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There has been a dramatic increase in appetite amongst funds for
sustainability linked loans (SLLs), which are often commonly
referred to as “ESG linked loans” or “KPI
loans,” an appetite that is expected to continue to increase
in the coming years. This article provides an outline of SLLs, as
well as some key structuring considerations.
What are SLLs?
SLLs are loans that incentivize the borrower’s commitment
to sustainability through predetermined sustainability performance
targets (SPTs) that are measured by using key performance
indicators (KPIs). When these KPIs are met, the borrower may
receive the benefit of a discount in its loan pricing. This is not
always the case. In certain circumstances where a discount is
provided, the parties may elect to donate such discount to
environmental charities or to other environmental, social or
governance (ESG) purposes or projects.
Are SLLs the same as Green Loans?
SLLs are not the same as green loans. Green loans must be used
to finance green projects, whereas the use of loan proceeds is not
a determinant for SLLs, although it is possible for a SLL to also
be a green loan.
Why are borrowers interested in SLLs?
Companies today are increasingly devising sustainable, diversity
and green strategies, which inevitably form part of the financing
criteria. SLLs help to achieve these objectives by holding the fund
in question accountable and offering greater transparency to
investors. Borrowers and lenders can also benefit by building
stronger value-based relationships with investors/funds that value
ESG investing, and both parties can also benefit from a positive
reputational impact as advocates of such ESG goals.
Setting the SPTs and KPIs
Borrowers and lenders will negotiate the SPTs and KPIs and,
typically, a “Sustainability Agent” or
“Sustainability Coordinator” will be appointed and will
lead negotiations on behalf of the lender group. While there is no
market standard for SPTs, the SPTs will be linked to one or more
ESG considerations that support the borrower’s existing
sustainability strategy. General examples of SPT categories include
board diversity, healthy living environment, and low carbon
emissions.
When determining the SPTs and KPIs, it is important to consider
the following:
(1) The life of the loan
SPTs should apply for the life of the loan, and so it’s
important to therefore consider how long the loan is when
determining the achievability of the SPT. Depending on the life of
the loan, the parties may wish to set the KPIs on an incremental
basis, or, alternatively, the parties might wish to include a
mechanism whereby the KPIs can be revisited periodically to assess
their suitability.
(2) The amount and complexity
of KPIs
While it is extremely important to properly monitor and measure
the SPT through the use of KPIs, consideration should also be given
to the administrative burden on the parties if using multiple
and/or complex KPIs. Quality over quantity is preferred. If
multiple and/or complex KPIs are being used, a third-party reporter
may be preferable, if such third party has knowledge of the
complexities involved and/or is better placed to properly monitor
the KPIs.
(3) Reporting obligations
Borrowers should report on the SPT at least once a year, and the
parties should also consider whether more frequent reporting is
required based on the nature of the SPT. SPTs can be internal and
defined and reported on by the borrower, external and assessed by
an external reviewer, or a combination of both. When determining
who is better suited to report on the KPIs, it is important to
consider the following:
- Existing reporting requirements and practices of the
fund
The parties should ascertain the existing practices of the fund,
and the existing reporting requirements, and whether the fund in
question is better placed and able to provide sufficient detail in
such reports. There may already be existing synergies that the
parties can avail themselves of.
- Cost/benefit of external reporting
If third-party reports are to be obtained, the costs associated
with obtaining such reports should be weighed against the margin
reduction that would be obtained from the SLL.
- External metrics
Depending on the nature of the SPT, there may be an external
metric that can be used to measure the SPT. For example, for an
environmental-related SPT, the Paris Agreement provides existing
regulatory targets with which the fund may wish to align.
What happens if a fund fails to meet a KPI?
The failure to meet a KPI will result in an inability to access
the incentivized discount, and typically won’t result in an
event of default. The pricing triggered by such failure will
typically apply until the next pricing adjustment date of the loan,
and if the KPI is satisfied on the subsequent reporting date, the
pricing will then be discounted on the subsequent pricing
adjustment date. It is common for an event of default to be
triggered from misrepresentation in the reporting related to KPI
compliance, particularly where there is an element of fault on the
part of the borrower for such misrepresentation. Such events of
default can also act as deterrents against sustainability
washing.
What is sustainability washing?
Sustainability washing is a term used where the sustainability
credentials in question are inaccurate, misleading or exaggerated,
and can occur, for example, when fund managers make exaggerated
claims about their ESG credentials in an attempt to muscle in on
the market. To avoid sustainability washing, funds should ensure
that they are transparent, and, in particular, that the SPTs are
adequately ambitious and meaningful and that they are adequately
monitored and reported. Negative reputational impact or a serious
undermining of this product are some of the main risks associated
with sustainability washing.
Closing remarks
In light of the events of 2020 (worldwide protests against
institutionalized racism, the COVID-19 pandemic and social crises,
and the environmental catastrophes triggered by global warming),
it’s only natural that socially conscious investing is
gaining more and more momentum. Quite simply, SLLs incentivize
funds to achieve their ESG goals while, at the same time, providing
greater transparency to investors and greater accountability
within. While at a nascent (but burgeoning) phase at the moment, we
expect SLLs to become part of the common landscape in Fund Finance
going forward.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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