The market for sustainable finance is growing fast as credit funds line up to offer sustainability-linked loans (SLLs) in response to sponsor and investor demand. Yet while borrowers benefit from cheaper debt on the back of ESG-linked margin ratchets, fears that the market is falling down on transparency threaten to damage credibility and suggest there is still some way to go before sustainable finance starts making an impact.

Management consultancy Baringa Partners recently conducted an analysis of a sample of 10 SLLs totalling circa $35 billion to a diverse pool of large, multi-region corporate borrowers. They found as many as half of those loans could be open to accusations of greenwashing. A fifth of the loans went to firms that had no publicly stated sustainability targets associated with the loan, while only half of the SLLs revealed how the targets set would be measured or externally validated.

Emily Farrimond, partner and ESG and sustainability lead at Baringa, says: “These loans are really positive when they are put in place to specifically drive some kind of sustainability outcome. The loans that are there for a specific point of transition, to support a borrower going from brown to green and with the potential pricing differential enabling the company to do that more quickly and efficiently, are a positive development. But we found a lot of this lending wasn’t tied to science-based targets and, where there were targets, those were often not tracked or reported on.”

The Loan Market Association says SLLs should be designed to help borrowers achieve “ambitious, pre-determined, sustainability performance objectives”, using performance criteria to measure progress either by way of ESG ratings or clearly agreed science-based targets or KPIs. But there are no commonly accepted standards around SLLs and their target measurement, leaving lenders open to charges of setting weak goals and doing little to ensure delivery.

Minimum requirements

Farrimond says there should be some minimum requirements if credit managers are considering lending on this basis: “First, there should be alignment with the LMA’s principles, with good clear and robust science-based targets in place that are going to be actively managed and monitored on an ongoing basis, and probably renegotiated as well.

“Then, it is about working out what the additional baseline requirements are. Is having a credible transition plan an entry-level requirement for a borrower? Or if they don’t have one, are you going to support them with getting one pretty quickly?”

Finally, Baringa says lenders must be prepared to proactively demonstrate to the market that sustainable lending has been done on a robust basis. A consultation paper from the Financial Conduct Authority is expected soon and it is likely the regulator will expect that transparency as a minimum, says Farrimond.

Despite these challenges, many credit funds are now actively pursuing SLLs and, according to research from Bank of America, the first half of 2021 saw the take-up of such loans hit $350 million. That was far in excess of the $200 million achieved for the whole of 2020, previously the busiest year for sustainability-linked lending.

ESG opportunity

One compelling advantage for private debt funds is that these loans give lenders an opportunity to discuss ESG with borrowers, despite having no ownership rights. The ability to exert that influence is appealing to investors.

Anthony Fobel, CEO at Arcmont, says: “We are increasingly linking loans to positive ESG outcomes for our portfolio companies. In particular, identifying company specific ESG improvements that, if met and independently verified, result in a margin ratchet, thereby reducing the interest cost to the company. In this way, although not the ultimate owners and controllers of businesses, private debt funds can put in place meaningful incentives to encourage portfolio companies to improve their ESG ratings.”

“We are increasingly linking loans to positive ESG outcomes for our portfolio companies”

Anthony Fobel

Tikehau Capital has been one of the leaders of ESG-linked loans. Cécile Lévi, Tikehau’s head of private debt, recognises the products still have some way to develop, saying: “The main hurdle is measurement, because you need to make sure that’s harmonised and there is some agreement on the way we report. That will take years, but maybe some accounting rules will come so that, like revenues and EBITDA, there will harmonisation on standards.”

However, she adds: “We consider these ESG ratchets will become market standard to the point where it should not be something you have to highlight and treat separately. They will become plain vanilla, and when that’s the case we will be where we should be. We don’t see any pushback – on the contrary, people are willing to embrace this.”

Ares goes big

At Ares, partner and co-head of European credit Blair Jacobson points to its recent £1 billion ($1.35 billion; €1.19 billion) loan to RSK, an environmental engineering consultancy, as a turning point for its business. Ares acted as sole lender of those debt facilities in August 2021, believing at the time that the deal was the largest private credit backed sustainability-linked financing deal ever agreed on the market.

Jacobson says: “In order to work well, the target KPIs on these loans have to be real, measurable and quantifiable by a third party, and it can’t be a one-way street. If a company does what it says it’s going to do, then any savings need to go to a good place. We have committed £1 billion to help RSK achieve their growth ambitions, and together we identified four different sustainability targets, from emissions reduction targets to inclusivity and diversification, and employee safety.”

If RSK meets the targets, it gets a break on the interest rate. If not, the rate ticks up, Jacobson explains, so it is not a one-way option. If there are cost savings, those have to be devoted to a sustainability-linked initiative or charity.

He says: “We were delighted to do the deal and have since done a couple more. But these loans have to go to the right companies. They have to take it seriously and it can’t be a free option – it needs to work for all the stakeholders. When it works it’s beautiful, and we believe it’s going to become much more common.”

Stuart Brinkworth is a partner and head of leveraged finance in Europe for the law firm Mayer Brown. He says funds are increasingly keen to offer SLLs, sometimes in response to LP demand, but it is not easy. “The challenge for the funds is how to come up with a set of criteria that’s applicable to a business and make the margin ratchet work in any kind of meaningful way.

“Typically, the incentives are quite small, with quite small increments on the margin, so that doesn’t necessarily make a material difference to the interest costs for the business. Borrowers are not going to spend money to achieve a 15bps reduction on the margin, and at the same time the funds don’t necessarily have the expertise in this particular area and so are struggling to come with up with relevant KPIs.”

He says a lot of ESG ratchets are now being put into term sheets, “but often when funds are offering these, nobody really knows how it’s going to work. It becomes a conversation, but people don’t necessarily understand what needs to be done to achieve the ratchets”.

Lenders stepping up

Sponsors are driving developments, but lenders are meeting the challenges

Thomas Smith, a partner at the law firm Debevoise & Plimpton, says: “The benefits of these facilities to lenders are certainly less tangible than they are for the borrowers. They may even end up accepting lower pricing on facilities if the sponsor performs against the ESG metrics set, though pricing adjustments are small. That said, the major benefit for lenders is being at the forefront of a growing market with a positive focus. There is little doubt this trend is one that will endure, so offering ESG-linked fund facility products allows lenders to potentially grow their market share.”

There is clearly some way to go before sustainability-linked lending can realistically tick all the ESG boxes, but there is appetite on all sides to get there. Stuart Brinkworth, a partner and head of leveraged finance in Europe for the law firm Mayer Brown, says: “People should absolutely be applauded for trying to do this, but the reality is the market is trying to do this properly today but the knowledge and capabilities don’t necessarily yet exist to do it in a meaningful way. At the moment, this is not realistically contributing to energy transition or slowing climate change, but as time goes on it has potential to make a real difference.”

ESG-linked financing

At Bridgepoint Credit, deputy managing partner Hamish Grant says the business now seeks to include ESG-linked financing on all new primary deals. “The key thing we are trying to achieve with these ESG ratchets is a meaningful improvement on ESG KPIs by incentivising companies to do something that they otherwise would not necessarily have done.”

Bridgepoint Credit recently closed an ESG-linked subscription line for each of its flagship credit funds, believed to be among the first of their kind entered into by a credit manager with its lenders. That arrangement includes KPIs that reward Bridgepoint Credit’s investors for improved diversity and inclusion within their fund manager, increasing the number of ESG-linked loans in their portfolios, and achieving external recognition as top-tier credit funds with a focus on sustainability.

“I think the genie is out the bottle on these types of financings”

Thomas Smith
Debevoise & Plimpton

Sustainability-linked fund financing is another growth area. EQT closed one of the first such subscription line facilities in 2020, securing €2 billion-plus from a club of lenders with an agreement that if it improved certain ESG metrics in its portfolio the margin of the facility would go down and, if not, the margin would go up.

Thomas Smith, a partner at the law firm Debevoise & Plimpton, advised on the EQT deal and says there are more SLLs to come in fund finance: “I think the genie is out the bottle on these types of financings. There is clearly investor appetite for sponsors to be putting these facilities in place, and lenders are alive to the opportunity. They won’t be appropriate in every circumstance or for every strategy, of course, but there’s little doubt this is a growth market that will continue to expand rapidly.”

While the trend has so far been driven by private equity sponsors, Smith says these types of facilities are expanding into real estate, infrastructure, secondaries and credit funds: “Secondaries and credit funds, which don’t necessarily have the control rights to effect ESG-linked changes to their investment portfolio, are thinking very creatively about ESG metrics that they could use.”