This article was first published in GLI - Fund Finance 2023, the leading publication on fund finance by Global Legal Insights, which provides financial institutions, funds, and investors comprehensive insight across 19 jurisdictions worldwide.
There is an ever-increasing focus on how financial instruments and every participant in financial markets from banks to fund managers to investors can positively impact climate change.
With this ever-increasing focus on the correlation between finance and climate change as well as other changes considered beneficial to society as a whole, green and environmental, social or governance (“ESG”) or sustainability-linked lending (“SLL”) in the fund finance market has become a core part of many fund finance facilities. ESG and SLL provisions are now incorporated in several large, high-profile multi-bank facilities and are starting to be seen in smaller and bilateral facilities too, across a wide range of asset classes. This general market movement towards cleaner and greener investing through either a use of proceeds-based approach or an overall ESG metrics approach has limited partners (“LPs”) increasingly interested in ESG factors. For funds and fund managers, this has resulted in an increasing inclusion of ESG provisions/obligations in side letters entered into with LPs. With more rigorous ESG obligations entering into force, particularly as a result of key ESG regulatory developments, this is evolving to become a core element of limited partnership agreements. While we saw a slight pause in some markets with regard to the growth of SLL and ESG financing due to the impacts of macroeconomic events, we expect that ESG will remain at the forefront of LPs’, and therefore fund managers’, minds.
Along with mounting public pressure to evidence ESG credentials, one of the key aspects driving this change is new regulation that has been introduced in Europe and shortly the UK and which sets ambitious objectives in reorienting capital towards more sustainable investments. The regulatory drivers will have a significant impact on funds and fund managers, how ESG factors and risks are incorporated into investment decisions and financing arrangements. As the pressure for funds to focus and report on ESG metrics increases, the question for funds will no doubt arise as to how this may flow through into their financing documentation.
Likewise, lenders are increasingly keen to be at the forefront of driving green and ESG change through financing products, and increasing the amount of lending linked to green objectives (also known as use of proceeds lending) or ESG objectives (also known as SLL) is becoming a board-level imperative for financial institutions as market participants realise that financial stability is intrinsically tied to sustainability and ESG risks. For a lender thinking about its own ESG strategy, there is awareness that funds with sustainability on their agenda are arguably those that are more likely to be better prepared for future risks and opportunities and, therefore, perhaps, a better credit risk. This, however, has to be tempered against an increased focus on claims of greenwashing and an overstatement of a firm’s product or service’s sustainability profile. Lenders are also becoming more sophisticated in mitigating the risks of greenwashing and also in their role as Sustainability Coordinators (a role where one of the lead banks has a separate role in agreeing ESG terms that work for all parties).
A quick overview
By now we are no doubt all very familiar with both use of proceeds and ESG financing, but by way of a quick overview:
Green or use of proceeds financing
While much of the focus on ESG lending in the fund finance market focuses on “ESG” lending, we should not discount green lending as also having a role to play in the fund finance market. Green loans are loans made for a specific green purpose that do not necessarily have pricing mechanics attached to them but rather a specific (usually green) commitment to making investments that meet this green purpose.
While being lent for a specific purpose has the potential to make them less flexible than their sister, the ESG loan, this does not prevent their use in the impact or green fund space – where the loans can be utilised to invest in “green” investments that meet the criteria set out in the loan agreement. For example, funds with a particular green or sustainable strategy (e.g. investment in renewable energy) may be well suited to a green loan. Similarly, 2021 saw the introduction of the Social Loan Principles by the Loan Market Association (“LMA”), which, like a green loan, are extended on the basis of a particular “purpose”. While we have not yet seen these arising in the fund finance market, recent world events are likely to see this product come into our market in the coming years.
ESG SLL is the provision of (usually) a revolving credit facility that includes certain ESG-related key performance indicators (“KPIs”), achievement of which links to a pricing toggle. In a nutshell, ESG or SLL is like any other loan to a fund, except with an additional layer of reporting (whether by a third-party verifier, auditor or the fund itself) on specific ESG/sustainability KPIs developed in respect of that fund or its investments. This expands the universe of borrowers and industries that can access the sustainable finance market by enabling funds that do not have an eligible project to still incorporate ESG considerations into their financing.
To date, much of the green or ESG financing we have seen in the fund finance space has been linked to an ESG financing as it provides funds and fund managers with the ability to retain a revolving credit facility at the fund level similar to that which they may have otherwise had in place, and rewards or (sometimes) penalises them for general ESG performance across the board or specific KPIs (rather than linking it to a specific investment/limiting the fund to making specific approved investments).
As ESG finance becomes increasingly popular, we have no doubt that market norms will emerge (particularly with the introduction of the LMA SLL provisions that are currently being developed) but, at this stage, no substantive market norms as regards documentation and practices have been established. Key characteristics of an ESG or SLL financing are:
A margin discount goes hand in hand with ESG or sustainability-linked finance (unlike green loans/finance, which does not necessarily offer a pricing adjustment) but consideration will need to be given as to what the appropriate level is to which this discount should be applied.
Generally, the market appears to have started from a position where a simple discount is applied when the relevant fund hits the requisite KPI and the discount is then disapplied when the relevant KPI is not met. However, as the market becomes more sophisticated, the spread for the margin incentive linked to KPIs becomes wider. In particular, an upwards and downwards margin ratchet linked to KPIs is now trending in certain markets, and we have already seen it appear in a number of ESG financings in the fund finance market. This means that if the KPI is met, then there is a downwards movement and if the KPI is not met, then the margin goes up.
Thought should also be given to what the fund will be encouraged to do (if anything) with any discount achieved. We have increasingly seen examples in some markets of borrowers agreeing to donate any discounts achieved to environmental charities or to demonstrate that such savings are applied to ESG purposes, and we expect this to also become a feature of fund finance ESG or sustainability-linked financings. Although, donations can present KYC and reputational challenges for lenders. A more recent development has been the discussion of whether penalties or benefits from SLL or ESG financing should be used to buy voluntary carbon credits to offset emissions. This of course negates the ability of the fund/borrower using any discount to drive further efficiencies within their own organisations and for this reason is being approached with caution by most lenders. There is also the argument that voluntary carbon credits encourage offsetting, which many sustainability advocates are actively trying to discourage as it is not seen as driving actual change in behaviours.
Key performance indicators
KPIs are at the heart of an ESG financing and the KPIs for each financing in the fund finance market will be unique and accordingly will need to be discussed and considered in context. In the fund finance space, the underlying investment strategy of the fund and what it would like to change within its business will also be an important factor in this discussion. While discussions regarding ESG finance often focus on the environmental gains to be made, consideration should also be given to the social and governance aspects – are there, for example, gender, diversity or governance improvements that could also be measured?
Similarly, while there is a tendency to focus on KPIs at the investment level, consideration should also be given as to whether fund-level KPIs may be appropriate (i.e. governance or social) or potentially even higher up the structure?
Regardless of what they relate to, we expect the KPIs to take into account considerations such as:
- The term of the loan – the longer the term of the loan, the more consideration should be given to the suitability of the KPIs towards the end of the loan. Should the KPIs be incremental, increasing year on year? Or is a mechanism required to revisit the KPIs periodically to reassess their suitability?
- Number and nature of KPIs – where there are numerous or complex KPIs, thought should be given to whether these are likely to be better monitored by third parties with appropriate knowledge of the complexities of said KPIs. Consideration should also be given to the administrative burden (for both the borrower and lender) resulting from including numerous KPIs and whether quality should be preferred over quantity.
- What is being measured – is it just the investment portfolio that should be tracked against KPIs? Or are there other fund-level metrics that should be considered whether ESG-related (e.g. a recycling target, reduction in energy use, moving away from single-use plastics or diversity KPIs)?
- How should it be measured – should there be a weighting given to the ESG score of the fund depending on the percentage of investment of the fund in a company against the fund’s total portfolio? Should consideration also be given as to the timing of when the investment is made when calculating the relevant ESG score
- What are the consequences of non-compliance with that KPI – while the obvious answer here is some upwards adjustment to the margin, query whether that should be the only consequence. Should some KPIs be hurdles/ones that have to be achieved before any other discount flowing from KPI achievement can be unlocked? Could KPIs be included that are not linked to margin adjustments but rather aimed at reputational motivation? This will likely require public disclosure of the relevant KPIs but, to the extent that funds are simultaneously making public commitments to ESG goals, funds are being increasingly held to account by stakeholders.
The unique challenge of setting KPIs for the fund finance market
One of the unique challenges the fund finance market faces with ESG financing is how we set appropriate, challenging KPIs for those financings put in place early in the life of a fund when few or potentially no investments have been made. While previous fund performance on similar ESG metrics may help to inform this process, thought should be given to whether there is a requirement for an ability to review KPIs on a regular basis (e.g. every 12 months to consider whether they remain appropriate and sufficiently challenging). Other ways in which to approach this may include an ability for either the borrower or finance parties to bring the parties to the table to discuss certain KPIs should they feel they are no longer appropriate (with a right to disapply a KPI if agreement cannot be reached on any necessary amendments).
Will there be regulatory drivers for KPIs going forward?
There are already a number of existing international standards and guidelines that fund managers may voluntarily disclose against with respect to ESG factors. Most recently, the EU – followed by the UK – has sought to codify these reporting obligations and harmonise what can and cannot be deemed “sustainable”.
The new EU regulation that seeks to achieve this is the EU Taxonomy Regulation, which creates a framework for what can and cannot be considered an environmentally sustainable financial product. The regulation introduces an EU-wide classification system (or taxonomy) of environmentally sustainable activities, which aims to provide more clarity for investors concerning financial products that purport to invest in sustainable activities or to promote environmental objectives. The EU Taxonomy Regulation sets out the criteria for determining whether an economic activity constitutes an environmentally sustainable activity that includes the requirement that the activity does “no significant harm”. This is intended to facilitate (or reduce the burden of) investors’ own due diligence with regard to a product’s environmental sustainability and eliminate the practice of greenwashing (where financial products are inaccurately marketed as “green” or “sustainable”). The EU Taxonomy Regulation goes hand in hand with the EU’s proposal for a Corporate Sustainability Due Diligence Directive as well as the Corporate Sustainability Reporting Directive, both of which aim to increase production of ESG data by in-scope corporate entities and reduce the burden for investors of ESG due diligence.
The second piece of the jigsaw puzzle is the EU Disclosure Regulation, which seeks to harmonise existing provisions on sustainability-related disclosures by imposing requirements on so-called financial market participants (e.g. EU AIFMs and EU UCITS management companies (or non-EU AIFMs marketing funds into the EU) and EU investment firms or EU credit institutions carrying out portfolio management) in relation to financial products.
The EU Disclosure Regulation requires certain information to be made available either at entity level or at product level, irrespective of whether sustainability risks are integrated into financial market participants’ investment decision-making processes. Further measures seek to increase transparency as regards financial products that target sustainable investments, including reduction in carbon emissions.
The final key regulatory development is the Low Carbon Benchmark Regulation. The Low Carbon Benchmark Regulation creates disclosure requirements on benchmark administrators as to ESG considerations for various different benchmarks. It also creates two new categories of benchmarks – the Paris-aligned benchmark and the climate transition benchmark – which will help fund managers measure performance against the Paris Agreement climate targets, if that is the objective of the fund.
The UK has lagged behind the EU in terms of the introduction of sustainability-related disclosures, mandating Task Force on Climate-Related Financial Disclosures (“TCFD”) reports for the largest UK asset managers.
More recently, it has been announced that the UK will, like the EU, introduce its own UK Taxonomy by the end of 2023 as well as Sustainability Disclosure Requirements (“SDRs”), which will create an integrated framework for “decision-useful disclosures on sustainability”. The SDRs will apply to asset managers and asset owners.
The UK’s approach to SDRs is in contrast to the EU Disclosure Regulation. Despite the name on the tin, the UK SDRs are a labelling regime with three categories of labels available:
(a) sustainable focus – products that invest predominantly in assets that can be deemed to be sustainable;
(b) sustainable improvers – products that aim to improve the sustainability of the portfolio over time; and
(c) sustainable impact – products that seek to achieve impact through the provision of finance, typically to underserved markets.
To meet any of these classifications, a product will need to meet:
(d) five overarching principles, referred to as general criteria, which will cover: sustainability objective; investment policy and strategy; KPIs; resources and governance; and/or investor stewardship;
(e) a number of key cross-cutting considerations; and
(f) certain key category-specific requirements.
Compared to the EU regime, the UK SDRs will provide a sustainability framework that in-scope asset managers and owners will need to embed within their processes for all aspects of the investment lifecycle. The UK will also implement its own taxonomy that will be largely based on the EU Taxonomy, although the underlying eligible economic activities may differ to take into account the distinction in the UK economy and industry focus. The UK Taxonomy classifications will in time flow through into the disclosures to be made under the UK SDRs.
Taken together, these EU and UK regulations are likely to shift behaviour in the fund market and in the fund finance market. With more focus on fund managers’ own ESG approach, there is a likely impact on the fund finance market with respect to the characteristics set out above. KPIs and reporting in particular are likely to be highly impacted with the data flow requirements that fund managers will be subject to as a result of the EU Disclosure Regulation and UK SDRs once these are in force.
Sustainability performance targets
Once you have set your KPIs, one of the unique challenges of the post-COVID world is how to set sustainability performance targets (“SPTs”). With few exceptions, carbon emissions, travel, use of plastics, waste, etc. across all industries were significantly reduced due to arrangements put in place to deal with COVID, and with few expecting to return to pre-COVID levels, how do you set SPTs? Are 2019 numbers the best to use? The LMA Sustainability Linked Loan Principles recommend three years of historic data to measure track record. Allowing for the interference of COVID, that three years of data is starting to look a bit out of date. Similarly, most industries are looking at returning to a “new normal” but what that looks like, and how much travel, emissions, etc. that will involve, remains unclear.
We have seen increasing use of side letters or “ESG Ready” facilities as a workaround to this problem, where facilities are put in place with the mechanics for an SLL or ESG financing but the KPIs and SPTs that will apply are agreed at a future date in a side letter. Sometimes, these are utilised to work around tight timing requirements for getting facilities in place. This approach, while giving more time (although query how long/whether it solves our out-of-date data issue), also brings with it its own challenges – in particular, reputational issues. For example, do we need to introduce publicity restrictions to ensure that one party does not unilaterally publicise the facility as being an SLL or ESG facility before that side letter is agreed? If we introduce such a restriction, should breach of it lead to an event of default? As alluded to above, SLL/ESG mechanics have traditionally remained outside the event of default regime but, without bringing this into the event of default regime, what teeth will such a restriction have?
There will also be a discussion to be had as to the reporting obligations of the fund and whether reports produced internally by the fund, and which are provided to investors, will be sufficient for the finance parties, and whether there should be an audit of internal ESG reporting or whether a third party should be engaged to provide an ESG report. Ultimately, there are a number of factors that will feed into this discussion, including:
- Existing practices of the fund – does the fund have a track record of disclosing ESG information to investors? Is the information disclosed sufficiently detailed to provide the requisite comfort to the lenders and measurement of the proposed KPIs?
- Underlying investments – depending on the fund, it may be that there are already reports being obtained from third-party providers; in which case, can these reports be made available to the lenders? Do these existing reports cover all the KPIs in sufficient detail?
- Cost-benefit analysis – if third-party reports are to be obtained, are the costs associated with obtaining such reports reasonable in the context of the transactions, or, more importantly, will the cost of procuring such a report exceed any gain in margin reduction? This will be a particular focus for the fund finance market where, unlike a corporate group, reporting might need to be carried out on an investment-by-investment basis. Particularly for funds with a large number of investments, this may put the possibility of third-party reporting out of reach.
- Timing of reports – at present, reporting obligations are usually on a semi-annual or annual basis. There may be consideration of increasing the frequency, but this will have a corresponding effect on cost as identified above.
- KPIs – what is being measured and can that information reliably be reported on by a third party?
Thought should also be given to whether the failure to provide an ESG report should trigger an event of default. Many will argue that the failure to provide a report should trigger an event of default in the same way a failure to comply with any other reporting obligation would under the facility. Alternatively, there is an argument to be made that failure to provide a report should have no more severe a consequence than delivering a report that shows a failure to meet the relevant KPIs (i.e. a margin premium/removal of discount applied).
What do we see for green and ESG/SLL fund financings in the next 12 months?
It would be remiss of us to write this chapter and not consider some of the challenges we see coming for ESG/SLL fund financings in the next 12 months. In our view, the likely headwinds will be:
Greenwashing: greenwashing is, broadly speaking, providing inaccurate or misleading information about the environmental impact of a product or service. In the fund financing space, it is most likely to be of concern if the KPIs and SPTs that are set for an SLL financing are not sufficiently robust or challenging, or for a green financing if the green project or asset is not sufficiently green. There is renewed focus from regulators on greenwashing, which brings with it regulation risk but also the risk of reputational damage or greenwashing litigation for fund managers and lenders alike. For fund managers and lenders, the focus on greenwashing risks in the next 12 months will mean a renewed focus on:
- KPIs/SPTs: have they been adequately diligenced? Are they sufficiently challenging or do they simply require the fund to do what they were already doing? Are the KPIs encouraging the right behaviours? Are they consistent with those of peers in the market? If not, why not?
- ESG/green information: linked again to the point above, is the data used to set KPIs/SPTs sufficiently robust? Has it been adequately tested?
- Refinancing risk: as the lifecycle of green and SLL financings rolls around to refinancings, fund managers and lenders will need to be careful to ensure that refinancings do not run into greenwashing territory. For example, if a green loan for a particular asset is being refinanced, is the asset still sufficiently green by the market standards at the time of the refinance? If the original green loan has been paid down, is the “green” portion of the new loan of a reduced value to reflect that reduced value (i.e. not just lending against the full asset value as this may not meet the green purpose requirements)?
- Macroeconomic influences: the macroeconomic headwinds in recent months are likely to continue in some form in the next 12 months and we can foresee a situation in which green or SLL financings take a backseat to more pressing considerations for fund managers. Hopefully this is not the case – sustainability is a long-term project and important to keep on everyone’s agenda, even when times are tough.
- Capital treatment: providing beneficial capital treatment for lenders in relation to green or SLL financings has long been a topic of discussion, the argument being that if the underlying fund/business is more sustainable, the likely better the credit risk. On this point, we do not think regulators are likely to move any time soon (and certainly not in the next 12 months) but it is nonetheless a worthy consideration as there is little doubt that beneficial capital treatment would encourage more green or SLL financings and hopefully have the flow-on effect of ensuring that funds and their investments are greener and more sustainable. Certainly a space to watch.
- ESG litigation: as ESG disputes and litigation become more prevalent, will we see this impact the fund finance market? At this stage, we think this is unlikely to have a direct impact but there is no doubt that this may play into the KPI/SPT setting and focus the minds of fund managers and lenders, particularly in relation to greenwashing concerns.
While we expect continued focus on the social and governance elements of ESG as well as green loans and continued interest in this product in the longer term, it remains to be seen whether the headwinds of the next 12 months will impact appetite for these products in the short term.