On March 2, 2024, the Loan Syndications and Trading Association (LSTA) announced the publication of the latest addition to its sustainable lending library — the Guide on Sustainability Linked Loan Principles (SLLP) in Fund Finance (the Guide). The Guide aims to provide practical guidance on the application of the SLLP in fund finance transactions by identifying challenges and considerations that may arise and discussing how the SLLP can be best utilized in the fund finance market in a manner consistent with the overarching goals of the SLLP.

Introduction

Environmental, social and governance (ESG) issues continue to be a focus for investment funds. Following the launch of the SLLP in March 2019, many lenders and borrowers in the fund finance industry have looked to the SLLP for guidance on the implementation of sustainability linked loans (SLLs) in fund finance transactions. Challenges can arise in the application of the SLLP to fund finance facilities, including (a) the difficulty of setting key performance indicators (KPIs) due to a fund’s limited physical operations, the uncertainty of an investment pipeline or a lack of consistent metrics across a fund’s underlying investments; (b) limited historical ESG data on borrowers, the fund or sponsor, as applicable, and the underlying investments; and (c) shorter tenures relative to other types of financings.

Differentiating Green Loans, Social Loans and SLLs

A key differentiator between SLLs and green loans or social loans is that the proceeds of green loans or social loans must be used exclusively to finance green projects or investments or projects or investments with a specific social impact. SLLs do not mandate the use of loan proceeds for green or social projects or investments; rather, the proceeds of SLLs can be used for any specific or general corporate purposes.

The Guide focuses solely on the implementation of SLLs in fund finance transactions.

Challenges in Applying the SLLP to Fund Finance Transactions

The Guide notes the practical challenges that have been observed in applying the SLLP in the context of fund finance transactions, including:

• The borrower in a fund finance transaction (particularly in a subscription line) will often be recently formed, with limited historical data or without a preexisting sustainability strategy.
• It can be difficult to identify relevant KPIs at the fund level because the borrower often will have limited internal operations.
• As funds are increasingly including ESG considerations in their investment strategy, borrowers in fund finance transactions may look to investments as a means to formulate KPIs. However, uncertainty and a lack of visibility of the fund’s pipeline of investments may make it challenging to predetermine sufficiently relevant and material KPIs and ambitious sustainability performance targets (SPTs) that can be consistently applied across different investments.
• While ESG considerations continue to be a focus for funds, some funds are just beginning to formulate ESG policies and face differing investor priorities.
• The diversity and quantity of investments can create concerns when it comes to the third-party verification process, as it can be cost-prohibitive to receive verification on an investment-by-investment basis and difficult to gather sufficient data from portfolio companies or find appropriate third-party verifiers across different investments.
• With respect to investments where the fund does not control the portfolio company, it may be difficult for it to exert the level of control required to ensure sufficient data can be collected or compliance with a stated SPT can be achieved.
• If a suitable KPI or SPT beyond “business as usual” cannot be determined in accordance with the SLLP, a fund will not be eligible for an SLL.
• Many fund finance facilities have a relatively short tenure of one to three years.
• Market convention and applicable regulations as to the application of sustainability principles to investment funds continue to evolve and differ by jurisdiction.

Selection of KPIs

The selection of KPIs and the incorporation of pricing adjustments must be tied to ambitious sustainability objectives relevant to the borrower’s core business or investment strategy beyond business as usual or mandated legal or regulatory requirements so as to maintain the integrity of the SLL market.

The borrower and the lender will work together to clearly identify KPIs and suitable SPTs:

• Where a KPI is tied to the fund’s investment, it may be calculated as a percentage of investments that have stated goals meeting the specified criteria.
• The KPI may also be applied to the operations of the individual portfolio companies or based on appropriate impact metrics for the fund as a whole.
• It may also be appropriate to incorporate gradual phasing in of KPIs or to include eligibility concepts to define investments that will be included in the calculation of the relevant SPTs.
• Given the potential for relatively short-tenured fund finance transactions with contemplated extension options, it may be appropriate to expand the SPTs to the latest possible contemplated maturity, or it may be more suitable to anticipate reevaluating SPTs once the facility has completed its initial term.

A non-exhaustive, indicative-only list of KPIs used in the fund finance context is set out in Appendix 1 of the Guide.

Calibration of SPTs

Market participants should carefully review the SLLP for guidance on calibration of SPTs. In all cases, the SPTs should be suitably ambitious and reflect the recommendations included in the SLLP, including (a) showing material improvement in KPIs beyond business as usual, (b) being benchmarkable or comparable to an external reference, (c) being consistent with the borrower’s sustainability strategy, (d) being generated through external guidance and discussions with any applicable sustainability coordinator, and (e) following a predetermined timeline.

Reporting

Per the SLLP, borrowers should provide reporting to the lenders as to monitoring of the SPTs at least annually. For investment-level KPIs, the loan documentation needs to build in a process for initial and ongoing evaluation by lenders of investments and verification. Lenders and borrowers should also consider the timing of reporting. If the borrower is relying on reporting from its portfolio companies, this information may be delivered at different times throughout the year. Lenders should provide borrowers with a reasonable time frame within which to collect and review information prior to delivery to the sustainability coordinator and lenders during each relevant reporting period.

Verification

The SLLP requires that borrowers obtain independent and external verification of each SPT for each KPI for any relevant period to assess performance. This should be conducted by a qualified external reviewer with relevant expertise. This external review can result in significant costs for the borrower if it needs to commission third-party reviews of reported data for a large number of investments. In order to address these challenges, lenders, sustainability coordinators and borrowers should agree upfront as to the nature and scope of verification.

Conclusion

The approaches identified in the Guide reflect strategies that have been adopted in the market but are not exhaustive regarding the means in which the SLLP can be adapted for fund finance transactions. Each transaction should be evaluated independently based on the ESG strategy, industry and investment policy of the relevant investment fund. In each case, there must be sufficient information available on the proposed KPIs, SPTs or other sustainability metrics to ensure that the stated goals or relevant KPIs and SPTs are reflective of the intention of the SLLP to advance ambitious and credible ESG policies and goals.

The Guide can be found here.

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