ESG integration in private debt

This article first appeared in the October issue of Butterworths Journal of International Banking and Financial Law.

Key Points

• Whilst the absence of a sustainability strategy or policy should not be a barrier to undertaking a sustainability linked loan (SLL), in the absence of robust ESG data to support and enable the selection of key performance indicators (KPIs) and the setting of sustainability performance targets (SPTs) direct lenders are having to turn down opportunities, use “sleeping SLLs” (ie those which switch on the SLL label after signing once full diligence of proposed KPIs and SPTs has been undertaken) or offer “ESG-linked” loans (ie loans which do not adhere to the sustainability linked loan principles (SLLPs) but will include a margin ratchet based on KPIs and SPTs.
• This is resulting in a two-tier system of SLLs: those which adhere to the SLLPs or will adhere when switched on and those that are ESG-linked in some way but do not adhere.
• Use of the phrase ‘ESG-linked’ without tying in the relevant loan products to a particular standard is fuelling accusations of sustainability washing.
• The regulatory regime for ESG finance continues to evolve, with the EU’s Sustainable Finance Disclosure Regulation (SFDR) imposing detailed disclosure and reporting requirements on debt funds/managers.
• Those funds that seek to comply with Art 8 or Art 9 SFDR disclosure requirements will need to have processes and procedures in place to ensure that their activities are aligned to their disclosed objectives.

The rise of ESG in private credit

Private credit has seen exponential growth since the global credit crunch playing an increasingly important role in addressing the financing gap resulting from the tightening of bank lending criteria, with assets under management of global private credit funds exceeding US$1.2trn by the end of 2021. Private credit or “direct lending” now represents a significant share of the lending market across various asset classes – most notably leveraged acquisitions and real estate, as well as distressed assets. This trend looks set to continue over the coming years as direct lenders aim to provide financing to achieve a just transition to a sustainable future. According to Debtwire Europe, “ESG-linked private debt” now accounts for 25% of all private credit market transactions and, in 2021, European ESG-linked loans exceeded €923m compared to €660m in 2020. A report earlier this year by the European Leveraged Finance Association underlines that ESG continues to drive investment decisions, with a majority of respondents having declined, reduced or sold out of investments due to ESG issues during 2021. Against the backdrop of challenges facing the sustainable finance and investment sector, the increased focus on ESG in the private debt market has led to a range of approaches to ESG integration in investment processes and the consideration of ESG criteria in loan issuance. As the market continues to evolve, a more holistic approach to ESG in direct lending will be required.

How are direct lenders integrating ESG?

The rising demand for ESG products from end-investors and private equity sponsors is increasingly being reflected in the loans provided by direct lenders with the main focus being on sustainability linked loans (SLLs) rather than use-of-proceeds loans such as green or social loans where the loan proceeds must be applied for green projects or social projects, as the case may be. The Loan Market Association (LMA), Asia Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA) published the sustainability linked loan principles (SLLPs) together with related guidance in 2019 with updated versions in 2022.

SLLs are loan products which incentivise the borrower’s achievement of ambitious, predetermined sustainability performance targets (SPTs) as measured by predefined key performance indicators (KPIs).

The inherent flexibility of SLLs is a primary factor behind this growth – SLLs are not use-of-proceeds loans and can be used for general corporate purposes and in a range of sectors. This is particularly appealing for the private debt sector who typically lend to mid-sized borrowers which may not have an obvious environmental or social agenda. SLLs can therefore be used to support and enable a borrower to begin or advance their sustainability profile.

The SLLPs set out five key features of an SLL: selection of KPIs, calibration of SPTs, loan characteristics, reporting and verification. KPIs need to be measurable or quantifiable, externally benchmarked and material to a borrower’s core sustainability and business strategy, whilst also addressing the ESG challenges of the relevant industry sector. SPTs should remain relevant throughout the term of the loan and be ambitious ie they must go beyond a “business as usual” trajectory. The LMA recommends that either external verification is obtained as to the appropriateness of the KPIs and SPTs to confirm that the SLL adheres to the SLLPs; or the lender satisfies itself that the borrower has the internal expertise to verify its methodologies. A key feature of SLLs is a two-way margin ratchet which is linked to the achievement or non-achievement of the SPTs. Whilst this remains the main form of incentivisation, other consequences for breach of sustainability provisions are now being considered by the market including access for lenders, amendments of KPIs and SPTs, additional information undertakings, declassification of loans as SLLs and in some cases, event of default. Annual reporting is required for the purposes of monitoring the achievement of SPTs and to ensure that KPIs and SPTs continue to adhere to the SLLPs. Independent and external verification of the borrower’s performance against the SPTs and KPIs is required at least annually.

Whilst SLLs have emerged as the loan product most used by the private debt sector, direct lenders are faced with the same challenges facing the sustainable finance sector generally and are also having to contend with the specific attributes of this asset class and the nature of private debt borrowers. These are typically mid-market corporates who may be limited in terms of resources, skills and the availability of relevant ESG data. Often these companies are at the outset of their sustainability journey and have not yet undertaken any ESG-focused materiality analysis or considered the impact of ESG risks and opportunities as they apply to their business, operations, industry sector or jurisdiction. The wider ESG eco-system is also lacking in relevant data, resources and benchmarks focussed on mid-market companies.

The reporting process required for SLLs can require the creation of additional internal processes and data collection. This can be time-consuming and private credit borrowers are unlikely to have the internal processes to sign off on the selection of KPIs and SPTs. This, together with the annual verification process can present a significant cost barrier as well as an administrative burden and may prevent borrowers from accessing SLLs.

Whilst selection of KPIs and SPTs fundamentally needs to be analysed in the context of each individual company, a lack of data and benchmarks is resulting in information inefficiencies, divergent analysis of KPIs, timing issues and a fragmented approach to benchmarking.

Whilst the absence of a sustainability strategy or policy should not be a barrier to undertaking an SLL, the lack of ESG data to support and enable the selection of KPIs and SPTs can leave direct lenders open to the risk of sustainability washing allegations on the basis that the KPIs are not material and the SPTs lack real impact and are merely a PR or marketing exercise.

As a result, direct lenders are having to turn down opportunities, use “sleeping SLLs” (ie those which switch on the SLL label after signing and only once full diligence of proposed KPIs and SPTs has been undertaken ) or offer “ESG-linked” loans (ie loans which do not adhere to the SLLPs but will include a margin ratchet based on KPIs and SPTs). This is resulting in a two-tier system of SLLs: those which adhere to the SLLPs or will adhere to the SLLPs when “switched on” and those that are ESG-linked in some way but do not adhere to the SLLPs. Use of the phrase “ESG-linked” without tying in the relevant loan products (and in particular KPIs and SPTs) to a particular standard is fuelling accusations of sustainability washing and leading stakeholders to question how effective the product is in achieving positive sustainable impact.

Regulatory Landscape

In the background, the evolution of the regulatory landscape for ESG continues to present additional and overlapping challenges and opportunities for direct lenders. For example, the EU’s Sustainable Finance Disclosure Regulation (SFDR) and Taxonomy Regulation (the Taxonomy) are designed to ensure institutional investors operate from a level playing field by requiring consistent, comparable ESG-related disclosures at both entity and product level.

There has been ongoing debate about the long-term effectiveness of the SFDR and Taxonomy, along with some criticism of the difficulties in ensuring compliance with this legislation. However, the funds disclosure system envisaged in the SFDR has been particularly successful in demonstrating huge investor appetite for ESG-focussed funds. In brief, the SFDR envisages three disclosure levels for funds as follows:

• Article 6 funds: funds which integrate sustainability risks as part of the investment process, but do not formally promote ESG factors or otherwise have not introduced sustainability as an investment objective;
• Article 8 funds: “light green” funds that promote E and/or S characteristics, but have not introduced these characteristics as a specific investment objective; and
• Article 9 funds: ”dark green” funds that specify sustainable investments as the fund’s investment objective – there are as yet relatively fewer of these funds. Sustainable investments are defined by the SFDR as investments in activities that contribute to E and/or S objectives (for example, climate change mitigation or adaptation), provided that such activities do no significant harm and follow good governance practices.

In addition, firms must disclose the extent to which their funds make investments that are aligned with the definition of “environmentally sustainable” under the Taxonomy.

Private debt funds, like other market participants, are having to juggle the competing demands of ensuring that funds are attractive to ESG-conscious investors (as Art 8 and Art 9 funds undeniably are), aligning investment processes with their own ESG commitments as well as and meeting the requirements of end-investors and, to the extent relevant, private equity sponsors. The challenges faced by direct lenders in structuring SLLs and obtaining relevant ESG data whilst mitigating sustainability washing risk is an additional layer of complexity which needs to be factored in when considering SFDR and the Taxonomy.

These challenges ultimately combine to affect freedom of manoeuvre in terms of the types of direct lending these funds can undertake, as it must be aligned to their disclosed strategy under SFDR.

This is particularly the case for those funds which aspire to Art 9 disclosures who will, in effect only be able to make loans that have E and/or S goals as their investment objective, for example, companies that actively seek to contribute to climate change mitigation.

What approaches can be used to address these challenges?

Direct lenders will need to respond to the demand for ESG integration both at fund level and in the form of loan products leading to greater scrutiny of Art 8 and Art 9 funds and loans classified as SLLs or ESG linked.

Aligning the process around Art 8 or Art 9 SFDR and considering ESG criteria in the context of underlying loans is an important and useful exercise to undertake and we are now seeing a lot more consideration being given to these issues including:

• increased collaboration between advisors, trade associations and field building organisations to create standardised approaches and achieve greater transparency to support ESG integration as well as engagement around timing, verification and assurance support required by mid-sized companies;
• creation of SLL frameworks focussed on educating and engaging with sponsors and potential borrowers – setting out direct lenders' minimum SLL requirements and ESG investment strategy;
• undertaking detailed analysis of existing lending frameworks and overhauling investment decision-making processes in light of regulation, soft law and SLL guidance and market practice as well as creating internal ESG criteria and E and/or S objectives;
• developing screening (moving from negative to positive screening) and laying ESG considerations in existing due diligence processes in order to assess potential borrowers and benchmark KPIs;
• creating internal benchmarks through a combination of borrower and sponsor engagement, application of frameworks (including the SLLPs) and additional resources (such as the European Leveraged Finance Association’s (ELFA’s) ESG Factsheets and the International Capital Markets Association’s (ICMA’s) KPI registry) in order to assess materiality and ambition of KPIs and SPTs in SLLs; and ensure disclosure under Art 8 and Art 9 SFDR where applicable;
• aligning ESG screening, scorecards and due diligence with reporting, verification and monitoring of sustainability as set out in SLLs in order for direct lenders to be able to meet their funds’ periodic reporting requirements under SFDR; and considering the consequences for investments that are not aligned with or cannot be shown to comply with the requirements of the SFDR as implemented by the manager, or Taxonomy, if applicable.

In turn we expect that these changes at fund level will flow through to market practice around how SLLs are structured and originated, as Art 8 and Art 9 funds continue to grow in both investor popularity and overall market share.

Authored by Sukhvir Basran and Eoin O Connor.