A few years ago, when subscription credit lines were first put under a harsh spotlight, some managers reacted with barely disguised annoyance. These were humdrum, fund-level credit facilities, they said, used to efficiently manage LP capital calls, uncontroversial for a majority of investors. So, what if they boosted IRR? That was a minor side effect, not a raison d’être. The media scrutiny, those GPs contended, was a classic storm in a teacup.
Fast-forward and sub-lines are again under the spotlight, this time wheeled there by managers. Humdrum no longer, they are now on the front line of ‘doing good’, tied to environmental, social and governance or sustainability criteria to create a ‘win-win-win’ scenario: a win for funds and their LPs, which benefit from better pricing if they meet the agreed KPIs; a win for portfolio companies, which have one more incentive to be better; and a win for lenders, who get to boost their sustainable books in exchange for a few basis points (or maybe in addition to, if GPs end up getting penalised).
Unsurprisingly, ESG-linked sub lines are generating “a huge amount of interest,” Tom Smith, partner at Debevoise & Plimpton, told Private Equity International. Smith helped organise two of them for EQT, including the largest in the market – a €2.7 billion sub line secured against EQT Infrastructure V. InfraVia Capital Partners’ SDG-linked bridge facility for its fourth flagship fund offers another recent example, as is ICG’s £550 million ($760 million; €626 million) revolving credit facility, and there are plenty more across asset classes.
Proponents of these instruments see them as a useful way for senior management to sharpen the minds of their deal teams, or as evidence managers are walking the talk. But if financial incentives are the name of the game, are sub lines really the best way to create impact?
For example, wouldn’t it be more impactful to first link portfolio companies’ senior debt to a set of ESG KPIs? After all, a 10 to 20 percent discount/penalty to market margins on senior debt – the kind of range attached to ESG-linked sub lines, sources told PEI – would have a much more material effect, sharpening all stakeholders’ minds. Tenor could also play a role, perhaps, with longer-term loans linked to hitting sustainability criteria – and the prospect of an early refinancing if targets fell by the wayside.
On the equity side, manager fees would be the obvious place to target. For example, LPs could get a rebate if sustainability targets were not met. Or perhaps ESG KPIs could form a bigger part of performance compensation, more on a par with traditional financial metrics.
We know some of the above is already happening, such as linking senior-debt loans to ESG targets, although we are unaware of a fund having most of its assets’ senior debt ESG-linked. We did ask InfraVia if it was currently linking portfolio-company senior debt to the SDGs and were told that is under consideration.
We are also not suggesting GPs are presenting ESG-linked sub lines as the be all end all of incentivisation. They are not, and most are clear these instruments fit into wider ESG or sustainability frameworks.
In that sense, they are one of the tools at managers’ disposal. But as they garner increased attention, we are not entirely convinced they are the sharpest tool in the shed.
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