Debevoise & Plimpton on a new string in fund finance’s bow

Private equity sponsors are driving ESG developments in fund finance, write Thomas Smith and Felix Paterson of Debevoise & Plimpton.

Thomas Smith
Felix Paterson

This article appears as part of our February Responsible Investment Special.

Environmental, social and governance considerations have only recently become a notable trend in fund finance, driven by developments such as the closing of EQT’s
ESG-focused subscription facility last year. The €2 billion-plus subscription line facility incorporated ESG mechanics and was signed up to by a large club of lenders. The theory of the mechanics is quite straightforward (though underpinned by complex ESG metrics) – if the sponsor successfully improves certain ESG metrics of its portfolio companies, the margin on the facility will go down and, if certain metrics are not met, the margin will go up.

The EQT facility was among the first of its type and remains the largest of its kind. There have been a handful of similar deals done since (including another very large transaction led by EQT), and the market is growing as sponsors, LPs and lenders alike see the benefits of a fund-level focus on ESG.

The real advantage of putting in place a capital call facility with ESG mechanics is that it institutionalises the focus on ESG for a sponsor. The benefit from the margin adjustment encourages management and deal teams to improve ESG metrics in portfolio companies, so all levels of a PE firm become focused around that objective.

For sponsors that are serious about ESG, adding ESG mechanics to a subscription line facility is a tool that allows them to demonstrate that commitment. The purpose is not to limit the type of investment the fund can make and ESG provisions in a subscription line facility are not intended to require a sponsor to pass up investment opportunities (although there are other types of ESG-focused facilities that can work this way).

Rather, the ESG mechanics in a subscription facility are designed with a focus on ensuring the sponsor improves ESG metrics post-investment. The metrics are therefore necessarily bespoke, as they must take into account the types of investments that may be made by a sponsor going forward, and the ESG-focused levers available to a sponsor in respect of those investments.

Changing lender views

For their part, fund investors are focused on encouraging sponsors to do more in the ESG sphere and the establishment of an ESG-linked fund facility is the sponsor’s assurance of alignment with its investors’ needs. It is also interesting to see lender views on
ESG-focused facilities changing. Although the benefit to lenders is less tangible and lenders may end up accepting lower pricing on their facilities if the sponsor performs against the ESG metrics, more lenders are seeing the benefits of using ESG-linked fund facilities, as offering the product allows them to potentially expand their market share.

ESG-focused developments in fund finance to date have been driven by private equity sponsors, but we see the market expanding to all types of strategy, including real estate, infrastructure and even secondaries and credit funds (where the sponsor does not have control over the underlying investment).

This is a novel and exciting strand of fund finance, reflecting both macro geopolitical trends and asset managers’ interest in responsible investing. We envisage it continuing to grow.

Thomas Smith is a partner at Debevoise & Plimpton. Felix Paterson is an associate.