On 28 July 2021, the Loan Market Association (LMA) and European Leveraged Finance Association (ELFA) published a best practice guide (the Guide) to Sustainability Linked Leveraged Loans (SLLLs). The Guide provides practical guidance for market participants on the application of the Sustainability Linked Loan Principles (SLLPs) to leveraged loans, particularly loans made at portfolio company level. ELFA and the LMA deemed the Guide necessary given the increasing prevalence of sustainability linked financings in the leveraged loan market.
The Guide is intended to assist borrowers, lenders, and advisers when considering the integration of sustainability factors in leveraged loan documents, and should be read alongside the SLLPs and the LMA Guidance on the Sustainability Linked Loan Principles. These complementary documents were updated in May 2021 to reflect progression in the market and to ensure alignment with the International Capital Market Association’s (ICMA’s) Sustainability Linked Bond Principles.
The Guide addresses a number of areas in relation to SLLLs, including:
The Guide seeks to explain and elaborate on a number of specialised roles that have arisen in the context of SLLLs, including ESG Ratings Providers, ESG Consultants, Sustainability Co-ordinators, and External Reviewers. Whilst the functions of these parties may be familiar to those who have regular involvement in SLLLs, market participants who are new to sustainable finance may welcome further insight.
The Guide notes that borrowers should provide pertinent (i.e., relevant and material) ESG information to prospective lenders in transaction disclosure and any relevant marketing materials. Such information may be included in existing ESG reports, historical data, third-party reports (such as by a ratings agency or ESG consultant), or even internal reports.
Selection of KPIs and Calibration of SPTs
The Guide confirms that borrowers should communicate key performance indicators (KPIs) and associated sustainability performance targets (SPTs) ahead of, or at the time of, marketing the deal for syndication in order that prospective lenders have sufficient time to review and, if appropriate, challenge the KPIs and SPTs. This confirmation reflects the findings of a July 2021 LMA investor survey in which 96% of respondents agreed that all relevant KPI information should be determined and disclosed before investors commit to a deal. However, the Guide acknowledges there may be limited instances in which flexibility on timing is appropriate — for example, if a SLLL is being used to finance an acquisition bid, it may be acceptable to delay the determination of KPIs/SPTs until there is certainty on the bid or until the bidder has access to target management.
The Guide also echoes the SLLPs in requiring SPTs to be “ambitious” and “material to the borrower’s core sustainability strategy”. The Guide notes that SPTs should be beyond a “business as usual” trajectory, be compared (when possible) to benchmarks, and be discussed and devised with assistance from third parties (such as sustainability coordinators) before the origination of the loan. The SPTs should also be consistent with the borrower’s existing sustainability / ESG strategy.
Reporting and Verification
The Guide notes that borrowers should monitor and maintain information relating to their SPTs, and should provide such information to their lenders at least once a year. Borrowers must also obtain independent and external verification of their performance level against each relevant SPT for each KPI annually, at least.
The Guide acknowledges the current lack of template wording in SLLL documentation and that much of the transaction documentation is precedent-based. However, the Guide notes the following key considerations for market participants and their advisers:
- Market Flex: ESG provisions in SLLLs should not be subject to any market flex provisions, which would have the potential to undermine the validity of the SPTs and could result in allegations of greenwashing.
- Ratchet: The Guide is not prescriptive on whether sustainability-linked ratchets included in SLLLs should be in the form of a discount, premium, or elements of both. However, the Guide states again that any triggers should be set at a suitably ambitious level.
- Fallbacks: Parties may wish to include fallback mechanisms in loan documentation in case SPTs cannot be calculated or observed in a satisfactory manner. Alternatively, fallbacks may also be required in cases in which the borrower or its business undergoes material change that renders the initial SPTs inappropriate, such as an acquisition or change in regulatory environment. However, the Guide does not specify what these fallbacks may look like in practice.
- Breaches: There is currently no accepted market practice around scope of a “sustainability” breach. Failure to meet an SPT does not usually constitute an event of default and typically results in an economic impact on margin (to the extent that it has already been reduced due to KPI–related margin step down). However, depending on the drafting of the relevant provisions of the facility agreement, delivery of inaccurate/delayed information in relation to KPIs and their associated SPTs may result in a breach of representation or covenant, giving rise to an event of default. Parties should be mindful of these issues and carefully consider scope and impact of any “sustainability” breach at the time of drafting.