The market for sustainable finance is expanding as sponsors increasingly look to source sustainability-linked loans in response to investor and regulatory ESG pressure. Yet, while borrowers can benefit from cheaper debt on the back of ESG-linked margin ratchets, fears that the market is falling down on transparency threaten to damage credibility and suggest there is still some way to go before sustainable finance starts to make an impact.

Management consultancy Baringa Partners conducted an analysis of a sample of 10 sustainability-linked loans, totalling circa $35 billion, to a diverse pool of large, multi-region corporate borrowers. It found that as many as half of those loans could be open to accusations of greenwashing. A fifth of the facilities went to firms that had no publicly stated sustainability targets associated with the loans. Only half of the loans revealed how the targets set would be measured or externally validated.

Emily Farrimond, partner and ESG and sustainability lead at Baringa, says: “These loans are really positive when they are put in place to specifically drive some kind of sustainability outcome. The loans that are there for a specific point of transition, to support a borrower going from brown to green and with the potential pricing differential enabling the company to do that more quickly and efficiently, are a positive development. But we found a lot of this lending wasn’t tied to science-based targets and, where there were targets, those were often not tracked or reported on.”

The Loan Market Association says sustainability-linked loans should be designed to help borrowers achieve “ambitious, pre-determined, sustainability performance objectives”, either by way of ESG ratings or clearly agreed science-based targets or KPIs. But there are no commonly accepted standards around sustainability-linked loans and their target measurement, leaving lenders open to charges of setting weak goals and doing little to ensure delivery.

Farrimond says there should be some minimum requirements if sponsors are considering borrowing on this basis: “First, there should be alignment with the LMA’s principles, with good, clear and robust science-based targets in place that are going to be actively managed and monitored on an ongoing basis, and probably renegotiated as well.

“Then, it is about working out what the additional baseline requirements are. Is having a credible transition plan an entry-level requirement for a borrower? Or if they don’t have one, are you going to support them with getting one pretty quickly?”

Farrimond says lenders must be prepared to proactively demonstrate to the market that sustainable lending has been done on a robust basis. She adds that a consultation paper from the Financial Conduct Authority is expected soon and that the regulator is likely to expect that transparency as a minimum.

Pursuing loans

Despite these challenges, many sponsors are actively pursuing sustainability-linked loans and, according to research from Bank of America, the first half of 2021 saw the take-up of such loans hit $350 billion. That was far above the $200 billion achieved for the whole of 2020, which was previously the busiest year for sustainability-linked lending.

“The momentum in the market is now very much geared towards having ratchets on transactions”
Stuart Brinkworth
Mayer Brown

Stuart Brinkworth, a partner and head of leveraged finance in Europe for law firm Mayer Brown, says: “About half of sponsor-led deals are now coming to market with some sort of ratchet, either very specific or with the details to be agreed with the lender at a later date. Twelve months ago they were few and far between. The momentum in the market is now very much geared towards having ratchets on transactions and I think they will become the norm. Obviously, the criteria will be bespoke for each particular business, but if they are not on every deal by this time next year, I would be surprised.”

Avoiding charges of greenwashing is a key concern for borrowers. Susannah Amini, a partner in the finance practice at law firm Kirkland & Ellis, says: “Sponsors want to show LPs they are putting in place ratchets and that the conditions they are choosing are both defensible and achievable. The reporting also has to be robust. Sponsors want to avoid any chance that a lender can come back and say, ‘You told us you had achieved X but actually we can prove you only achieved Y’, or any risk that the ESG label has to be removed from the loan. Now these ratchets are getting tested more and more, which means we will see a more robust set of drafting in due course.”

“I think the genie is out of the bottle on these types of financings”
Thomas Smith
Debevoise & Plimpton

At Tikehau Capital, head of private debt Cécile Lévi recognises that the products still have some way to develop: “The main hurdle is measurement, because you need to make sure that’s harmonised and there is some agreement on the way we report. That will take years, but maybe some accounting rules will come so that, like revenues and EBITDA, there will be harmonisation on standards.

“We consider these ESG ratchets will become market standard to the point where it should not be something you have to highlight and treat separately. They will become plain vanilla, and when that’s the case we will be where we should be. We don’t see any pushback – on the contrary, people are willing to embrace this.”

At Ares, partner and co-head of European credit Blair Jacobson points to its £1 billion ($1.4 billion; €1.2 billion) loan to RSK, an environmental engineering consultancy, as a turning point for its business. Ares acted as sole lender of those facilities in August 2021, believing at the time that it was the largest private credit-backed sustainability-linked financing deal ever agreed on the market.

Jacobson says: “In order to work well, the target KPIs on these loans have to be real, measurable, quantifiable by a third party, and it can’t be a one-way street. If a company does what it says it’s going to do, then any savings need to go to a good place. We have committed £1 billion to help RSK achieve their growth ambitions, and together we identified four different sustainability targets, from emissions reduction targets to inclusivity and diversification, and employee safety.”

If RSK meets the targets, it gets a break on the interest rate, Jacobson explains. If not, the rate ticks up, so it is not a one-way option. If there are cost savings, those have to be devoted to a sustainability-linked initiative or charity.

“We were delighted to do the deal and have since done a couple more,” says Jacobson. “But these loans have to go to the right companies. They have to take it seriously and it can’t be a free option – it needs to work for all the stakeholders. When it works, it’s beautiful. And we believe it’s going to become much more common.”

Setting KPIs

Brinkworth says funds are increasingly keen to offer sustainability-linked loans, sometimes in response to LP demand, but this is not easy.

“The challenge is how to come up with a set of criteria that’s applicable to a business and make the margin ratchet work in any kind of meaningful way,” he says. “Typically, the incentives are quite small, with quite small increments on the margin, so that doesn’t necessarily make a material difference to the interest costs for the business. Borrowers are not going to spend money to achieve a 15bps reduction on the margin, and at the same time the funds don’t necessarily have the expertise in this particular area and so are struggling to come with up with relevant KPIs.”

At Bridgepoint Credit (whose owner, Bridgepoint, is the owner of Private Equity International publisher PEI Media) deputy managing partner Hamish Grant says the business now seeks to include ESG-linked financing on all new primary deals: “The key thing we are trying to achieve with these ESG ratchets is a meaningful improvement on ESG KPIs by incentivising companies to do something that they otherwise would not necessarily have done.”

Bridgepoint Credit closed an ESG-linked subscription line for each of its flagship credit funds, which are believed to be among the first of their kind entered into by a credit manager with its lenders. That arrangement includes KPIs that reward Bridgepoint Credit’s investors for improvements it makes in terms of diversity and inclusion, increasing the number of ESG-linked loans in its portfolios, and achieving external recognition for its funds as top-tier credit vehicles with a focus on sustainability.

Sustainability-linked fund financing is a growth area. EQT closed one of the first such subscription line facilities in 2020, when it secured €2 billion-plus from a large club of lenders. This included an agreement that if EQT improved certain ESG metrics in its portfolio, the margin of the facility would go down and, if not, the margin would go up.

Thomas Smith, a partner at law firm Debevoise & Plimpton, advised on the EQT deal and says there are more sustainability-linked loans to come in fund finance. “I think the genie is out of the bottle on these types of financings,” he says. “There is clearly investor appetite for sponsors to be putting these facilities in place, and lenders are alive to the opportunity. They won’t be appropriate in every circumstance or for every strategy, of course, but there’s little doubt this is a growth market that will continue to expand rapidly.”

Although the trend has so far been driven by private equity sponsors, Smith says these types of facilities are expanding into real estate, infrastructure, secondaries and credit funds. “Secondaries and credit funds, which don’t necessarily have the control rights to effect ESG-linked changes to their investment portfolio, are thinking very creatively about ESG metrics that they could use,” he adds.

There is clearly some way to go before sustainability-linked lending can realistically tick all the ESG boxes, but there is appetite on all sides to get there. Brinkworth says: “People should absolutely be applauded for trying to do this, but the reality is the market is trying to do this properly today but the knowledge and capabilities don’t necessarily yet exist to do it in a meaningful way. At the moment, this is not realistically contributing to energy transition or slowing climate change, but as time goes on it has the potential to make a real difference.”