Podcast: The Rise of ESG-linked Debt
In this Ropes & Gray podcast, members of the finance practice group discuss the rise of ESG-linked credit facilities and bonds in the corporate and private fund finance markets, provide an overview of the mechanics of sustainability-linked debt instruments, discuss the forces driving their recent surge in popularity and consider what to expect for them going forward.
Douglas Hollins: Hello, and thank you for joining us today for this Ropes & Gray podcast. I’m Douglas Hollins, and I’m an associate in the Boston office of Ropes & Gray in the finance practice group—here today with Alex Zeltser, a partner in the finance group, and Patricia Teixeira, counsel in the finance group, to talk about the rise of ESG considerations in leveraged loans, high yield bonds and subscription facilities. Alex, can you kick us off by explaining what we mean when we talk about “ESG,” and why that term seems to be cropping up everywhere in finance markets these days?
Alex Zeltser: Sure. “ESG” stands for “environmental, social and governance,” and in the context of finance and investing, it’s shorthand for criteria that can be used to assess the sustainability of an investment or a company’s practices. ESG has been around in debt markets for at least fifteen years in the form of “green bonds” or “green loans,” where the debt proceeds are required to be used for a purpose with a positive environmental benefit. Issuers have been attracted to these types of instruments because they provide an opportunity to broadcast their environmental credentials and brand themselves as innovative and sustainable, increase their visibility through inclusion in green bond indexes, diversify their investor base, and in some cases, take advantage of tax benefits. But these instruments obviously have a limited pool of issuers as there are only so many companies or funds that need to raise debt for a “green” purpose. Companies that do tend to be larger and higher rated than companies that raise debt in the leveraged loan and high yield markets. So, we’ve historically seen green bonds primarily in the investment grade space and much less so in the leveraged finance space.
Douglas Hollins: But ESG has taken off in finance markets this year. Refinitiv LPC has reported that, globally, ESG-related financing is up more than 80% over 2020, which was itself a record year, as measured by total dollar volume. What do you think has contributed to that?
Patricia Teixeira: For one thing, a newer way of structuring sustainable debt instruments has taken off, known as “sustainability-linked loans” (or SLLs) in the loan context, and “sustainability-linked bonds” (or SLBs) in the bond context. The Loan Syndication and Trading Association defines SLLs broadly as “any type of loan instrument that incentivizes the borrower’s achievement of ambitious, predetermined sustainability performance objectives.” The key difference to green loans or bonds is that the proceeds of these instruments can be used for anything—acquisitions, refinancings, general corporate purposes, etc. What makes SLLs or SLBs sustainable is an incentive (or a disincentive, depending on how it’s structured) in the form of a pricing adjustment for the borrower to pursue a sustainable goal. Since the use of proceeds is flexible, these have opened up sustainable finance to just about every company or fund incurring debt so long as they are aiming for ambitious targets to transition themselves to become more sustainable, irrespective of the company or the fund’s main strategy. We started seeing these structures mainly in European debt markets in 2019, and, except for a brief slow-down during the early pandemic, they’ve been gaining momentum ever since. Their popularity hasn’t been as strong in the U.S., but did start picking up starting in the second half of 2020 and building since then. SLLs are still far more common in investment grade loans, but there are an increasing number trickling into the levfin space, especially in Europe, but also in the U.S.
Alex Zeltser: Right—what is believed to be the first SLL funding an LBO in the U.S. came to the market in November, and a couple of private credit SLLs have also been reported on this year. Borrowers have been taking advantage of the opportunity these structures offer to lower their costs of capital. And both borrowers and lenders see them as an opportunity to respond to a rapidly increasing focus on ESG by market participants of all kinds. Private equity sponsors, their funds, and the banks and debt investors that lend to them have been coming under increasing pressure to make sustainable investments. The pandemic and the social justice issues that have come to forefront over the last year or so have added an extra impetus.
Patricia Teixeira: We’re certainly seeing an increasing focus on ESG in the fund finance space. The Institutional Limited Partners Association (ILPA), for example, when it released its ILPA Principles 3.0 in 2019, had an entire section related to ESG policies and reporting. Principles for Responsible Investment (or PRI) has released numerous requirements, expectations and guidance for integrating ESG into investment decisions and monitoring—generally and relating to specific issues. Pressure for ESG integration and reporting by GPs has increased substantially over the last couple of years and is expected as part of new institutional capital commitments. As ESG integration has continued to mature, it’s becoming more metrics and data driven, which facilitates building ESG metrics into loan facilities at both the manager and the portfolio company level.
Alex Zeltser: To be clear, ESG considerations in loans aren’t driven by altruism. From the investor perspective, there’s a large body of research showing that ESG factors are indicators of both risk and long-term returns, and that taking ESG factors into account at a business can benefit its overall financial performance. So, debt investors are starting to consider borrowers or issuers with better ESG profiles to be safer and more sustainable investments, and to see red flags in the ESG context as signaling potential financial risks. In that vein, some banks have been working to reduce their exposure to industries that aren’t considered ESG friendly, like fossil fuels and munitions.
Middle market and direct lenders may also see a competitive advantage in having ESG expertise in that the types of smaller companies they invest in don’t already have developed ESG programs and strategies, so their ability to help guide them through that process may give them a way to differentiate themselves, especially in what is currently a very crowded market. Though ESG activity in the private credit sphere has been limited so far.
Douglas Hollins: It seems like the regulatory landscape is also contributing to the ESG momentum, at least in Europe, where ESG disclosure requirements have started coming into effect. The EU Taxonomy Regulation comes into force on January 1, and aims to delineate more clearly what actually constitutes an ESG investment by setting out criteria that economic activities have to meet to be considered environmentally sustainable. And in March, the EU Sustainable Finance Disclosure Regulation (or SFDR) went into effect, which imposes standardized disclosure rules and requirements on certain financial market participants, including banks, asset managers, pension funds, etc., with respect to how they implement ESG considerations. Both regimes will be supplemented by more detailed regulatory technical standards that are expected to be implemented by January 2023. The SFDR is notable even from a U.S. perspective because it applies to financial market participants who either have business in the EU or who sell products to persons in the EU. That may capture certain institutions (such as credit fund managers) that lend to U.S. companies, so those companies could start being asked to collect and disclose ESG-related information about themselves. When companies have accumulated this kind of information and developed a process to track and measure it, it creates the opportunity for them to put debt facilities in place that are linked to ESG metrics.
Alex Zeltser: Regulatory agencies in the U.S. have been slower to engage with ESG issues, but have been substantially more active in the past year, particularly with respect to climate change. For example, the SEC is preparing a proposal for mandatory climate risk disclosures by public companies that is expected early in 2022, so more regulation of some kind is definitely on the horizon. In the meantime, the SEC has been sending letters to certain public companies and has published additional climate risk disclosure guidance. Regulators have also been focusing on ESG in ways that spotlight banks to take ESG issues into consideration more systematically. In October, the Financial Stability Oversight Council released a report that identified climate change as an emerging threat to the financial stability of the United States, and made a number of recommendations applicable to banks and other market participants, such as enhancing disclosure, and improving and standardizing data and measurement methodologies. In November, the acting OCC Comptroller called on the boards of large banks to consider five questions he posed about climate change risk management. In October, one of the Governors of the Fed announced that the Fed is developing scenario analysis tools to model the economic risks of climate change and to assess the resilience of individual financial institutions and the financial system as a whole to those risks. It’s also indicated that it will provide supervisory guidance on climate change to help banks measure, monitor, and manage risks related to climate change.
Douglas Hollins: And setting the regulatory landscape aside, coming out of COP26, 450 financial institutions, including banks, asset managers, asset owners and others, pledged, under the Global Financial Alliance For Net Zero, to deploy capital to reach net zero emissions by 2050. Among the ways they can do that is by making investments that contribute to reducing emissions and influencing the cost of capital through lending decisions. So, we may see that pledge continuing investor interest in environmentally sustainable debt instruments.
Now, let’s pivot to talk about how SLLs and SLBs work in practice. Patricia, you mentioned that the sustainability incentive is structured as a pricing adjustment. Can you explain what that looks like?
Patricia Teixeira: Sure. Most commonly in SLLs, these are set up such that there is a step-down in margin or coupon if a pre-determined quantifiable sustainability performance target (or “SPT”) is met at a certain point. You could also have a step-up in SLLs if the SPT is not met. And sometimes it works both ways, with a step-up if the SPT is not met and a step-down if it is. In SLLs and SLBs, the achievement of a sustainability performance target is measured by reference to pre-selected key performance indicators (or “KPIs”). With SLLs, there are usually three to five performance targets, and the margin adjusts up or down based on how many of them are met. Also, some SLLs provide for the borrower to donate any margin savings from a step-down, or for lenders to donate the amount of any margin increase, to ESG-related charities or for the borrower to use the amount of margin savings towards a sustainability objective.
Alex Zeltser: SLBs are structured similarly, except that there are usually only one or two SPTs, and even if there are multiple SPTs, the issuer sometimes has to meet all of them to get the pricing benefit. In comparison to SLLs, there is only an upward adjustment in interest if the SPT is not met. Usually, the redemption premium also increases if the rate increases as a result of the issuer’s failure to meet the SPTs.
Patricia Teixeira: From the borrower’s perspective, apart from the pricing incentive, there’s also a reputational incentive. That’s particularly true in the fund finance space. With the move to ESG integration so driven by pressure from LPs, a fund borrower will not want to have to explain to its investors why it missed its performance targets.
Douglas Hollins: Apart from the pricing incentives, and the reputational concerns, what are some other differences from regular-way financings, in particular, with respect to testing SPTs and KPIs? Does sustainability-linked debt mean more reporting for the borrower? Or create the potential for additional defaults?
Alex Zeltser: With respect to SLBs, the SPTs are usually only tested once, usually about three years after issuance depending on the SPT, and are either met at that point or not. The testing usually consists of the issuer delivering an officer’s certificate to the trustee that the SPTs have been met that attaches an assurance letter to that effect from an external verifier, which is usually a reputable audit firm that is selected by the issuer. If the targets aren’t met, the only penalty is the pricing adjustment and redemption price increase—missing an SPT doesn’t result in a default. In terms of periodic reporting, issuers generally state in their OMs that they intend to report on their KPIs at least annually, but that typically isn’t required under the documents, and failing to do so will not result in a default.
Patricia Teixeira: The SPTs in loans are usually tested more frequently, typically once a year, so the loan documents contemplate the borrower delivering a certificate as to achievement of the various targets on an annual basis. As with SLBs, the Borrower’s performance with respect to those targets is often required to be externally verified. In some loans, failure to meet the targets may result in a default, but more typically, if the SPTs are not met or if the certificate is not delivered, the only penalty is the pricing increase, rather than a default. But to be clear, there would be a default if the borrower materially misrepresents the achievement of its KPIs. It’s also worth noting that we aren’t seeing any new ESG-specific representations or covenants either in sustainability-linked debt or otherwise.
Alex Zeltser: Some market participants argue that the consequences of failing to meet targets should be more meaningful, and the fact that they are not, weakens the sustainable integrity of these instruments. But the other side of that argument is that making the consequences of failure a default or even an event of default, would result in less ambitious targets being set, which would equally weaken the sustainable impact of SLLs and SLBs.
Douglas Hollins: Can you give some examples of SPTs and KPIs? And how are they selected?
Patricia Teixeira: Reducing greenhouse gas emissions is probably the most common KPI. Reducing workplace injuries and increasing gender or racial diversity of a company’s management or board are fairly common ones under the “social” and “governance” umbrellas, respectively. Others include the borrower achieving a particular score from a third party that provides ESG ratings, although that’s becoming less typical, or simply developing and delivering an ESG strategy. But they can also be more bespoke to a borrower’s industry—for example, an SPT in a bond issued by a manufacturer of wood-based products involved increasing its use of recycled wood.
Alex Zeltser: In terms of process, a bank with ESG expertise often takes on the role of sustainability coordinator and works with the borrower to develop these. Companies entering into SLLs and SLBs already consider ESG factors in their businesses and have set sustainability-related goals, so the sustainability coordinator works on incorporating these goals into the loan documents. Industry-specific frameworks have been developed that provide guidelines for identifying KPIs, setting SPTs and measuring progress towards them. The International Capital Markets Association administers the Sustainability-Linked Bonds Principles. And the Loan Syndication and Trading Association (LSTA), in collaboration with its counterparts in Europe and Asia, has promulgated the Sustainability-Linked Loan Principles. In general, these frameworks provide that SPPs and KPIs should be relevant and material to a company’s business, and of high strategic significance to its current or future operations. They should be measurable and quantifiable on a consistent methodological basis, externally verifiable, and able to be benchmarked using external references to facilitate the assessment of the SPT’s level of ambition.
Patricia Teixeira: There are a number of frameworks and standards available that can inform the selection of KPIs and SPTs. For example, the Sustainability Accounting Standard Board, the Task Force on Climate-Related Financial Disclosures, the Global Reporting Initiative, and the World Economic Forum have all developed metrics for reporting on various ESG-related factors. In addition, the UN Sustainable Development Goals (or SDGs) are broad sustainability goals that many issuers seek to align with.
One additional consideration in subscription facilities is where the SPTs are being measured. Usually, they are linked to portfolio companies in the borrower’s investment portfolio, but they may also be measured at the fund itself. That was the case in a loan we worked on earlier this year that we believe was the first ESG-linked subscription facility for a fund-of-funds borrower. Given that it wasn’t possible to link KPIs to portfolio companies in that case, the KPIs related instead to ESG considerations in the borrower’s investments.
Alex Zeltser: There’s a real concern in the ESG space about so-called “greenwashing,” or overstating positive ESG impact by, for example, setting SPTs that aren’t meaningful enough to a company’s industry to make an impact or aren’t ambitious enough to actually improve a company’s behavior. Contributing to this concern is the fact that there is currently not a single set of KPIs and SPTs used, so parties are free to select whatever targets and metrics they want, subject only to lender approval at the negotiation stage. This flexibility may have contributed to the popularity of these instruments in that they are extremely customizable across industries and companies regardless of their varying sustainability goals and sophistication. But the problem from a lender perspective, apart from keeping track of all the KPIs and SPTs, is that this makes it difficult to compare ESG performance among borrowers.
Patricia Teixeira: Another trend in loan documentation has emerged this year that allows a borrower to delay selecting KPIs and SPTs altogether until after the loan is initially entered into by permitting their implementation, including the related pricing adjustments, through a streamlined amendment process. Reductions to the interest rate are one of the so-called “sacred rights” that ordinarily require consent of all affected lenders. But these new provisions allow the borrower and either the sustainability coordinator or administrative agent to select KPIs at some point during the life of the loan, and incorporate pricing adjustments within a pre-determined range of basis points. Any amendment implementing those changes would become effective subject only to the negative consent of the majority lenders. So, this is a way for borrowers who may not yet have concrete sustainability goals to benefit in their existing debt instruments once these goals are established, and to signal to the market that they are focused on ESG factors. But lenders may be concerned about the limited visibility that they will have in the process of selecting KPIs and the brief time they may have to diligence them during the negative consent exercise period, which usually is about five to ten business days.
Douglas Hollins: Looking ahead, what other trends or developments do you expect to see on the ESG front in debt markets?
Patricia Teixeira: Debt market participants will be affected by broader trends in ESG integration by financial market participants. We expect that investors will increasingly demand ESG-related information from borrowers and issuers irrespective of whether a debt instrument is an ESG-product, both at origination and as part of ongoing monitoring. Various tools and products are being developed to meet these information needs, some having been announced as recently as in the last couple of weeks.
Alex Zeltser: In addition, ESG metrics in lending products will continue to evolve. Some of this evolution will be driven by new standards setters and the convergence of existing standards setters. During COP26, as expected, the IFRS Foundation announced the creation of the International Sustainability Standards Board (or ISSB), which will develop a comprehensive global baseline of sustainability disclosures. By June of 2022, the IFRS Foundation plans to consolidate the Climate Disclosure Standards Board and the Value Reporting Foundation, the umbrella organization of SASB. New regulatory disclosures and prudential requirements applicable to lenders also will drive the evolution of metrics. Consumers of ESG data are also becoming more sophisticated, and in areas such as climate risk, methodologies continue to evolve.
Patricia Teixeira: Even with greater standardization, KPIs and SPTs will still need to be flexible, since ESG concerns and priorities are not uniform. And, in any event, greater standardization of KPIs and SPTs will not address market expectations around target levels, which also will continue to evolve.
Alex Zeltser: It will be interesting to see how the leveraged loan market for SLLs takes shape in the U.S. and if it will turn out differently from what we’ve been seeing in European or investment grade markets. For example, Covanta’s SLL, reported by the first SLL supporting a leveraged buyout in the U.S. and which was issued alongside an SLB, was in fact structured more like an SLB. That loan includes two KPIs, and the margin will increase by 12.5 bps per KPI that is not met by a specified date. There’s no margin step-down for meeting the KPIs, so no pricing incentive for the borrower in this case, and the KPIs are only tested once, not periodically. It’s possible that investors in the U.S. syndicated market, at least in the context of an LBO, will be more conservative about pricing incentives in SLLs, though it’s too early to tell. On the other hand, one of the few reported SLLs provided by a direct lender, Barings’ loan to Northstar Recycling to fund an investment by Ridgemont, included only margin reductions, for each of five KPIs the company meets and no margin increases for failing to meet them. So, it will be interesting to see how the SLL market in the U.S. continues to evolve.
Douglas Hollins: We’ll have to stay tuned, and I know that both of you and the rest of the Ropes & Gray finance team are active in this space and continue to monitor developments. Thank you both for taking the time to discuss this important and evolving topic. And thank you to our listeners for joining us. For more information on the topics that we’ve discussed, or other topics of interest to the finance community, please visit our website, www.ropesgray.com. Also, visit our website for information on our ESG, CSR and business and human rights practice. Senior members of the practice have advised on these matters for more than 30 years, enabling us to provide a long-term perspective and depth and breadth of experience that few firms can match. And of course, if you have any questions about what we’ve discussed, please don't hesitate to get in touch. You can also subscribe and listen to other Ropes & Gray podcasts wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.