Sustainability and the German mid-cap finance market

With an increasing number of sustainability-linked loans being issued in Germany, Oliver Hahnelt of McDermott Will & Emery looks at how firms can integrate ESG into their loan process.

Amid the still-lingering covid-19 pandemic, historic production disruption and shortages in raw material, increasing inflation and the Ukraine war, M&A activity managed to be very strong in Germany, with a large number of transactions closed in the first half of 2022. This is in line with many other Western European jurisdictions where asset managers report more business is being done in the first half of 2022 than in the first half of 2021.

Dr Oliver Hahnelt

On the other hand, it is a clear trend that sponsors are increasingly concerned with overpaying for assets in the context of a global revaluation of public market stocks. As a consequence, sponsors are enhancing due diligence processes to assess even more thoroughly transaction risks (for example, the impact on continuing supply chain instabilities).

However, enhanced due diligence takes time, resulting in transactions taking longer than they did over the last few years, and there is great likelihood this trend will continue in 2022. Overall, this may lead to a lower number of closed transactions, at least in certain segments.

Another trend is that sponsors, investors, corporates and likewise financiers put an increasing emphasis on broader corporate social responsibility and the contribution of investments and businesses to sustainable development. In that context, environmental, social and governance issues are on the rise in making investment decisions. What has already been well established in the public markets has now found its way to the private lending sector.

As there is not currently a legal standard, neither for addressing ESG issues nor for measuring ESG compliance despite the best efforts of a large number of participants, there is no uniform approach in the German market for sustainability-linked loans. However, in the German mid-cap financing space, most firms say addressing ESG goes beyond the measurement of mere credit risks, but also incentivising a company to improve its environmental and social impact.

The focus of ESG-linked loans is not to finance green projects only, but to measure and monitor ESG compliance against sustainability-linked KPIs. Those KPIs may either be very generic or very specialised, but they also link to the inclusion of environmental protections in credit documentation, which had disappeared from many leveraged loans.

The setting of these KPIs (as well as the number of performance indicators itself) is left for the participants to decide on a deal-by-deal basis. Within this dynamic, the Loan Market Association has developed its Sustainability-Linked Loan Principles to promote the integrity of sustainability-linked loan products.

Where possible and as a recommendation, KPIs should be, among other things:

  1. Relevant, core and material to the borrower’s overall business, and of high strategic significance to the borrower’s current and/or future operations;
  2. Measurable or quantifiable in a consistent methodological basis; and
  3. Able to be benchmarked.

While it is clear that benchmarking and measurement are key constituents of the KPI indicators, our experience is that some indicators remain more generic in nature.

As with the setting of KPIs, there is not (yet) a binding framework as to the methodology of reporting KPIs, and there is clear and obvious difficulty in making any framework binding. The market offers everything from external analysis and third-party reporting (sometimes proving a formalised ESG rating score) to self-imposed verification and reporting by the relevant company’s management. The option selected is the result of negotiation and often driven by the party that is pushing hardest for the inclusion of ESG-linked indicators.

The incentivisation component of ESG-linked financings comes with the pricing ratchet. In practice, failure to comply with the KPIs is generally not subject to a margin premium, whereas compliance with all or some KPIs may result in a reduction of the margin. In more recent and sophisticated ESG-linked financings, the documentation provides for the obligation to apply the equivalent amount of the reduced margin in a pre-defined manner (for example, reinvestment to improve ESG performance), though this is a minority deal feature.

Irrespective of how the German mid-cap finance market will develop overall, integration of sustainability-linked finance is and continues to be one of the hot topics in 2022, and we do not expect it to lessen in the near future.

Dr Oliver Hahnelt is a partner at McDermott Will & Emery in Frankfurt.