In the second of our three-part series focussing on ESG in PE, we discuss the green halo effect, and the differences between green loans, sustainably linked loans and green bonds.

ESG within PE debt documentation

As we highlighted in part one of our ESG in PE series, weaving environmental, social and governance (ESG) issues into investment decisions and portfolio management is now a core area of focus for private equity (PE) managers. This has accelerated over the last 18 months despite the UK being in recession for most of 2020, proving that ESG is not a “trend” but a core part of a fund’s strategy to remain resilient as the whole economy transitions to a more sustainable future.

What role can debt finance play in the ESG strategy of a PE fund?

The borrowing of ESG linked loans, both at fund and portfolio level, can ensure that the core ESG strategies of the fund manager are integrated. Additionally, such borrowing can help align the ESG values of the fund with that of its lenders, limited partners (LPs) and portfolio companies. LP’s have made it clear that they want to see a positive impact (or simply a reduction in the negative externalities) of their investment throughout the full value chain of their investment into the real economy.

How can ESG be integrated?

A sustainability linked loan, or ESG linked loan is a loan in which the margin payable (and sometimes other financial metrics), is tied to ESG performance.

The borrower and lenders agree a series of ESG key performance indicators (KPIs) (being a set of measurable values), around which pre-determined targets are then set, which are set out in the facility agreement. If those targets are met (or some of them), the margin on the debt will reduce, thus incentivising strong ESG performance. Margin premiums are also becoming a more dominant feature, thus punishing poor ESG performance.

ESG linked loans have been well publicised in the funds focused publications. Initially PE funds have been borrowing ESG linked loans at fund level (in their subscription credit lines) throwing them into the spotlight in what has been described as a “green halo”. More recently these have started to take off in the unitranche debt market, a common debt product utilised by sponsor backed portfolio companies.

This concept is similar to leverage margin ratchets used to reward sponsor backed portfolio companies with a reduction on their debt margin as they de-lever. In the leverage context it is widely accepted that the credit worthiness of a borrower increases along with the business de-leveraging (hence the mechanic), however some question the rationale of pricing adjusting to a set of ESG KPIs distinct from financial performance. Leaving aside the well debated question of whether or not ESG integration adds direct value, what is clear is that a well-managed portfolio company looking at ESG (as with any other business risk) holistically both from a risk perspective and as an opportunity, is likely to be a well-managed business attractive to a broad pool of lenders.

What is a green loan, how does this interact with a sustainability linked loan and what is a green bond?

A green loan is a loan for which the proceeds are used for a specific “green” purpose which provides clear environmental benefits. An example of application of green lending in a PE context could be funding the installation of solar panels on the roof of a factory owned by a portfolio company, or the purchase of highly energy efficient equipment for a manufacturing business owned by a sponsor, resulting in a much reduced carbon footprint. In these facilities the proceeds are carefully tracked and segregated from other cash.

Generally speaking, it is thought that ESG linked loans or sustainability linked loans will have a wider application in a PE context as the use of proceeds is not fixed, meaning that many debt facilities can be turned into sustainability linked loans.

It would be unusual for a sustainability linked loan to also be a green loan, given the result would be a requirement to fall within two separate regimes (the loan would have simultaneously to have a green purpose as well as meet a series of ESG KPIs). It would be possible for a green loan to sit alongside another type of loan in the same facility agreement, for example a revolving credit facility, much like a capex facility for a specific purpose is often included in the same documentation as a unitranche facility.

The green element of a green bond operates in a similar way to a green loan, therefore the proceeds of such bond are carefully segregated, tracked and monitored.

KPIs, SPTs, ESG facilities and sustainability linked lending - a case of identity politics?

The Loan Market Association (LMA) have produced guiding principles, The Sustainability Linked Loan Principles (SLLPs) for these transactions to assist market participants in the prevention of sustainability washing. The principles were structurally updated in May 2021 with the majority of the updates seeking to raise standards across the industry.

In the LMA’s principles and guidance they distinguish the ESG KPIs from the targets themselves. The ESG KPI targets are termed sustainability performance targets (SPTs) with the KPIs distinguished as the set of measurable values within which the SPTs are set. To articulate this with an example, board diversity would be an example of a KPI with the percentage target increase of diverse board members by a certain date being the SPT. The majority of market participants within the PE community typically use the term ESG KPIs, either interchangeably with the term SPTs or merely reference ESG KPIs without reference to the LMA’s preferred terms. Similarly, the loans themselves are not typically called sustainability linked loans, but instead ESG linked loans. With the recent updates from the LMA the term SPTs could be more readily adopted providing some clarity in the distinction.

The differentiation between an ESG facility and a sustainability linked facility could be indicative of a greater divergence than merely nomenclature. A debt facility described using the LMA’s terminology of “sustainability linked” could be indicative that the LMA’s principles have been closely followed and the use of the phrase “ESG facility” could be indicative that the LMA’s principles were not closely followed. However this will not always be the case and many transactions will have followed the LMA’s principles to the extent appropriate for the transaction.

KPIs/SPTs

In setting ESG KPI targets the most important consideration for both lenders and sponsors are that the targets are predetermined, relevant, meaningful and ambitious. It is not sufficient to set KPIs at levels which do not meet these requirements, which could lead to accusations of sustainability washing. Some level of independent verification and methodology reporting is also critical, with the LMA stating (in their May 2021 revisions of their principles) that when following their principles borrowers must obtain annual independent external verification of borrower performance against the pre-determined targets.

The KPIs (and associated targets) selected for inclusion may look very different as between funds, even between funds managed by the same manager, but both could be relevant, meaningful and ambitious. Differences could reflect fund strategies, sector focus, geographic focus, or could simply result from the varying stages of ESG integration between those funds. For a portfolio company, again KPIs will differ as between businesses sponsored by the same house, given variations in geography and sector, however it is expected that a fund will tie in their ESG strategy with that of their portfolio companies. This is to create alignment of purpose, and assist in the fund meeting its objectives at fund level and for consistent reporting to LPs.

It is wise to ensure that an opportunity is not missed to include a KPI (or more than one) relating to the “E” in ESG. It is expected that the Task Force on Climate-Related Financial Disclosures (TCFD) will become mandatory for all asset managers by 2024 and more private funds are adopting the various climate disclosure regimes as well as joining the Net Zero Asset Managers Initiative and other voluntary groups and regimes . A sustainability linked debt facility can be one trigger for aligning a fund’s ESG strategy with the TCFD and the other disclosure regimes in preparation for formal legislation or regulation making it mandatory.

Challenges

The biggest issue is a lack of data throughout the entirety of the private markets (both debt and equity). Although it is often inconsistent, an investor investing in the public equity or debt markets typically has access to corporate governance research and analytics, allowing them to make a relatively more informed choice. Some businesses are even rated from an ESG perspective and will often have a team of ESG professionals collecting and reporting data for investors. This is not the case for most PE sponsored portfolio companies, however there is a wealth of regimes and guidance which can help funds collect and asses data themselves.

Another challenge is ensuring that the ESG KPIs remain meaningful and ambitious throughout the life of the facility. Again, this is subject for discussion, but there are ways of drafting documentation to ensure that KPIs can be visited annually to ensure that this standard is maintained.

A lack of consistency and variation between how the LMA’s principles are applied by lenders is also a current challenge, with sticking points often being the level of third party verification and oversight required by the lenders and the role of the sustainability co-coordinator (this role is typically performed by the same entity as the arranger of the debt). These issues will settle as the market matures and lenders themselves obtain more experience.

What is exciting is that ESG integration within debt documentation now presents an opportunity for evidencing the positive change occurring in the PE community. ESG linked loans are one of many manifestations of that transition and an example of market innovation.

The motivation

The current margin discounts available are not significant and certainly do not represent the primary motivation for borrowing an ESG linked debt facility. It is clear however that those funds who are taking into account all aspects of ESG, who consider both the transition risks, physical risks and negative externalities of the way they manage their portfolios, are likely to be the managers that are building resilient funds for tomorrow, and best placed to take advantage of investor capital opportunities relating to ESG. An ESG linked credit facility, by corelation of pricing with ESG performance is one way of demonstrating that commitment to a wider ESG strategy, as well as potentially attracting both a wider investor pool, a wider pool of debt funders and a wider pool of exit opportunities.