Leveraged loans have lagged other asset classes when it comes to embracing ESG but things are changing fast.

Environmental, social and governance (ESG) criteria are becoming increasingly influential among financial institutions deciding where to put their money.

Despite this momentum, the leveraged loan industry has been slow to adopt ESG criteria. Lender and borrower attitudes, however, are shifting fast, with three key themes dominating the discussion.

1. Borrowers and sponsors are driving ESG – have lenders now joined them?

The inclusion of ESG criteria in leveraged loan documentation has been driven primarily by borrowers and sponsors, where there has been alignment between the core business and their ESG goals.

In July 2020, Swedish oat milk provider Oatly secured a club loan of €184 million on which pricing could be adjusted if the business hit agreed sustainability targets. Oatly’s positioning as a sustainable alternative to dairy milk is a core part of its business proposition and brand, which aligns with the structure of its financing package.

Sponsors are also eager to burnish their ESG credentials to attract investors and position portfolio companies in the best possible light on exit.

A poll, conducted by global secondaries investor Coller Capital, of 97 general partners representing 452 funds, found 89 per cent of those surveyed had an ESG policy in place. More than four-fifths had also initiated programs to improve portfolio company ESG performance.

Arrangers also now appear to be pushing for ESG provisions to improve sell-down and distribution, with investors showing interest in ESG terms for leveraged loans when they are included.

Meanwhile, ratings agencies are already factoring ESG criteria into their determinations, with Fitch including ESG risk assessments in its credit reports and S&P launching a separate ESG evaluation product.

Of course, some cynicism remains, with questions as to whether targets are sufficiently ambitious and meaningful – and suggestions that, in some cases, compliance is inevitable as long as the company operates its business in the ordinary course.

2. Defining targets remains a challenge

At present, ESG compliance is limited primarily to pricing, with a margin ratchet linked to performance against certain key performance indicators (KPIs) or an ESG score determined by an external ESG rating agent. Borrowers obtain a premium or discount to the margin based on performance against the agreed KPI or score.

Ratchet discounts are still fractional and typically set at a maximum of 15 basis points, but as investors pay closer attention to ESG concerns, these could become more material financially over time.

A key challenge facing the market, however, is whether one format for testing criteria will become the market convention – and if it does, on what basis the targets will be set.

The majority of deals so far in 2021 measure ESG margin ratchets against KPIs, with the number of KPIs typically ranging from one to three, but independent ESG agents are still winning business, as with the buyout of Asda, which used an external ESG rating as the benchmark for future ESG-related margin adjustments.

KPIs for carbon footprint, water consumption and governance are seemingly widely included, but in cases where credits have a strong ESG differentiator, borrowers will need to engage with the ESG teams in underwriting banks (often delegated to one or two banks as a "sustainability coordinator") to agree more bespoke KPIs.

Everyone is paying close attention to the documentation of other credits for a sense of how the market is adjusting and how to present their own terms. Standardisation is still a way off and while some market precedent is beginning to form, varying approaches are still emerging – we’ve recently seen the first example in the leveraged market, where part of the ESG discount will be paid to ESG charities (Flender), which was quickly followed by Stark’s €1.3bn TLB, which earmarked the ESG-related savings for reinvestment in ESG projects.

3. Reporting obligations must be outlined and refined

Work from industry bodies is helping to establish industry-wide benchmarks for disclosure.

The US Loan Syndications and Trading Association released its first-ever ESG Diligence Questionnaire in February 2020. The questionnaire is designed to steer due diligence in this area through the loan origination process and enhance sharing of ESG information among borrowers.

The Loan Market Association and the European Leveraged Finance Alliance, meanwhile, have developed a set of ESG disclosure topics on which investors can expect borrowers and issuers to make public reports.

These type of initiatives have started the ball rolling on the creation of a standard ESG disclosure template, but much work remains.

Should the adoption of ESG by the leveraged loan market continue to lean toward standardised disclosure, there will be wider implications for how borrowers report to investors.

Inclusion of ESG criteria will require investment in infrastructure to oversee reporting. This will involve additional training or the appointment of an in-house ESG officer, or alternatively, the hiring of third-party appraisers to report and audit ESG compliance on an annual basis. As we have observed in the setting of ESG KPIs, industry practice on reporting is also variable and best practices are still developing – likewise, no consensus has yet formed as to what level of scrutiny sponsors will accept and how robust investors will need the monitoring to be.

Any form of ongoing reporting, however, raises deeper questions for leveraged loan markets. An ESG reporting obligation could ultimately have an effect similar to that of a maintenance test, which is significant given that, over the past decade, the market has pivoted almost completely to cov-lite terms and incurrence covenants.

An ESG test moves the needle back the other way. Even though margin-ratchets are still de minimis and an “ESG default” is nowhere near as serious as a financial covenant default, it does create an ongoing maintenance position for the issuer.