It’s hard to think of too many positives from the pandemic that has blighted the world for close to two years. But Timo Hara, founder and partner of Finnish fund of funds manager Certior Capital, hints at one: “Maybe covid gave managers of private debt firms a bit of time to sit at home and think strategically about what they could do to ensure their survival and prosperity over the long term.”

Of course, ESG was already firmly on the agenda for private debt firms long before the coronavirus but it may be no coincidence that 2020 was the year when sustainability-linked loans were first adopted by the larger managers and some noise started to be generated around these new products. Perhaps long-term strategic thinking, of the type identified by Hara, was the order of the day. Moreover, if 2020 was the birth of SLLs, 2021 was the year when they exploded onto the scene.

So far, most SLLs have been based on margin ratchets – designed to reward borrowers for meeting key performance indicators by reducing the amount they have to pay in interest on their loans. If SLLs may be likened to the ‘carrot and stick’ approach, then margin ratchets are the carrots – market observers say that, while it’s possible for deals to incorporate a ‘negative ratchet’ where rates move higher when KPI targets are missed, these are very rarely seen in practice.

This has led to some criticism that maybe SLLs don’t have enough heft to bring about meaningful change. For one thing, interest rate savings can be as low as five to 15 basis points and some say this is a level that doesn’t offer enough reward. At the other end of the spectrum, the argument can be made that there is not enough of the stick. Some advocate linking performance against ESG criteria to covenants – something Hara thinks is next in the SLL evolution.

“Ratchets provide a clear incentive for the borrower,” he says. “Covenants will be next, and that means demanding something and not only encouraging. You could take various approaches when you have an ESG covenant breach, including penalties that fall short of default. But ultimately there could be a default trigger.”

“Out of $65 billion worth of lending I looked at, around half of it was questionable in its claim to be sustainable”

Emily Farrimond
Baringa Partners

If private debt deals are not seen to be incorporating KPIs with sufficient incentives and disincentives, they risk being associated with the dreaded tag: greenwashing. This accusation has certainly been made against the broadly syndicated leveraged loan market, where many loan-related innovations are seen first before finding their way into the mainstream private debt arena.

But as yet, private debt is not nearly as advanced as the BSL market in terms of SLL adoption and there is a view that it would be harsh to form judgements at this stage, when the asset class is still taking tentative first steps. Thus far, SLL implementation has largely been driven by fund managers, with many investors happy to sit on the sidelines and see what they come up with.

Eventually, though, investors are likely to voice more of an opinion on what they do and don’t want.

Currently, the SLL push in private debt is being driven by managers, with the likes of London-based Pemberton and Paris-headquartered Tikehau Capital getting numerous mentions in dispatches.

But while they have led the way, LPs are likely to become more proactive with solid ESG/sustainability policies having to become an increasingly essential element in fundraising pitches. “The next few years will see a refining of the approach for real impact and the whole industry becoming more sustainable and more in line with what LPs want,” predicts Hara.

A failure to live up to LP expectations could mean a failure to raise capital, some think.

KPI variance

The way to get to the Promised Land is not entirely clear, however. For example, deciding what the KPIs should be is no simple matter and can vary a lot from one borrower to another.

“The KPIs may well be tailored to the type of company being lent to,” says Mikael Huldt, head of alternative investments at Stockholm-based AFA Insurance. He notes that a software company may be more likely to have KPIs focusing on diversity targets whereas, for an industrial company, environmental improvements may be the chief objective.

Joe Siprut is chief executive officer and chief investment officer at Chicago-based Kerberos Capital Management, which last September launched what it claimed was the first ESG-linked debt product, featuring margin ratchets, in the litigation finance market.

Illustrating how varied the KPIs can be, depending on who’s lending and borrowing, Siprut says Kerberos’s KPIs will be some combination of: a) demonstrating a material and ongoing commitment to pro bono legal services; b) generating a threshold amount of revenue related to ESG-advancing case types; and c) establishing that the borrower does not prosecute cases, or conduct business, counter to ESG principles.

The KPIs may be unusual within the broader private debt universe, but Siprut describes what they are setting out to achieve in a way that surely resonates with other GPs: “When we set KPIs for a new law firm loan, we are both recognising their current ESG achievements and also encouraging them to reach, to do more and go further.

“The KPIs have to be set at the right level to incentivise the desired behaviour. Too high is no better, and in some ways worse, than too low, because then the KPIs are just ignored.”

“To set KPIs before signing may feel too rushed and smaller managers in particular may argue they need more time to get their heads around it”

Sabrina Fox
European Leveraged Finance Association

Aside from the nature of the KPIs, another consideration is whether to include them pre- or post-deal completion. Sabrina Fox, chief executive officer of the European Leveraged Finance Association, says many don’t want to include ESG KPIs before the deal closes. Instead, they would rather sign the deal with the understanding that KPIs will be set by a stated deadline – 60 days, for example. This is more typical of private debt than the BSL market, where there is a tendency to push for KPI inclusion before a deal is signed.

“One of the characteristics of private debt is that it is more of a one-to-one relationship where you can engage more directly with the borrower,” says Fox.

“To set KPIs before signing may feel too rushed and smaller managers in particular may argue they need more time to get their heads around it. But it does mean the spectre of greenwashing hovers because you might say you’ll put in place robust KPIs and ultimately fail to commit. Engagement is key if you draw up KPIs after signing – it’s really important to keep checking in on progress.”

Most progress on SLLs so far has been made by larger managers based in Europe, with the US relatively slow to respond. “In Europe it started one or two years back. Pemberton were early to it, others have caught on and now we’re seeing more examples,” says Huldt.

“But in the US, there’s little movement, mainly because there’s not much interest from US LPs. But as more European capital goes into the US, the topic will be raised more.”

Kerberos is an exception to the rule as a smaller, US-based manager that has nonetheless been at the forefront of the trend. “A few years ago, we made ESG part of our underwriting through negative screening and then we did some positive screening, identifying those companies doing a good job on ESG.

“Then we saw an opportunity to go further, using the margin ratchet. Ours is a specialty market and the number of institutional-grade players is quite small. You’ll see more of this over time but we’re proud of the fact that we were ahead of the curve.”

Alex Griffith, a partner in the private credit group at law firm Proskauer, says: “The trend started around two years ago and there was an expectation that it would be taken up quickly, driven by the experiences and learnings in the large-cap space. But it’s actually only developed in fits and starts amongst the private credit managers.”

Lack of resource

But Hara is optimistic that ultimately SLLs will be widely adopted by smaller managers. “A project of ours over the last 12 months has been educating emerging managers on this and steering them in the right direction. Up to now, their focus has been more on PR and investor relations but there’s no reason for them not to follow the lead of the bigger managers. When it comes to documentation their deals are often less competitive so it may be possible to achieve more impact.”

However, there is concern that many smaller managers simply don’t have the resources to feel confident that they can match what the larger managers are doing. “You need someone on your team who really understands ESG and sustainability and price the risk accordingly,” says Huldt.

“If you only have a dozen people in total, do you have the bandwidth and the expertise? It’s where the market is heading so they have to try and find a solution but some are scratching their heads, not sure how they’re going to do it.”

There’s also the cost issue to consider. “The cost implications of independently verifying and confirming that KPIs have been met can be considerable,” says Griffith. “Some management teams and sponsors have questioned this cost against economic benefit to the borrower from achieving the ratchet.”

“Ratchets provide a clear incentive for the borrower. Covenants will be next, and that means demanding something and not only encouraging”

Timo Hara
Certior Capital

Sabrina Fox reinforces the point that, whatever the challenges, smaller managers need to raise their game. She points to her organisation’s ESG factsheets as a useful resource and says the Alternative Credit Council has also done important work on the topic. “To the extent they haven’t already, the smaller managers need to get to work on this,” says Fox.

“There may be some tolerance from LPs for them to get up the ESG learning curve, but the market is moving incredibly fast on this topic that patience may quickly fade.”

Managers also need to be focused on regulations and guidelines, such as the role of Sustainable Finance Disclosure Regulation, but that’s not all GPs need to consider.

The Climate Change Adaptation Report by the UK’s Financial Conduct Authority examines whether loans are being labelled correctly. If they claim to be green, do they live up to that claim? The Loan Markets Association has also produced a set of principles for SLLs, which investors may expect managers offering such loans to meet.

Regulatory differences

Not everyone thinks gaining regulatory approval is absolutely necessary though – not, at least, at this point in time. “The regulations can be very unclear,” says Huldt. “There’s a lot of room for manoeuvre and it’s quite subjective. Regulatory approval would be nice to have but the key thing is tying the loans to your own overarching goals as an organisation eg, aiming to be net zero by 2040, irrespective of regulation.”

Aside from widespread adoption, the biggest challenge for SLLs at the current time appears to be credibility. “I think it’s a major problem,” says Emily Farrimond, a partner and ESG and sustainability lead at Baringa Partners, a London-based consultancy.

“Out of $65 billion-worth of lending I looked at, around half of it was questionable in its claim to be sustainable. Some of it was revolving credit facilities, which were in no sense being used to drive a sustainable outcome. Taxonimies are going to be increasingly important in assessing inbound greenwashing risk.”

Farrimond highlights other weaknesses she has found, including: the dominance of environmentally-focused KPIs, meaning social aspects are going largely ignored; a lack of transparency, with information about SLLs being kept between the borrower and the lender rather than being made publicly available; a lack of climate transition plans (Farrimond thinks it’s illogical to offer SLLs without one); and, in some cases, management not being sufficiently incentivised to bring about action on climate change.

Nonetheless, with the private debt market having only recently come to the SLL party, it seems reasonable to suggest that teething troubles are not too surprising. For the time being, investors appreciate the small steps forward. Before much longer, they are likely to become more demanding.

“This is still a ‘nice to have’ for smaller managers at the moment which means LPs can be pleasantly surprised,” says Siprut.

“But it’s probably already a ‘must have’ for larger managers and will end up being an essential offering for everyone. You have to evolve or the competition will pass you by.”

What’s material amid the green bond boom?

“When we started to do green bonds almost 10 years ago the question was ‘what is green?’,” says Tanguy Claquin, head of sustainable banking at Credit Agricole CIB and deputy chair of the Green Bond Principles Executive Committee.

“We are now entering a world where we need to establish what is material and what is ambitious for an SPT [sustainability performance target] and a KPI, and that is an even more difficult question,” says Claquin.

“I don’t want to minimise the fact that some structures may be better than others, but given the number of [KPIs] that can be taken, the various industries and company specifics, I think we have a lot of work to be done to provide guidance on what is material and what is ambitious,” he adds.

This is echoed by Rahul Ghosh, managing director of outreach and research at Moody’s ESG Solutions. “With any new product that grows quickly, there’s talk about market integrity. We saw that with the use of proceeds market, too, back in 2014-15,” he says.

Recent Moody’s analysis also suggests that sector diversification of sustainability-linked bonds is greater than in the early days of use-of-proceeds bonds.

“Over a third of the 43 deals we looked at since June 2020 were from non-investment grade issuers, whereas encouraging high-yield supply has been a challenge for the use-of-proceeds market,” says Ghosh.

While he does admit that best practice is still developing, given that relatively few bonds reference Scope 3 emissions or science-based emissions targets, Ghosh says that as more issuers came to market, investors would be able to better scrutinise KPIs and penalties.

“As we see the market grow, investors will be able to better price the potential impact of not meeting SLB targets, and that should begin to be reflected in coupon adjustments,” he says.

This extract was taken from an article published by affiliate title Responsible Investor


Watch out for the regulators

Private debt investors aiming to make a positive impact with their investments need to be able to ride the upcoming regulatory wave of sustainable finance regulations aiming to reduce the risk of greenwashing, says Jegor Tokarevich, chief executive officer and founder of Substance Over Form, a London-based alternative investments service provider.

The Sustainable Finance Disclosure Regulation came into effect in March 2021. SFDR sets out disclosure requirements for the financial sector and defines the term “sustainable investment” for the first time. It also introduces financial products with different degrees of sustainability ambitions, Article 8 and Article 9 products. Disclosures have to be made in the prospectus, annual reports, the website and marketing documents.

The general idea is simple – if you promise to make a certain impact, you need to disclose if and how you achieved it. KPIs and thresholds need to be defined and provide evidence for creating a positive impact while also avoiding a negative impact, if the fund makes sustainable investments. SFDR compliance is expected to be externally audited and in some countries, such as Germany, the external audits already began last year. From 2023 additional detailed requirements including disclosure templates and Principal Adverse Impact KPI’s are expected to become effective via SFDR Level 2 RTS. Under the SFDR, claiming that you make a positive impact requires proving it on a regular basis with impact KPIs.

Another key framework is the EU Taxonomy. The EU Taxonomy is a “green dictionary” aiming to inform the user if a certain activity is sustainable based on a set of technical criteria. It will become effective in 2022 for the first two climate goals, climate change mitigation and climate change adaptation. In 2023 the EU Taxonomy is supposed to be extended to the other four environmental goals. A Social Taxonomy is also under development.

Private debt funds will need to make Taxonomy disclosures. Various financial and non-financial “large public interest entities” (currently subject to the national implementation of the Non-Financial Reporting Directive) will have to make Taxonomy disclosures. In 2023 Taxonomy disclosure obligations are expected to be further extended to various large and listed companies via the Corporate Sustainability Reporting Directive. Taxonomy coverage and the relevance of the EU Taxonomy will gain importance over the coming years.