Arcmont Asset Management will offer sustainability-linked loans to all borrowers in its second senior loan fund, which reached a final close at €5 billion last month.

“The idea is that the portfolio company mitigates its ESG risks, which should lead to a better financial outcome for the company, which often as a by-product would have benefits for the environment or for society,” Nathan Brown, Arcmont’s chief operating officer, told PDI‘s affiliate title, New Private Markets.

The London-headquartered private debt firm has released a guide to structuring sustainability-linked loans, which give borrowers a discount on the margin if they meet agreed ESG KPIs. This is a growing space among private debt managers: Ares Management Corporation issued a £1 billion ($1.3 billion; €1.2 billion) loan to engineering company RSK in August, while Amundi plans to provide ESG-linked loans for its fourth senior impact debt fund, which has a €1 billion target. Other managers that have issued sustainability-linked loans include Barings, Capza, InfraRed, Aviva Investors, LGT, Natixis Investment Managers’ MV Credit and Eiffel Investment Group.

Arcmont started linking loan margins to ESG targets in April. The firm focuses on one area of improvement in ESG for each portfolio company and develops a three-stage improvement plan. The portfolio company receives a 2.5 basis point discount on the loan margin when each stage is met – so portfolio companies could receive up to 7.5bps discounts.

For example, Arcmont issued a loan to a packaging company earlier this year, which the borrower used to acquire a smaller packaging company. The first stage target is to measure the volume of raw materials the smaller packaging company recycles; the second and third stages are for the smaller company to reach certain recycling volume targets, said Brown.

“Another business has low-skilled employees with a high staff turnover. They do minimal training,” said Brown. The company is introducing an education programme for staff. “We’ve got a three-step plan depending on the amount of money spent [per staff member] and the amount of hours of education provided,” said Brown. “You’ve got better trained staff and you’re offering something attractive for them, so you’re more likely to get better staff retention. That has a social benefit and leads to improved performance for the business.”

A key challenge for sustainability-linked loan providers is setting quantifiable and measurable KPIs. “You’ve got to get involved, you’ve got to understand the borrower’s business,” said Brown. “You can engage with management in the upper mid-market sector. You can phone them up and persuade them to do this and that.

“The other piece is engagement with the sponsor. Ultimately, the private equity backer is the owner of the business and they can enforce and mandate change. Working with them is as important as working with the borrower.”