Lenders zero in on the fine print as ESG issuance surges

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White & Case LLPThe rise in sustainability-linked debt issuance observed in 2021 has shown little sign of slowing down as borrowers continue to focus on improving environmental, social and governance (ESG) performance in response to investor demand.

According to the Institute of International Finance, global issuance of sustainability-linked bonds—where issuers pay higher or lower coupons depending on compliance with ESG key performance indicators (KPIs)—nearly quadrupled over the first half of 2021 to US$160 billion.

White & Case’s September ESG Leveraged Loan Deal Tracker, meanwhile, shows that ESG-linked loan issuance in Europe (the world’s largest ESG debt market) climbed to €18.52 billion from 29 deals for the year to August 10, 2021. This has seen ESG-linked loans account for 19% of overall European term loan B issuance in 2021, up from only 4% in 2020.

ESG-linked margin ratchets have also gained traction in private debt markets, with Ares Management laying on a £1 billion sustainability-linked funding package for environmental engineering and technical services business RSK Group.

The deal is the largest ever private debt sustainability-linked transaction and will connect RSK’s funding costs to carbon reduction, health and safety and ethics targets. If these KPIs are met, RSK could save up to £500,000 a year in interest costs. It has pledged to donate half of any interest savings to charities.

Tightening up monitoring

As borrowers have noted the opportunity to tap the buoyant ESG-linked debt market for capital and reduce borrowing costs, lenders have taken a step back to reappraise the qualifying criteria for ESG-linked loans and high yield bonds.

White & Case research shows that 84% of ESG-linked debt deals have used KPIs as the benchmark for margin ratchets, with only a limited number opting for ESG scores or a blend of KPIs and ESG score metrics.

The rapid growth in ESG-related issuance, however, has raised the risk of “greenwashing” and the measurement and reporting of KPI compliance has become a particular area of concern for lenders, who believe further scrutiny is required.

A survey of 170 credit investors conducted by the European Leveraged Finance Association (ELFA) found that 72% of high yield bond investors want to see external verification of KPI selection and targets as a requirement pre-issuance. A quarter (26%) of respondents say they are willing to forgo third-party verification if there is full disclosure of the internal expertise and methodologies used to set KPIs. Almost all high yield participants agree that issuers should report on progress toward KPIs at least once a year.

Leveraged loan investors also want to see more rigor applied to ESG KPIs, with 71% calling for a ratings agency or third-party ESG agent to be involved in establishing KPIs. A third of loan investors want their input incorporated into setting KPIs. More than four-fifths of loan lenders (87%) want to have KPIs audited annually by external parties, with 82% saying that interest rate margins should be stepped up when issuers neglect to provide a sustainability report or third-party sign off.

Since the survey was conducted, the ELFA and the Loan Market Association have updated their Sustainability Linked Loan Principles and released a best practice guide that focuses on establishing well-defined KPIs before ESG-linked loans are offered to market.

It is hoped that this guidance will help to ensure that ESG-linked loans are credible, thus reducing any implication of “greenwashing,” but guidance is voluntary. It remains to be seen whether investors and lenders will continue pushing for mandatory third-party verification.

The right deal at the right price

In addition to reassessing verification, lenders are also considering ways to ensure that ESG-linked margin ratchets are high enough to incentivize borrowers to make impactful change.

Lenders want to ensure that margin discounts are influencing behavior in the right way and are sensitive to risks of issuers gaming the market to lock in so-called “greenium” pricing advantages.

Investors in green bonds—where proceeds are raised for specific qualifying ESG projects rather than via margin ratchets linked to overall ESG company performance—have already been grappling with this issue and examined whether offering cheaper debt for specific projects is effective when the rest of a business carries on operating with little change.

After a period where debt for particular green projects was available at a meaningful discount to “conventional” debt, spreads have narrowed as investors have become more particular about cutting the cost of capital simply because a bond fits into the “green” category.

Leveraged finance investors are also looking at whether ESG-linked discounts deliver value for money and are an effective tool for changing lender behavior. Rather than just considering their own costs, these investors are exploring whether increasing step-ups (the increments at which interest rate margins drop or increase as borrowers hit or miss KPIs) will have greater impact.

The ELFA survey found that, on average, step-ups come in at 0.25%, but that three-quarters of the investors polled say they do not believe this is substantial enough. Well over a third (39%) say a step-up in the range of 0.25% and 0.5% is suitable, with a further 30% saying that level should be 0.5% or more. Almost all lenders (90%) agree that ESG KPIs should be crystallized from the outset and not subject to flex for deals in high demand.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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