despite the challenges related to transparency and universally effective sustainability-related disclosure practices, there are potential opportunities to be gained from moving the dial on ESG and sustainability – not least to tap into the increasingly ESG-conscious capital markets and greater capital flows into ESG and sustainable investment strategies.
Leveraged loan investors have certainly been open to the idea of ESG-linked pricing structures as the loan market steadily embraces the adoption of better ESG dis- closure and target-setting, given the grow- ing awareness and enthusiasm among institutional investors around ESG and sustainability matters.
- LCD Research ESG 2Q21, percentage share of European term loans with ESG margin ratchet. Data through 16 June 2021.
- S&P Global Ratings, “Environmental, Social and Governance: How Sustainability-Linked Debt Has Become A New Asset Class”, 28 April 2021.
- White & Case, “ESG is everywhere (even in leveraged loans) and everyone’s an expert – here are three talking points to make you look like one”, February 2021.
- S&P Global Market Intelligence, “ESG Sustainability linked bonds offer pricing perk for right high yield credits”, 27 May 2021.
