9 min read 26 May 22
Environmental, social and governance (ESG) factors have long been considered in leveraged loan investing as private lenders have pushed for greater transparency around ESG issues and encouraged portfolio companies and their owners to embrace more sustainable practices through pro-active and systematic engagement.
The rise of ‘labelled’ loan issuance in the sub-investment grade (sub-IG) space took market participants by storm in early 2021, as the sustainability-linked loan (SLL) market roared into life. It was emblematic of a greater awareness of ESG risks and move towards positive action on the part of investors. Unsurprisingly, the ESG revolution that had permeated the institutional loan funds has recently filtered into the European collateralised loan obligations (CLO) market too – important given these structured vehicles are now the biggest buyers of leveraged loans. For now, ESG-based exclusions criteria are the norm. A handful of CLO managers are, however, looking to up their ESG credentials.
The growing proportion of CLOs incorporating ESG language, either positive or negative, in documentation should be highlighted. Nearly all new-issue or reset deals in Europe – and more than 60% in the US – incorporated some form of ESG language in 2021, according to a Barclays Research report. ESG-based exclusions included in documentation restrict CLO managers from investing in loans to obligors that are engaged in certain industries or activities, based on selected ESG eligibility criteria, typically if they derive more than a certain percentage of revenues from such businesses.
CLO managers have made efforts to broaden ESG-related exclusions as part of their investment eligibility criteria, and many deals also have “ESG-related reporting commitments, internal ESG scoring, and often language around selling obligations which cease to meet ESG standards.” Barclays Research notes that the average CLO in 2021 excluded 13 industries, up from six in the previous year, while the average US CLO restricted four industries – tobacco being among the most commonly-excluded sector in the US. The top four excluded sectors for European CLOs were ‘controversial weapons’, ‘tobacco’, ‘nuclear weapons’ and ‘thermal coal’.
However, as 9fin notes in a recent article1, some of these provisions are little more than the incorporation of existing laws or international treaties, including the UN Global Compact, into investment provisions. Also, despite their prevalence, ESG restrictions in CLOs are often not standardised and it can be difficult to limit exposure to certain industries completely.
In Europe, there has been a handful of CLOs marketed as “ESG CLOs”, that extend beyond collateral exclusions and use positive screening, based on proprietary ESG scoring methodologies of the CLO managers. Such vehicles – while not technically being subject to the disclosure regime itself – have been tagged ‘Article 8 aligned’ CLOs. It remains to be seen whether the standards of positive tilt and efforts to promote sustainability characteristics will coalesce around common goals.
Since early 2021, there has been a sharp rise in the volume of sustainability-linked loans across the global syndicated loan market. Last year, SLL issuance alone increased by 239% to US$430 billion, 86 times the size of a market that began only four years ago. While issuance levels have fallen back, in part related to the broader disruption in primary markets during the first quarter, SLLs remain a popular instrument – particularly among European-based borrowers.
European SLL issuance volumes have been consistently high (absenting seasonal, monthly lulls), but Q1-22 saw a decline in issuance on an absolute basis, and as a portion of new leveraged loan primary market issuance, with loan market activity more generally supressed since the outbreak of war in Ukraine. April once again saw issuers returning to the market.
According to LCD’s Quarterly Review, in 2021, c.22% of institutional term loans launched in Europe carried ESG-linked margin ratchets, relative to 1.38% in the US. In contrast, in Q1 2022, only 11% of the same market activity included ESG margin ratchets in Europe, equating to €1.82 billion of issuance.
Part of the appeal to borrowers over and above the ability to set pricing provisions for financings, may be down to the fact that the proceeds from a SLL may be used for general corporate purposes, unlike some of the longer-established labelled instruments, like Green or Social loans, whose proceeds are ring-fenced for specific environmentally- or socially-friendly use
For loans, a key element of the sustainability-linked structure is the selection of key performance indicators (KPIs) which ideally, would be based on the sustainability framework and objectives of the business and the industry in which it operates. These KPIs are used to assess the sustainability performance of the borrower and commonly have margin ratchets (or coupon step-ups/step-downs) based on fulfilling the KPIs.
As with most fast-developing markets, ‘greenwashing’ claims were quickly flagged, after a handful of sustainability-linked financings were called out by the lender community for referencing immaterial or questionable KPIs. The Loan Syndications and Trading Association (LSTA) updated the Sustainability Linked Loan Principles (SLLPs) in mid-2021, having warned of this issue. While there remains a healthy degree of scepticism among lenders, SLLs have proved they have staying power. The Loan Market Association (LMA) in Europe also recommends that there should be alignment with clear, robust and science-based targets. Ideally, those KPIs should be ratified by a third party too.
The SLLPs aim to promote the development and preserve the integrity of the SLL product and also go some way to promote common market standards, but each SLL is, to some extent, bespoke and selected KPIs can vary significantly. Nevertheless, the SLL market still lacks standardisation. As the market develops further in 2022 and beyond, both lenders and borrowers have the opportunity to better understand and develop the SLL product to ensure credibility around the use of sustainability-linked loan pricing mechanisms.
According to Environmental Finance Bond Data, which offers comprehensive coverage of the sustainable bond and loan markets, the number of KPIs including in sustainability-linked loans most commonly tends to be one (representing 40% of the issues covered by the EF database2). While the data may not represent the full SLL activity, it does offer some colour on commonly-selected KPIs.
Environmental KPIs tend to be favoured. The most commonly selected KPI in sustainability-linked financings is, by far, carbon/GHG emissions based. The range of KPIs also appears to be more diverse for SLLs than for sustainability-linked bonds (SLBs), while EF notes that ‘Carbon/GHG emissions’ and ‘Global ESG assessment’ KPIs feature significantly more regularly in SLLs compared to SLBs. Among the social themes, ‘Gender quality’ and ‘Health and safety’ appear to show the most interest.
As we mentioned in a recent article, ‘Private equity has put sustainability firmly in its sights’, data consistency, measurement and disclosure remain among the biggest challenges for investors on the private side. Encouragingly, there are various initiatives underway that seek to improve ESG data disclosure and consistency from corporates and their PE owners.
While stronger intent from borrowers/sponsors when setting out specific sustainability objectives and selecting KPIs is encouraging, there will be a tendency for borrowers/sponsors to agree on KPIs that they think they can achieve. On the other side, lenders to these companies will be looking for better ESG disclosure and rigour via credible and measurable KPIs that step beyond the normal course of business, and which are based on valid and stretching company targets.
Private fund financing lines – where ESG ratchets are embedded in the subscription lines of a fund – have been seen in both private equity and debt arenas. This speaks to a theme of fund managers being prepared to commit on behalf of an overall portfolio’s credit metrics when their influence over those companies is significant. EQT secured €2 billion for such a line, for example, dependent on the achievement of various ESG metrics in its underlying portfolio.
The SLLPs aim to steer borrowers to use pre-determined performance targets that can be benchmarked, as they note “…either internal (defined by the borrower in line with their global sustainability strategy) or external (assessed by independent providers against external rating criteria)”. Benchmarking carbon/GHG emissions reduction targets to Science-Based Targets (SBTs), ie. for operations (scope 1 and 2 emissions) and for investment and lending activities (scope 3), which require validation by the Science Based Targets Initiative (SBTi), would be an example of an external benchmark for lenders to assess the level of ambition.
Private lenders must nevertheless remain alive to the risk that some borrowers may seek to overstate their green or sustainability credentials to obtain better financing terms, or that selected ESG targets lack the substance or credibility to contribute to ESG improvements in any meaningful way. This underscores the need for lenders to undertake proper due diligence on each potential SLL transaction, including a thorough review of the terms and targets to ensure they are meaningful and ambitious.
To potentially assist lenders in this undertaking, ELFA published an ESG Exclusion Checklist for Business Activities towards the end of last year, which is designed to streamline the negative screening and exclusion process for European credit and CLO managers and equip them with the necessary information to make an assessment at the time of a new corporate loan or bond syndication. “The ESG Exclusion Checklist provides information on the percent of revenue that a company derives from its business activities that might impact an investor’s internal ESG guidelines.3” ELFA has also published sector-based ESG disclosure recommendations to promote consistency and best practice in ESG disclosure, and are intended to serve as a starting point for ESG discussion between all parties. The sector-specific ESG Fact Sheets are designed to be used by sub-investment grade corporate borrowers as a guideline for the most important areas ESG disclosure, and include a table outlining ESG KPIs. The KPIs include metrics relating to areas such as energy consumption, GHG emissions and board diversity.
More broadly, we believe there is a valuable role for lenders to facilitate dialogue with borrowers to ensure they demonstrate progress in achieving key ESG metrics over time. At ELFA’s recent ESG Engagement Workshop with the investment community, participants noted that engagement focuses on improving ESG data disclosure by borrowers, in the first instance – adding that it is important that engagement extends involves PE sponsors and (arranging) banks as well as individual borrowers, as they all play a crucial part in driving change in the leveraged finance market.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.