Sustainable investments in private credit: demystifying growth of ESG in leveraged loans

September 2020 | PROFESSIONAL INSIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

September 2020 Issue

As global financial markets recover from the coronavirus crisis (COVID-19), limited partners, pension funds and family offices are pushing private equity (PE) funds and direct lenders to integrate environmental, social and governance (ESG) considerations into their investments.

Historically, the marriage of ESG in credit products has been confined to the more liquid fixed-income market. The global leveraged credit market, which provides significant volumes of credit to enable acquisitions and buyouts by PE sponsor-backed companies, has stayed clear of embracing ESG factors in investments.

However, this pattern will likely change. This article discusses the regulatory landscape governing sustainability linked loan (SLL) products, analyses structures used in some of the market-first transactions that have successfully integrated these principles, and evaluates the challenges that stymie implementation of ESG principles in leveraged lending.

Key drivers

For investors, being aware of ESG risks and how these risks are being addressed on an ongoing basis constitutes an important metric to ascertain a borrower’s broader risk profile, ensure downside protection and guide overall investment decisions. In recent times, direct lenders have shown increased appetite to integrate ESG values throughout a lending deal cycle.

This momentum comes close on the heels of a proliferation of regulatory initiatives across leading financial markets, including the launch of the ‘green principles’ and ‘sustainability linked loan principles’ developed jointly by the Loan Syndications and Trading Association (LSTA), the Loan Market Association and the Asia Pacific Loan Market Association.

Green loans are accommodated to finance or refinance new or existing eligible green projects, while SLLs offer greater flexibility to a borrower which may use the loan proceeds to meet its general corporate requirements, so long as it complies with its ESG targets. The structural flexibility of SLLs over green loans has led to its strong demand across global markets.

On 3 February 2020, the LSTA published an ‘ESG due diligence questionnaire’ required to be submitted by borrowers (albeit voluntarily) during the diligence phase of a loan origination process. The comprehensive questionnaire is a first-of-its-kind initiative in the lending market and is tailored to apply to US-based borrowers and provide them an opportunity to pitch their ESG vision to prospective creditors.

To enhance consideration of ESG factors in the assessment of a borrower’s creditworthiness, the LSTA also recommended that specialist ESG rating providers and credit rating agencies monitor a borrower’s ESG performance and incorporate key performance indicators (KPIs) into overall credit ratings.

Similar to the LSTA, the European Leveraged Finance Association is working on a unified list of activities that could be classified as environmentally sustainable and finalising a set of material ESG disclosure topics which funds and asset managers in the region would be expected to comply with and report on publicly (to be introduced later in the year).

SLLs have typically been structured as revolving credit facilities that include a separate margin ratchet linked to the borrower’s ongoing achievement of its sustainability performance targets or its ESG risk rating score. A good score is rewarded with a reduced interest rate while a low score is penalised with a higher interest rate. Considering the competitive margins at stake and highly levered debt positions in the current market, any cost savings incentivise borrowers to meet their sustainability targets and in turn enable creditors to demonstrate ESG commitment to their investors.

A combination of these factors has successfully brought about increased recognition of the socioenvironmental impact on credit investments, and creditors have become attuned to their responsibility to finance companies in a more sustainable way and with a longer-term view.

Recent transactions

SLLs operate like any other traditional credit product, except that they impose additional reporting obligations on the company’s ESG rating and sustainability KPIs developed in the context of its operations. KPIs in recent credit agreements have included considerations such as deployment of renewable energy, management and recycling of waste, and percentage of female employees.

Masmovil was the first European borrower to tie ESG components into a leveraged debt package. Its €250m revolving credit facility – as part of a larger €1.7bn debt package – included an ESG rating-linked margin ratchet that adjusted the margin by 15bps. This was followed by a debt package for Jeanologia SL (a portfolio company of the Carlye Group) which linked the margin on its credit facility to compliance with sustainable KPIs, with a margin trigger if it missed the targets by 15 percent or more. Masmovil and Jeanologia achieved financial close in May 2019 and December 2019, respectively.

Logoplaste Consultores Técnicos SA (Logoplaste), a Portugal-based portfolio company of the Carlyle Group, amended its credit terms to link the interest payments on its €570m facility to ESG factors (i.e., on the quantum of carbon dioxide it was able to conserve), thereby making it the first ESG-institutional term loan. EQT Partners recently availed a €5bn ESG-linked syndicated subscription facility that will cater to its private equity portfolio businesses. EQT’s bridge facility has an upper limit of €5bn and the pricing is linked to the performance of the group’s portfolio companies in the areas of gender equality and investments in renewable energy, with KPIs required to be reported quarterly and audited annually. Logoplaste and EQT achieved financial close in June 2020.

Headwinds affecting integration of ESGs

While thematic impact investments and SLLs have gradually become more pronounced in the infrastructure and real estate sector, they are yet to gain similar levels of prominence in a leveraged lending context. Scarcity of reliable ESG data on privately owned portfolio companies has affected credit appraisals.

Conversely, a lack of experience among borrowers concluding meaningful sustainable investment goals and achieving a healthy balance between the objectives of the borrower and the overall group on a consolidated basis (considering, a larger group with diversified portfolios will often have different ESG objectives and KPIs) has dampened growth.

ESG investments so far have been guided by ‘soft law’ principles, and the absence of uniform disclosure standards across the US, Europe and Asia has deterred progress. The imposition of mandatory ESG reporting requirements, standardisation of disclosure obligations and convergence of global best practices should instil more confidence in these products.

While the integration of ESG risks in a credit report, as well as consolidation among rating providers (i.e., credit rating providers assuming the role of ESG reporting which was previously a function performed by specialist ESG rating agencies) is advantageous from a creditor’s standpoint (enabling creditors to minimise transaction costs and agency fees) it has presented some unique challenges.

ESG borrowers have complained that their credit scores often vary across rating agencies, signalling disparate ways of measuring between credit rating agencies and independent ESG rating providers. Some of the reasons for variance reportedly include divergence in scope of assessment of risks, assigning a different degree of importance to common risk factors and use of different attributors to measure an identical situation or risks. These divergent approaches should be quickly mitigated to boost the market for ESG-linked loans.

Although leveraged borrowers are usually subject to an array of reporting and monitoring obligations under a credit agreement, adding a list of ESG-related compliances to the mix may lead to an increased cost and compliance burden. In what is already considered an extremely competitive market, an additional cost burden would dampen a borrower’s ability to comply with ESG reporting obligations as well as affect the ability of creditors to underwrite, syndicate or sell-down these loans. Moreover, considering that ESG products are still in their infancy and associated risks in emerging markets are more profound, creditors should adopt a more consultative approach with borrowers in case of non-compliance with ESG metrics or KPIs, rather than trigger a default.

Arguably, a lack of pronounced economic incentives and concessions for creditors offering ESG-linked loans, an absence of standard tools and techniques for measuring and reporting implementation of ESG strategies, weak investor confidence to structure business strategy around ESG considerations, and the belief that ESG-based investment decisions could yield lower returns, may have stymied their growth in the leveraged credit market.

The way forward

Against the backdrop of a severe economic slowdown emanating from COVID-19, it is expected that global investors will gradually press for their investments to go only to responsible businesses that have an existing ESG strategy in place. As creditors become wary of the risks associated with lending to unsustainable businesses, credit appraisals will likely become increasingly dependent on the outcome of ESG-focused due diligence exercises.

To tackle the surge in demand for leveraged loans with an ESG focus, central banks must promote concessions and promulgate policies that incentivise SLLs for borrowers and creditors alike, regulators must standardise ESG disclosure obligations, and market participants must develop best practices that can be adopted by businesses globally. While there is no one-size-fits-all answer, all these measures should improve commitment toward ESG products and ensure their growth.

Soumava Chatterjee is an associate at Minter Ellison LLP. He can be contacted on +61 (412) 092 675 or by email: shom.chatterjee@minterellison.com.

Soumava Chatterjee

Minter Ellison LLP