The European leveraged finance market is dynamic. It constantly responds to changing investor demographics and their impact on a variety of factors, including credit protection provisions, ever-increasing sponsor muscle, legal developments and lender management of risk. The latest development that has caused the market to adapt and respond has been the increasing focus by all market participants on environmental, social and governance factors.
The impetus to embrace ESG is coming from both borrowers and sponsors, as well as lenders. Borrowers and sponsors are keen to attract a diverse range of lenders and other investors, to potentially benefit from positive pricing metrics, and to position themselves well in the sustainability landscape. Lenders are looking for ESG metrics to appeal to their own investor base in turn, to improve syndication and, as their counterparts are doing also, to position themselves well in the sustainability landscape.
“One of the key challenges in both setting and meeting KPIs is that there is currently no market standard or universal measurement methodology for ESG criteria.”
The leveraged loan markets are a perfect platform to house sustainability-linked instruments – the market is sector agnostic, always hungry for price incentives and there is customarily a deep dive into a borrower and its business, leading to a close relationship between borrower and lender.
Two specific debt products have emerged in response to ESG pressures and concerns more generally. These are ‘green’ instruments, the key feature of which is that the proceeds of the financing are used for ‘green’ purposes; and ‘sustainability-linked’ instruments, under which certain terms are tied to the issuer’s performance against certain pre-determined sustainability-linked key performance indicators. While not yet a feature of every transaction, it is the latter product that is increasingly prominent in the leveraged finance space.
In practice, assessing the viability of a sustainability-linked instrument can begin at the outset of a financing transaction, and disclosure of ESG metrics and performance can readily be included within information memorandum and roadshow materials. This can assist in demonstrating an overall commitment to ESG, but also can identify where there may be opportunity to peg a borrower’s performance to pre-determined sustainability-linked KPIs. There is no market standard as such, but, typically, sustainability-linked instruments contain a margin ratchet, which is linked to the performance of the borrower against these pre-determined KPIs.
There has been a fair amount of debate as to whether any pricing ratchet should be one-way or two-way. If the former, the margin on the loan is reduced if the issuer satisfies the predetermined KPIs. If it fails to meet the target the margin does not change. However, if two-way, there is an adjustment to the margin upwards if the issuer fails to meet its KPIs.
While margin adjustments may be small, they are meaningful and, accordingly, it is important that no misleading impression is given to the market regarding a borrower’s ESG performance. To this end, transparency and verification are key to ensuring any KPI is both justifiable and defendable, while at the same time as having sufficient teeth.
Static or dynamic KPIs?
A further debate focuses on whether KPIs should be so-called “static” or “dynamic”. A static target permits the issuer to improve its performance over the pre-determined level and then plateau, whereas a dynamic target will require continuous improvements year-on-year. Clearly a dynamic target puts greater pressure on the borrower but at the same time it is likely to herald greater change and lead to improved sustainability.
One of the key challenges in both setting and meeting KPIs is that there is currently no market standard or universal measurement methodology for ESG criteria. KPIs tend to be tailored for, and specific to, each borrower, and performance may be dependent upon self-reporting, which may or may not involve a third-party rating agency or other verification.
As a consequence, generally the failure to meet a KPI will only affect the margin, and there will be no other documentation impact. However, as methodology and standardisation increases, it is expected that failure to meet KPIs, or other on-going ESG information reporting requirements, may have broader consequences such as resulting in the underlying instrument falling into default.
There are clearly challenges when introducing anything “new” into an established market and there remain a number of open questions and areas of debate. However, the European leveraged markets have certainly embraced ESG and sustainability-linked lending.
There is a similar story in US markets, and, while slightly behind Europe, the leveraged loan markets in the US are also embracing sustainability-linked instruments. As global political agendas pivot towards ESG and sustainability, and as there is a heightened awareness of ESG issues more generally, it is expected that ESG and sustainability-linked instruments in the leveraged markets will only continue.
Amy Kennedy is a leveraged finance partner in the London office of international law firm Akin Gump