The rise of ESG in leveraged loans
Sustainability-linked loan volumes have taken off since the publication of the Sustainability-Linked Loan Principles in 2019. While much of the activity has centred around investment-grade loans, the leveraged loan market is increasingly engaging with ESG and sustainability-linked financing. In recent months, a number of large sustainability-linked deals have entered the leveraged market, drawing attention both positive and negative.
Such deals typically include a so-called “margin ratchet,” rewarding borrowers for meeting specified ESG-related targets, such as CO2 emission reductions.
Several characteristics of leveraged loans support the inclusion of ESG targets: the close relationship between borrowers and lenders; bespoke information reporting; and investors already accustomed to performing deep-dives into borrowers’ businesses.
On the other hand, borrowers in the leveraged loan space typically don’t have the same resources as an investment grade issuer, and leveraged loan deals are often run on extremely tight timeframes, making the due diligence on ESG metrics more of a challenge.
“Everyone now cares about ESG, whether you’re talking about loan investors or the businesses themselves, or even the sponsors of those businesses,” Emma Norman, Senior Legal Counsel at Invesco and Co-chair of the Loan Investor Committee at the European Leveraged Finance Association, told the audience at a recent webinar held by the Loan Market Association (LMA) on ESG trends in leveraged loans.
“It’s a nascent trend that’s emerged in the last six months, something we’re all grappling with and trying to figure out how to make meaningful and ambitious in practice,” she said.
Everyone now cares about ESG, whether you’re talking about loan investors or the businesses themselves, or even the sponsors of those businesses.
What’s driving the trend?
Consideration of ESG factors in leveraged loan deals is not simply a response to legal or regulatory changes, such as those under the EU Action Plan on Sustainable Finance. Investors incorporate these factors into their credit analysis, and financial sponsors are also under investor pressure to put ESG targets in place for their portfolio companies.
“Ensuring there are ESG-related terms in the financing they’re raising for their portfolio assets is one way (financial sponsors) can demonstrate they are contributing to the ESG story,” said panellist Pathik Gandhi, a partner at law firm Linklaters.
What’s more, ESG considerations have a direct bearing on credit risk, noted panellist Jacob Michaelsen, head of Sustainable Finance Advisory at Nordea.
“If a company is able to demonstrate to you that they’re reducing the amount of water they use or they’re reducing the amount of virgin plastic they have in their production, or the amount of CO2 emitted, all things equal, that has to be a safer credit,” said Michaelsen. That’s not only due to the costs associated with the specific parameters, but it also shows that the company has a governance structure better able to respond to risks such as climate change.
Ambitious, meaningful and sincere
The panellists agreed that one of the main challenges is ensuring that any ESG-related targets that are incorporated into leveraged loans are ambitious, meaningful and sincere, requiring the issuer to go beyond their business as usual approach.
“A big part of the EU legislative agenda is to avoid greenwashing… It’s in the interest of all stakeholders in the leveraged loan space to make sure we’re not accused of doing that,” said Norman.
The LMA is currently working with the European Leveraged Finance Association to provide specific, practical guidance regarding the incorporation of ESG targets into leveraged financing.
“Hopefully it will discourage practices such as not including KPIs (key performance indicators) at the term sheet stage or potentially flexing them if the deal goes well,” Norman said.
If a company is able to demonstrate to you that they’re reducing the amount of water they use or they’re reducing the amount of virgin plastic they have in their production, or the amount of CO2 emitted, all things equal, that has to be a safer credit.
A need for patience and flexibility
Michaelsen stressed the need for patience and giving the leveraged finance market flexibility to develop in the sustainable finance space while also not cutting corners. He noted that EU regulatory developments, including the recently announced Corporate Sustainability Reporting Directive, which widens the scope of companies required to report their sustainability information, should help.
“I’m convinced that in the foreseeable future, we will have smaller companies and even non-public companies mandated to a certain extent to disclose more standard ESG-related data. As that happens and other market standards evolve, such as the Science-based Targets Initiative that we use to safeguard some of these commitments, we will have a better developed infrastructure to put into place these facilities,” he said.
Gandhi also noted that much of the current debate focuses on the reporting regime for each deal, to ensure as much transparency as possible. While some deals appoint external agencies to provide sustainability reports and tie the pricing ratchets to the ratings provided by those agencies, other deals rely on the borrower’s internal compliance reporting.
“There’s a fair bit of debate around whether there should be auditor confirmations around that,” he said.
The LMA in the EU, the Loan Syndications and Trading Association in the US and the Asia Pacific Loan Market Association recently updated the Sustainability-Linked Loan Principles, introducing mandatory external verification of companies’ performance on their ESG targets.
Watch the full webinar, “ESG Trends in Leveraged Loans,” on the LMA website (registration required).