The (r)evolution In ESG-Linked Financing
There is no doubt that ESG issues have grown in importance in many areas of commercial life over the last 15 years. In the credit markets, so-called ‘green finance’ has been around for most of that time, but until recently it has not been a regular feature of leveraged finance transactions. That all changed in 2020 and 2021.
Amid the surge in deal-making unleashed by the COVID-19 pandemic, the volume of sustainability-linked financing across the globe hit record levels. Deep liquidity on the buy side, coupled with a mainstream recognition of the importance of ESG issues, drove global sustainable debt capital to over $700bn in 2020, up from $160bn in 2019. That number looks set to be exceeded in 2021, with $450bn issued by the end of May, and $1trn predicted by year-end.
Whilst these numbers may be skewed by the large issuances by government agencies and supranational bodies borrowing money for healthcare and other COVID relief measures, the growth trajectory is matched in the private credit markets and, increasingly, the leveraged finance market.
What Are We Talking About?
Broadly, sustainable finance products break down into 2 separate categories:
In this article we are concerned with the Pricing Incentive Products, and their increasing prevalence in leveraged finance transactions.
In the early days of the market, sustainability-linked debt was most likely to be issued by large, listed, investment grade companies, often in the form of a bond1. Where sustainability-linked provisions were included in a loan facility, they often only applied to the revolving credit facility, not the term facility. Until MasMovil’s deal in May 2019, there were virtually no leveraged loans issued with sustainability-linked provisions.
The slower uptake among financial sponsors was in part due to some practical challenges. Negotiating and agreeing a meaningful and realistic package of ESG metrics takes two things that leveraged buyout processes often do not allow for: time and access to management. The typical auction process for a leveraged buyout is usually run on a rigid, and compressed, timeline. Until recently, financial sponsors and their counsel have been more pre-occupied with pushing their lenders on pricing and the covenant package than on working out the appropriate ESG metrics. And without extensive access to management, an ESG pricing ratchet could end up being set at levels which are either too conservative or too optimistic to be meaningful.
But the key driver in the emergence of sustainability-linked loans in the leveraged finance market has been the increased importance of ESG issues to both the ultimate investors in leveraged loans2, and the limited partners who invest in the PE funds themselves. No longer is ESG a side-issue when allocating commitments – for many LPs it is now one of the most important factors.
Sustainability-linked provisions are no longer restricted in their application to revolving facilities – they are now more commonly seen applying to the term loan B too. One of the earliest examples was in the debt package backing Carlyle’s buyout of Jeanologia in 2019, which contained a margin ratchet linked to the company’s water-saving processes. This business was a good candidate for an ESG ratchet, since the margin tracked a performance indicator the target company was already using, and the key purpose of Jeaonologia is to reduce the environmental impact of clothing production. So performance against the ESG-metric was a good proxy for the broader financial performance of the business.
2020 saw an increase in the use of ESG margin ratchets in the financing (and refinancing) packages for a number of leveraged businesses. And 2021 looks set to eclipse the 2020 total. According to Fitch’s Covenant Review service, in the first half of 2021 €16.6bn of European leveraged loan issuance had a margin ratchet linked to ESG-related KPIs (versus €2.4bn in H1 2020). And these ratchets are no longer confined to ‘green’ businesses or smaller capital structures – the buyout package backing TDR Capital’s acquisition of the supermarket chain ASDA contained a margin ratchet linked to the target business’s ESG rating from S&P.
There is no formal regulation of sustainability-linked lending. But various trade bodies have produced a number of guides and principles. The Loan Market Association (the “LMA”) and the European Leveraged Finance Association (“ELFA”) are now working in tandem on sustainable finance initiatives in Europe, and the Loan Syndications and Trading Association (the “LSTA”) has taken the lead in the U.S.
The key guidelines in the context of leveraged loan transactions are:
So far, no market standard drafting has yet emerged for sustainability-linked loans - the provisions continue to be highly bespoke. However the basic framework for these mechanisms is the same: the margin varies based on the borrower’s performance against certain specified ESG metrics. If the borrower meets the criteria, the margin decreases (a ‘one-way’ ratchet). In most cases (but not all), if the borrower fails to meet the criteria, the margin increases (a ‘two-way’ ratchet). The amount by which the margin moves is deal-specific, but it has historically been between 0.05% and 0.075%. More recently we have seen a number of deals with ratchets that can move the margin by up to 10 or even 15 basis points.
Most deals include multiple ESG targets, and usually the margin will decrease even if not all of the targets are hit. Or it may be that the borrower must hit 2 of the 3 metrics to get the discount. Various formulations are possible.
Failure to hit the relevant ESG metric should not constitute an Event of Default in itself. But what happens if an unrelated Event of Default occurs? Should the ESG margin discount cease to apply until the Event of Default is waived or remedied? In most deals we have seen so far, the ESG margin ratchet is not affected by the occurrence of an Event of Default. This represents a deviation from the established market practice in the context of leverage ratio-based ratchets, where the margin would default to the highest level if there is an Event of Default or, in some deals, a non-payment or insolvency Event of Default. Where the default is caused by a failure to deliver any required ESG reporting it is becoming more common for the margin to default to the highest level.
Choosing the right KPI
The KPIs used to determine the ESG margin ratchet will vary from deal to deal (some examples are in the box below), and no single target has become market standard. The majority of deals contain environmental targets, with social targets a close second. Typically there will be between 1 and 3 separate KPIs, one of which may be defined by reference to an overall ESG rating provided by a third party.
When choosing the appropriate KPIs, the LMA and ELFA recommend that metrics should be chosen which are:
- relevant and material to the borrower’s overall business;
- measurable on a consistent basis;
- able to be benchmarked as far as possible using an external reference;
- address relevant ESG challenges in the sector; and
- be discussed and devised with help from a sustainability co-ordinator3 or external consultant.
In a recent survey conducted by ELFA, most loan investors who responded expressed a preference for using a specific KPI instead of a third party ESG rating. That reflects our own experience in the market, where third party ratings have not yet become common, and in many cases may not be available.
Setting the KPI at the right level
Calibrating the level at which the borrower must perform against the chosen KPIs in order to benefit from any margin reduction can be a tricky balancing act. We have seen deals with ‘dynamic’ levels (requiring continuous improvements year-on-year) as well as ‘static’ levels (set at a single target level). What is appropriate will vary from deal to deal, but the LMA/ELFA guidance suggests the following principles should be observed:
- targets should be ambitious (i.e. represent a material improvement over and above a ‘business as usual’ trajectory); and
- targets should be based on the borrower’s own recent performance levels, as well as those of its peers.
Whilst over-ambitious calibration of the KPIs would not make sense for the borrower or sponsor, neither would setting the target levels too low. There is significant reputational risk involved here – ‘greenwashing4’ is very much a badge of dishonour. And in the leveraged finance world, providing for a KPI level that is too easily achievable could lead to accusations that the entire sustainability-linked provision is simply a device to further enhance returns for the sponsor, by offering a ‘freebie’ margin reduction. Borrowers and financial sponsors are acutely aware of the risks here. And in most cases we have seen, the selection and calibration of the KPI metrics has been a collaborative process between the borrower and its lenders. We see the role of sustainability co-ordinator becoming increasingly important in that process, particularly in large deals.
In many cases these provisions do not legislate for what happens if the KPI metrics cannot be calculated, or if the borrower’s business is transformed by material M&A or a change in the regulatory environment. We expect the drafting to continue to evolve as the documents are tested in practice.
Reporting and testing/verification
Once the KPI has been chosen and calibrated, the loan agreement also needs to provide for a mechanism for reporting and verifying the borrower’s performance.
The SLLPs recommend that borrowers should report to the lenders at least once per year (sometimes starting from an initial date when a certain milestone is expected to be reached), and in our experience that has been adopted pretty consistently. An ESG compliance certificate is delivered (usually with the annual financial statements), and from that point onwards the margin adjustments take effect until the next compliance certificate is delivered (or the deadline for its delivery has passed).
Many deals do not currently impose external verification requirements on borrowers, particularly where the KPI was in existence and publicly reported against prior to the specific transaction. But increasingly lenders are pushing for the ESG reporting to be checked either by the borrower’s auditors or by an independent ESG consultant. Approximately half the deals in Q2 2021 had this feature according to Covenant Review. That is certainly the preferred position of the LMA and ELFA, who note that leveraged loans represent a unique opportunity to offer enhanced reporting, because there tends to be a closer relationship between the borrower and its lenders, and reporting is not constrained by securities laws – it can be entirely bespoke. In a recent survey conducted by ELFA, 87% of respondents expressed a desire for annual auditing. But whilst demand for leveraged loans continues to outstrip supply, we expect lender-driven changes in this area to be slow to gain traction.
Some market commentators have questioned the ultimate benefit of sustainability-linked lending. They argue that these provisions are there purely to save money for the borrower, and their tangible effect on the environment or social issues concerned is negligible5. Our own experience is that the impetus to introduce a sustainability-linked element in a financing comes from the very highest level in the borrower’s governance structure (CEO and main board), and is part of a broader corporate strategy with respect to ESG initiatives.
In some cases, we have seen provisions included in loan agreements that require any money saved through the application of the ratchet to be applied towards investments or initiatives which improve the borrower’s environmental performance. Other deals require all or a portion of the money saved to be donated to ESG-related charities. We expect these provisions to become more common as the market develops (although they may require analysis under existing covenant packages).
A further guardrail that the LMA and ELFA recommend is to specify in the commitment papers that the sustainability-linked provisions are not subject to market flex. Whether this is appropriate will vary from deal to deal, but so far we have not seen sustainability-linked loans price or syndicate differently to regular leveraged loans.
The leveraged loan product has come a long way in the last 10 years, especially in Europe. Pricing and covenant erosion have been part of a broader homogenisation of the asset class, which has seen the dominance of the New York style TLB product. And for the largest sponsors, an English law leveraged loan agreement from 2021 looks a world away from its 2011 equivalent. Market participants continue to innovate, and nothing stays the same for very long. We are still in the early days of the development of sustainability-linked provisions, and the evolution of these instruments looks set to continue in the post-COVID era. We expect to see a continued growth in these provisions, with new social based KPIs continuing to be developed and for them to become more common in acquisition financing transactions.