Sustainability-linked loans – where a loan’s economics are tied to the borrower’s achievement of certain ESG or environmental (or, less often, social or governance) key performance indicators – aren’t coming to the loan market. They are already here.
According to PRI, the United Nations organisation created to foster sustainable investing, “global sustainable lending activity grew from $6 billion in January 2016 to $322 billion in September 2021. As of that month, sustainable lending represented more than one-tenth of the global corporate syndicated loan market”.
Nowhere is the SLL market more developed than Europe: According to the European Leveraged Finance Association, the volume of leveraged loans containing an ESG-linked margin ratchet reached three-quarters of the total issuance in the fourth quarter of 2022. Comprehensive data for private credit is harder to come by, but Debtwire reported that, through the first three quarters of last year, one in four privately negotiated loans in Europe contained ESG triggers.
Sustainability triggers are less common in the US loan market, but they are gaining traction – at least relatively. In 2022, a year when overall leveraged loan issuance was down 24 percent, SLL issuance was down only 12 percent versus the previous year, reaching $206 billion in the US last year.
With the growing prevalence of sustainability-linked loans – and especially as the structures push down into the mid-market from the broadly syndicated space where they are more common, and where value is easier to determine by reference to pricing services, actual trades and indications from market makers – private debt valuation teams will need to refine their approaches to assessing fair value for less liquid SLL loans.
In most SLLs, the lender(s) and borrower establish KPIs and sustainability performance targets tied to those indicators, and if the borrower achieves the SPTs, it is rewarded with lower interest; if it falls short, it pays higher interest. The pricing adjustments tend to range from 5-25 basis points. Performance against the SPTs is typically assessed annually when borrowers certify their performance – in many cases, with an accompanying report by a third party.
Interestingly, the annual certification feature and the relative newness of the SLL market – at least in the US – means that many SLLs have not yet celebrated their first birthday but will in the coming months.
How are SLLs initially priced and valued? Most market participants are familiar with performance-based pricing, which is a relatively common feature of loan agreements regarding credit quality – credit rating triggers or, more commonly in the private market, accounting ratios concerning leverage, usually debt/EBITDA.
For SLLs, valuation methodologies and processes are essentially the same. The pricing grid will account for meeting or not meeting the KPIs. However, valuations will require comparing the SPT-driven pricing grid to the current market. For example, if the subject company is not meeting its KPIs and its coupon pricing adjusts up by, say, 10bps, but current market SLL loans not meeting SPT targets may be priced at a much higher premium than 10bps. The valuation yield would need to be adjusted up to the market, above the pricing grid coupon, and be priced at a discount.
As the SLL market for BSL and private loans continues to develop, pricing services and valuation agents will begin to better track pricing for SLL loans to have adequate benchmarks. Currently, there are not a lot of data points, but this will change as SLLs become more prevalent.
SLL valuation is similar. VRC views the SPT and margin adjustments as part of the underwriting calibration, like other pricing grids. All else equal, if an issuer moves within the pricing bands, VRC would generally apply a similar margin adjustment in line with the pricing grid. As a result of the offsetting adjustment, changes would be value-neutral.
VRC may view the pricing grid as value-impacting if the pricing for market clearing SLLs, margin ratchets or SPTs materially changes from the calibration. A more common example would be for a leverage-based pricing grid where the market reduces allowable leverage limits after issuance and, therefore, the original leverage limits are not representative of market terms. VRC would adjust the credit spread to reflect the higher relative risk of the existing pricing grid versus the “market” pricing grid.
As borrowers and end investors alike look to bolster their ESG bona fides, SLLs are becoming an increasingly common feature in the private credit market that valuation professionals will have to deal with, but the concepts of performance pricing with respect to leverage ratios that are well known to most market participants are a good place to start in reflecting the new instruments.
John Czapla is chairman of VRC and leads the firm’s Private Portfolio Group; Adrian Lowery is a managing director in the group, specialising in valuations of privately-held debt and equity securities.