2021 was the year that ESG-linked credit facilities truly emerged.
“This year we really started to see a lot more ESG-linked loans issued,” said Jonathan Beeson, an associate director at InfraRed Capital Partners. Beeson was taking part in a New Private Markets virtual roundtable alongside three other private markets managers in December. All the managers involved had substantial experience in the emerging area of ESG-linked credit facilities in private markets.
To recap: this year has seen numerous examples of credit facilities arranged – both at the fund or at the asset level – with a margin ratchet linked to sustainability goals. Put simply: if you meet sustainability targets, the cost of your facility it lower.
“I think a few years ago it was a case of lenders and borrowers educating each other, frankly, in terms of what the KPIs or targets should be: what can be verified,” said Beeson, who noted that “the banks have become a lot more established” in the area and are competing to get into these facilities. “I’ve been surprised – from 12 months ago to now – by the sheer appetite from the banks and their desire to push into the space.”
InfraRed manages two listed infrastructure investment vehicles, both of which have revolving credit facilities that are linked to ESG targets.
Zongzhong Tang, ESG and sustainability manager for Baring Private Equity Asia, said he had been surprised by the “genuine, innovative, entrepreneurial spirit” shown between firms like his and the banks. BPEA worked with BNP Paribas and Standard Chartered as sustainability coordinators as part of a group of nine participating lenders, on a massive $3.2 billion ESG-linked facility to support its private equity platform.
“We are all very creative in a way,” he said, explaining that targets for portfolio companies progressively step up in line with portfolio companies’ progress. So, if the company in question is not yet measuring emissions, then that will be its target for year one. Once that target is met, then the next year’s target is to set emissions reduction goals. “We know some of these topics can take some time, and some companies will need some hand-holding,” he said.
With firms and lenders getting creative, there is also a desire to share information on emerging practices. ESG is a “collaborative corner” of finance, as Megan Starr, head of impact at Carlyle Group, put it. Carlyle has now secured about $12 billion of ESG-linked financing at both the asset and fund level; Starr recently had a call with fellow ESG head at a US private equity firm to walk through Carlyle’s approach to setting and negotiating KPIs.
There is competition as well as collaboration, Starr added, but “that is going to lead to better outcomes and environmental and social progress”.
EQT is another firm that has taken an early lead in this space. In June 2020, the firm secured an ESG-linked fund-level bridge facility with an upper limit of around €5 billion. BNP Paribas and SEB were the sustainability coordinators. “We are very happy to be transparent about it and share our learnings,” said James Yu, a partner at the firm responsible for the financing activities in the private equity and mid-market teams. “Our banks are asking us for permission to pitch other sponsors with what they have done with us… and we welcome that.”
InfraRed’s Beeson is seeing ESG innovation move beyond credit facilities into other banking products, for example foreign exchange hedging or inflation swaps. “InfraRed has done both of these,” he said, which is “part of trying to engrain ESG into everything we do”.
Beeson described how the ESG-linked revolving credit facility on one of its listed vehicles – a margin ratchet linked to three sustainability metrics – had been adapted. “We have taken that same basic mechanism and applied it to foreign exchange hedging and also to inflation swaps,” he said. “If we hit these targets, we get a benefit across the fund in our various products with the banks. It is really taking one mechanism and applying it across several areas of risk management.”
Expect more of this type of innovation, said Beeson: “That is definitely a shift we are going to see.”
What else will 2022 bring? More sophistication, according to Carlyle’s Starr. “These ratchets are going to get more sophisticated and more nuanced with every single transaction done,” she said. “That’s a great thing for the field as we all have to keep raising the bar.”
She cited creative use cases for the proceeds as another area of development in the next 12 months: “How do you incentivise management to direct [proceeds] towards green capex, for example?” She also pointed to the development of more ambitious targets, noting that in the €2.3 billion line of credit arranged for its European private equity business this year, one of the targets was that every Carlyle director serving on a portfolio company board to go through “really rigorous external training” on ESG management best practice.
This development must not happen at the expense of simplicity, Starr said: “God forbid we get an ESG-linked ratchet with 100 underlying KPIs.”
BPEA’s Tang agreed on the likely development of more ambitious targets, adding that we may well see an added layer of qualitative assessment over the quantitative targets. “For example, instead of only looking at female board members or senior managers as single metric, it may be even more meaningful to see what the companies are doing qualitatively to get there,” he said, giving examples of unbiased recruitment processes and better provision for parental leave.
Indeed, one of the banks BPEA worked with on its loan did ask for qualitative information, specifically updates on companies’ policies and processes, as well as the top-line quant data. “Maybe that part is not directly linked to the ratchets, but it can be part of the overall package,” he said. “And that’s a good thing.”
Along with more ambitious and sophisticated targets, we will see more scrutiny of the data, said EQT’s Yu. “We are getting a lot of comments from lenders generally in the leveraged finance space; they like to see issuers be more consistent and robust in their disclosure.”
Such a desire may be met by greater involvement of third-party ratings agencies, said Yu. “Whether it is a rating agency or another third party; they are trying to insert themselves into this,” he said. “This is not necessarily a bad thing,” but he questioned whether a third party proactively giving ESG ratings without the issuer’s consent is really “always the right way to do it”.
Yu continued: “We may have what we think are robust KPIs and robust disclosure, but it can be hard for lenders to know: is this company the best it can be in this space or not? Who’s going to help them analyse and determine that; that’s something we may see more of as well.”