Defining sustainable investments in European leveraged finance and CLOs: Part 2

The effect of a company on the environment or society may be encompassed in a score. Therefore, in addition to improving coverage, a full understanding of approach – and its fit with an investor’s own – is required before leaning on any third-party for support. This is also true when fixing fund parameters.

“The presence of impact strategies in CLO form could be an interesting market development and pave the way for the needs and risk tolerances of different impact investors to be accommodate.”

Who opines on sustainability? 

Precisely defining “sustainable” has been a topic of much debate, including across European leveraged finance but, broadly speaking, it is an economic activity that contributes to an environmental or social objective. ‘Sustainable’ may mean revenue derived from environmental solutions or activities that contribute to the circular economy or better health, for example. Sustainable investments may be those made in companies that are Paris-aligned or with diverse boards and management teams. They will not be companies active in harmful sectors nor reckless with their waste or water nor inattentive to the needs of their workforces around the world. They will have strong defences against malpractice too, including whistleblowing.

The onus is on the investor to assess each investment and to disclose its underlying assumptions when ascribing the adjective. That said, in regulatory speak, a sustainable investment consists of three aspects:

1. Contribution; 
2. Doing no significant harm; and 
3. Good governance.

Grappling with precisely what activities and minimum thresholds must be cleared for all three has been a complicated affair for investment managers, including in European leveraged finance. Much precision of terminology, careful categorisation of activities and proofs via consistent measurement have gone into rendering of a robust definition but it is likely that no two approaches are identical even if they have both been subject to considerable scrutiny.  

Furthermore, for all market participants, there is scope for confusion: environmentally-sustainable activities may be described in the EU Taxonomy, for example, but a sustainable investment does not necessarily have to be aligned with those. Consideration of relevant and material principal adverse impacts plays a part in confirming that a sustainable investment has been roundly assessed. It is important also to note that SFDR is a disclosure regime only – the onus is on the investor to assess each investment and disclose its underlying assumptions when deeming it sustainable.

A sustainable investment is not necessarily synonymous with a sustainability-linked loan (SLL) or sustainability-linked bond (SLB) either. SLLs and SLBs are also different to loans with an embedded ESG margin-ratchet, having more rigour if the market guidelines have been fully observed. All involve the linkage of financing cost to the achievement of pre-defined ESG targets but those targets – whether or not embedded in a financing instrument – need to be relevant, stretching and monitored to count for something in any assessment of sustainable investment.  

As a side note, SLLs are the labelled instruments of choice for borrowers and issuers in the European leveraged finance markets as opposed to a “green” or “social” instrument that demands a single purpose for the use of its proceeds versus the permissible “general corporate purposes” of the SLL/SLB). The trade bodies have issued helpful guidance here on principles and best practice.

Regulation’s role

What does it mean when a company says that it is targeting net zero? Increasingly, loan and CLO investors are getting themselves educated and will no longer confuse vague assertions with science-based ambition, rooted in fact. Regulation like the UK’s Green Taxonomy make clear precisely which economic activities enable a path to net zero. This gives shape to an investor’s analysis and a company’s Capex can be assessed in context because it will be reported on in a consistent way, thanks to requirements of the taxonomy.

The playing-field will be further levelled between those who already provide extensive voluntary disclosure and those who do not. The Corporate Sustainability Due Diligence Directive, or CS3D, will require disclosure on climate, supply chain and protection of human rights¹ and will encompass many of the companies (500+ employees and net €150 million+ turnover worldwide) in the leveraged finance market when it is fully in force. While the advent of yet another regulatory measure has its critics, at heart it is an attempt to bolster corporate conduct, the damaging effects of which are strewn across the media near daily.

Much of this regulation is evolutionary and a host of earnest – but not always perfectly co-ordinated – processes are in train in Europe, the UK and around the world. Already, the SFDR is subject to request for consultation and adaptation so we must get used to constant evolution. Market participants have likened what it might take to achieve regulatory maturity to the length of time taken for international accounting standards to be agreed and embedded: 70 years! Set in that context, the noble ambition of regulators can be seen with some empathy and some inconsistency of overlap and lack of perfect synchronicity can be forgiven awhile.

Sustainable versus impact

While thematic and impact funds are already apparent in private markets, they are typically active in defined projects or single-purpose companies or platforms where the societal or environmental positive benefit is clearly demonstrable and in which the investor has been integrally involved from an early stage. It would require a step-change in disclosure (and population) for leveraged finance strategies, including CLOs, to adopt a particular sustainable theme as sole investment objective (e.g. better health). That said, the presence of impact strategies in CLO form could be an interesting market development and pave the way for the needs and risk tolerances of different impact investors to be accommodated.

The ABS state of play

The market lacks a coherent approach to ESG evaluation in asset-backed securities. That does not thwart the establishment of a framework and principles by individual investors in the meantime. And, structured finance products will soon have climate-change disclosure requirements. Motivated in part perhaps by its extensive ABS investment programme – that sees the European Central Bank (ECB) as one of the largest ABS holders – the European Supervisory Authorities (ESAs) and ECB are calling on issuers, sponsors and originators of securitisations to proactively collect “high-quality and comprehensive” information on climate-related risks².

The sustainability toolkit for the European leveraged finance market is developing, and, when taken with regulation will help provide a balanced assessment. However, context is key, and it remains to be seen whether leveraged finance investors can take a leaf from the book of other important action groups.

¹ European Commission, “Corporate sustainability due diligence – Fostering sustainability in corporate governance and management systems”, commission.europa.eu, 2022.
² European Supervisory Authorities and European Central Bank, “Joint ESAs-ECB statement on disclosure on climate change for structured finance projects”, ecb.europa.eu, 13 March 2023.

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.