Sustainability linked lending in the European leveraged loan market
Sustainability linked loans continue to attract attention in the European loan market. Until recently, activity has focussed on investment grade loans. However, sustainability features are increasingly being incorporated into leveraged loan agreements, signalling that the European leveraged loan market is beginning to embrace environmental, social and governance ("ESG") issues.
The pressure to give greater emphasis to ESG considerations comes not just from legal and regulatory change, but also from investors who incorporate these factors into their credit analysis and from financial sponsors' own funds and investors prioritising commitments to ESG when allocating capital. With market participants generally aligned on the importance of these issues, the prevalence of sustainability features in leveraged loan agreements, together with an increased focus on disclosure and reporting, are themes that are expected to continue and develop in the leveraged loan market.
Defining sustainability linked loans
A sustainability linked loan should be distinguished from a green loan. Unlike green loans, sustainability linked loans are not conditional on the loan proceeds being used for a green purpose. Instead, the defining characteristic is that the terms of the loan incentivise the borrower to improve its performance against certain predetermined ESG criteria.
In documentary terms, the core feature is a sustainability linked pricing ratchet – if the borrower satisfies certain predetermined sustainability targets, the margin on the loan is adjusted. There will also likely be other provisions, for example, a requirement to provide supporting information which relates to, and evidences, the group's sustainability performance.
Key features of sustainability linked leveraged loans
Over the past few years there have been several green and sustainable finance initiatives in the loan market designed to encourage the integration of ESG factors into loan documentation and to promote consistency and best practice across these products. A joint working group consisting of the Loan Market Association ("LMA"), the Asia Pacific Loan Market Association and the Loan Syndications & Trading Association, published a set of green loan principles in 2018, followed by sustainability linked loan principles in 2019 ("SLLP"), both of which were supplemented by further guidance published in 2020. The SLLP and supplementary Guidance ("SLLP Guidance") are voluntary standards setting out the characteristics of a sustainability linked loan. They do not have the force of law but are widely followed internationally.
There is currently no market standard drafting for the sustainability linked loan provisions in a loan agreement. Naturally, this means that documentation varies between transactions, but some key themes are emerging.
One-way or two-way pricing ratchets
Sustainability linked pricing ratchets can operate on either a "one-way" or a "two-way" basis. The "one-way" basis means if the borrower satisfies the predetermined sustainability targets, the margin on the loan is reduced. If the sustainability targets are not met, the margin does not change.
The alternative "two-way" basis retains the margin discount upon satisfying predetermined sustainability targets, and introduces a margin premium which is triggered where sustainability performance falls below certain predetermined levels. Since the underlying objective is to incentivise borrowers to improve ESG performance, it is perhaps not a surprise that the majority of sustainability linked leveraged loans have adopted a "two-way" rather than "one-way" mechanism.
The size of the reduction or increase to the margin varies but might typically be in the range of 0.02% to 0.075%.
The sustainability linked pricing ratchet relies on setting targets for improvements in ESG performance. In practice, ESG performance is measured either by reference to an overall ESG score or through more specific key performance indicators ("KPIs").
Overall ESG score: An overall ESG score is assigned to the group by an external third party rating agency, with the group's overall ESG score at either the date of the loan agreement or the first utilisation date being used as a "baseline". The group's ESG score is reassessed annually, and if the overall ESG score improves above a threshold determined by reference to the baseline, the target is achieved.
Specific KPIs: Performance is assessed across a selection of KPIs, with the number and type varying depending on the nature of the group's underlying business. The SLLP include an indicative list of criteria which can be used to develop KPIs and are clear that the KPIs should be appropriate in the context of the group's business. Examples of specific KPIs in recent facilities include KPIs relating to carbon emissions and wind power.
The approach adopted on sustainability linked leveraged loans is mixed and there are examples of transactions that measure ESG performance based on an overall ESG score, as well as those that rely on specific KPIs.