The year 2019 has seen responsible business, climate change and impact financing feature high on the agenda with increasing focus on the sector by investors, regulators, trade bodies and financial institutions. As a result, there is growing evidence of the influence of environmental, social and governance ("ESG") factors in mainstream finance.
Historically (with notable and significant exceptions) the leveraged finance market has been slower to focus on this than the investment grade market. Unlike banks (many of which contributed and publicly committed to the UN Sustainable Development Goals and other policies and standards (including the Principles for Responsible Investment)), arguably, there has been less corresponding pressure on private equity funds, asset managers and alternative lenders to integrate ESG considerations into the way they conduct business. There is also less useful ESG data, reporting and non-financial disclosure available in relation to private companies (being the form which most portfolio businesses take) compared to that required (or expected) of publicly listed companies. After all, private companies lack the same level of resources, incentives and pressure to comply as publicly listed companies.
The tide has, however, firmly turned on that position with alternative lenders and the funds which dominate the buy-side of the leveraged finance market building up ESG expertise within their organisations, committing to international policies and standards and encouraging management of portfolio companies to engage with ESG factors. In addition, the number of impact funds has also continued to increase. The main reasons for this change reflect those which underpin the momentum in the impact financing sector generally. These include:
- the increasing and focused demand from relevant stakeholders (including pension funds, LPs, GPs and CLOs) for ESG specific investments and for financial analysis to be supplemented with ESG analysis;
- growing evidence that integrating ESG analysis during investment and deal cycles is likely to improve financial performance (particularly in the context of long term investments) whilst ESG risks or red flags can be indicative of potential financial losses (which can be significant if the ESG risk is material); and
- the reputational risks associated with ignoring the demand for business to be conducted responsibly and for finance to have a positive ESG impact.
Earlier this year, the LMA issued its principles for sustainability linked loans (SLLs) and the leveraged loan package for the Spanish Telecoms company Masmovil included a margin ratchet based on a specific ESG KPI. As well as the use of an incentivisation mechanism, the very nature of leveraged finance transactions offers parties a breadth of potential ESG touch points, including as part of the investment criteria (e.g. by way of a fundamental ESG analysis process, or thematic investing or as part of negative screening or best in class); detailed and specific legal due diligence reports which flag potential ESG issues; increasing and consistent engagement of management (including during the post-investment phase through corporate governance and non-financial disclosure and reporting requirements); enhancing terms and conditions of finance documents to engage and support the required positive outcome (such as conditions around borrower and guarantor accession, use of proceeds, ESG focussed conditions precedent and drawdown criteria and positive outcomes based terms); and capturing value on exit.
As for the impact financing sector generally, there are many challenges remaining before ESG factors are fully incorporated into the leveraged finance market. Amongst the key challenges are:
- the rapidly increasing body of law and regulation affecting the impact finance sector which are likely to affect investment criteria and decisions1;
- the lack of consistency of sources, quality and reliability of data and disparate ways of measuring and reporting - with funds currently using data from rating agencies and third parties to develop their own ESG valuation frameworks;
- the need to increase engagement but also to avoid over-burdening borrowers and issuers with non-financial reporting requirements. Where relevant and appropriate, breaches of any ESG terms and conditions can be used as an opportunity to further engage and improve operations rather than to take punitive action. This is particularly important in the context of private portfolio companies with extensive supply chains and/or operating in emerging markets where ESG risks are often more pronounced;
- confusion around terminology and the extent to which this will be addressed by initiatives such as the EU regulations aimed at establishing a unified EU classification (taxonomy) system of sustainable economic activities;
- the effect on fiduciary duties when making investment decisions. This has been brought sharply into focus in the context of recent investment decisions relating to so-called "stranded assets" (ie. assets which institutions no longer want to retain on their balance sheet because they expect them to lose value due to new technologies and a change in stakeholder demand, such as loans to fund fossil fuels for instance). It is possible that investor activists may be prompted to launch claims against funds which have retained such assets and sustained losses as a result.
- the need for continued innovation of financial products. Whilst SLLs can be seen as a step in the right direction for the leveraged finance market, not all investors are keen as it potentially reduces income in what is already a highly competitive market; and
- aligning financial and non-financial value creation objectives and ensuring that a balance is achieved between both.
Not only have leveraged finance market participants responded well to the increasing and evolving challenges posed by the impact financing sector but the leveraged finance market also offers great opportunity. The sheer number and range of market participants and, in the context of leveraged loans, the direct private contractual relations between key parties, offers an opportunity to significantly deepen engagement across a range of financial institutions and private companies in a way which is not possible in the investment grade market. In addition, the increasing volume of SLLs demonstrates financial innovation leading to a positive impact in the leveraged finance market. It is anticipated that 2020 will see the market continue to evolve rapidly through the sharing of knowledge and increased collaboration resulting in the creation of new structures, products and documentary terms and conditions taken from across the impact finance sector.