Legal development

Do challenging market conditions and rising regulation spell the end for fund finance and ESG?

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    The rise in green and sustainable lending in recent years has brought about many opportunities for all participants in the financial and loan markets to focus on developing their own environmental, social and governance (ESG) strategies and to consider how their activities impact climate change. The increasing focus on sustainability globally has resulted in lenders and borrowers reassessing financing arrangements in order to retool traditional lending products into arrangements that incentivise and promote improved sustainability performance across sectors. After emerging in the fund finance space a few years ago, sustainable lending products now encompass everything from large, high profile multi-bank facilities to smaller bilateral facilities. However, the growth of these opportunities has not come without challenges that run the risk of stagnating the rapid development experienced to date.


    ESG lending has developed into two main forms, categorised broadly into “performance based” and “use of proceeds” financings. The former has evolved into what is now known as sustainability-linked loans (SLLs). The key characteristic of these loans is that the use of proceeds is not restricted – rather, the loans can be used for any of the traditional purposes, including general working capital, financing acquisitions and, in the fund finance space, bridging capital calls for investments and paying fund costs and expenses.

    SLLs include mechanics in the loan documentation in order to measure borrower performance in agreed areas relating to sustainability objectives (these objectives are termed “key performance indicators”, or KPIs) against agreed targets (being the “sustainability performance targets”, or SPTs) with the result that borrowers are incentivised – through pricing changes – to improve their sustainability performance over time.

    On the other hand, “use of proceeds” loans in the fund finance space have evolved from green loans seen on corporate and acquisition financings. These loans are commonly put in place by impact or green funds and are used to fund green investments. This can be compared with traditional green loans, which restrict the application of proceeds to a specific green project.

    While both forms of financing are present in the fund finance market, the execution of SLLs has become more prevalent across the various fund strategies due to the inherent flexibility that these products offer, flexibility that is sought by general partners and managers to ensure that fund finance facilities can be deployed seamlessly for the purposes of a variety of investments and working capital purposes. Use of proceeds loans are, however, better suited to net asset value financings and green/impact funds, and we have seen increased adoption in this space.

    The growth of green and sustainability-linked lending has been underpinned by the development of the Green Loan Principles (GLP) and Sustainability Linked Loan Principles (SLLP) by the LMA and LSTA. Each provides a framework of standards and principles applicable to green loans and SLLs that are considered the core requirements in order for a loan or facility to be considered a green loan or an SLL. Satisfaction of the core components is therefore subject to detailed scrutiny when structuring the transaction.

    For green loans, the GLP focus on the use of proceeds, the process for the selection andevaluation of the green project, the management of proceeds, and ongoing reporting. Whereasfor SLLs, the SLLP look to the selection of KPIs, the calibration of SPTs, the economic outcome of meeting SPTs and the reporting and verification of sustainability performance.

    2023 also saw the publication of the model provisions for SLLs by the LMA (model provisions). The model provisions provide a drafting framework for SLLs that is aligned with the SLLP, allowing approaches to terminology and drafting mechanics, in particular regarding the economic consequences of satisfying, or failing to satisfy, SPTs, to be harmonised across the market. This wider adoption of these model provisions on SLL transactions will result in efficiencies during the documentation process and greater negotiation focus on settling the terms that relate directly to the SLLP – such as the level of reporting and verification that is required in the context of the particular fund’s or portfolio company’s sustainability performance.

    Fund finance market challenges

    While the development of the SLLP and model provisions have provided crucial touchstones for integrating sustainable lending principles into financings, the fund finance sector still faces a number of unique challenges when implementing the SLLP on transactions. These challenges arise due to the unique characteristics of fund finance transactions as well as macro considerations, including how the current economic outlook and regulatory developments are impacting funds and lenders.

    Selection of KPIs and development of SPTs

    The primary aim of the SLLP is to ensure that the integrity of sustainable and green financing products is prioritised by ensuring that any incentivisation is linked to relevant and ambitious sustainability targets. However, the selection of KPIs and calibration of SPTs can be difficult in fund financing transactions, particularly where a fund is making a number of diversified investments or is new in its life. This requires a different assessment lens in order to set KPIs and SPTs on a fund finance transaction compared to a corporate or acquisition facility, where lenders can look directly to the performance of the company or target in question.

    Typically, KPIs and SPTs are focused at the investment level, looking to the ESG performance of underlying portfolio companies. However, in the context of a fund that is yet to make investments or is in the early stages of its investment period, formulating bespoke KPIs and calibrating SPTs can be difficult or even impossible. If an investment has not been identified or there is any uncertainty regarding the investment pipeline, it is hard to gauge what would be a “material” and an “ambitious” KPI or SPT. Where investment opportunities have been identified or even executed, there may be circumstances where there is limited information as to historical performance, which of course has an impact on selecting an appropriate KPI and then setting SPTs.

    Additionally, setting KPIs and SPTs by reference to specific investments may result in substantially increased costs of third party verification of ESG performance, due to the number of investments for which ESG performance needs to be verified.

    As a result, KPIs and SPTs for fund finance transactions have diverged from those commonly seen on corporate or acquisition facilities. Some examples of unique approaches regarding KPI and SPT setting that we are seeing more frequently on fund finance transactions include:

    • Regular review of KPIs and SPTs to ensure continued relevance – the inclusion of provisions that deal with the assessment of KPIs and SPTs post signing (commonly known as “rendezvous clauses”), whether at regular, predetermined intervals or at the instigation of the borrower and/or lenders under a facility. This process allows the existing KPIs and SPTs to be revaluated to ensure they remain relevant to the fund and appropriate, with ambitious targets for ESG performance.
    • ESG weighting – ESG scores that are given to funds are weighted based on the percentage of the investment of the fund as against the total portfolio value.
    • Inclusion of “sleeping SLL” provisions – sleeping SLL facilities include the mechanics for an SLL other than the KPIs and SPTs, which are agreed at a point in time post signing and documented by way of a schedule or side letter. This allows for the facilities to be set up to operate as an SLL once KPIs and SPTs have been agreed.These facilities include restrictions on the borrower disclosing sustainability-linked characteristics of a facility or labelling it as an SLL until the point at which KPIs and SPTs have been agreed, and we are seeing that lenders generally require that agreement is reached within 12 months of signing.
    • Traditional KPIs – where traditional KPIs are selected that are to apply across a portfolio of diversified investments, these KPIs often look to incentivise ESG performance against sustainability objectives that are company and sector agnostic. Examples of these include transition to renewable energy, improving gender balance of boards and implementing ESG-linked facilities at the portfolio company level.

    Although the above approaches are increasingly common across sustainability-linked fund financing transactions, there is still great variation in approaches taken by borrowers and lenders across the market. This lack of consensus had led to challenges in adopting KPIs and SPTs that account for the specific circumstances of a fund in financings with diverse lender groups, particularly those that have a range of experience in sustainable and green lending.

    Another key concern for lenders in the fund finance space is the risk of greenwashing, particularly where KPIs and SPTs are set on a forward-looking basis in anticipation of making future investments. Greenwashing, broadly speaking, is providing inaccurate or misleading information about the environmental impact of a product or service – in this case, the sustainable financing. In the loan markets, it is most likely to be of concern if the KPIs and SPTs that are set for an SLL financing are not sufficiently robust or challenging. Greenwashing concerns can be mitigated through increased verification, both of the KPIs and SPTs prior to signing any sustainability-linked facility and then through the ongoing verification of ESG performance by the relevant fund or underlying portfolio companies.

    While an increased level of verification serves to provide comfort to lenders, this ultimately has to be balanced against the increased cost of obtaining such verification with such cost ultimately borne by fund borrowers. Where the balance is struck will always be determined by deal-specific criteria and lender appetite; however, the market has generally moved to a position where third-party verification is usually required to be obtained in connection with the initial KPI and SPT setting as well as ongoing monitoring of ESG performance.

    Regulatory developments

    The increased focus on sustainability objectives globally has resulted in a substantial increase in sustainability-linked reporting and, in the financial markets, disclosure to market participants. This increased disclosure has led to both EU and UK regulators continually assessing disclosure and reporting obligations, and how these should apply to loan market participants going forward.

    There are already a number of existing international standards and guidelines that fund managers may voluntarily disclose against with respect to ESG factors. Most recently, the EU – followed by the UK – has sought to codify these reporting obligations and harmonise what can and cannot be deemed “sustainable”.

    EU position

    The EU regulation that seeks to achieve this is the EU Taxonomy Regulation, which creates a framework for what can and cannot be considered an economic activity that aligns with certain environmental objectives. The regulation has introduced an EU-wide classification system (or taxonomy) of environmentally sustainable activities, which aims to provide more clarity for investors concerning financial products that purport to invest in sustainable activities or to promote environmental objectives. The EU Taxonomy Regulation sets out the criteria for determining whether an economic activity constitutes an environmentally sustainable activity that includes the requirement that the activity does “no significant harm”. This is intended to facilitate (or reduce the burden of) investors’ own due diligence with regard to a product’s environmental sustainability and eliminate the practice of greenwashing.

    The EU Taxonomy Regulation goes hand in hand with the EU’s Corporate Sustainability Reporting Directive and the EU’s proposal for a Corporate Sustainability Due Diligence Directive, both of which aim to increase the production and harmonisation of ESG data by in-scope corporate entities and reduce the burden for investors of ESG due diligence.

    The second piece of the jigsaw puzzle is the EU Sustainable Finance Disclosure Regulation, which seeks to harmonise existing provisions on sustainability-related disclosures by imposing requirements on so-called financial market participants (e.g. EU AIFMs and EU UCITS management companies (or non-EU AIFMs marketing funds into the EU) and EU investment firms or EU credit institutions carrying out portfolio management) in relation to financial products.

    The EU Sustainable Finance Disclosure Regulation requires certain information to be made available either at entity level or at product level, irrespective of whether sustainability risks are integrated into financial market participants’ investment decision-making processes. Further measures seek to increase transparency as regards financial products that target sustainable investments, including those funds that target a reduction in carbon emissions.

    The final key regulatory development is the Low Carbon Benchmark Regulation. The Low Carbon Benchmark Regulation creates disclosure requirements on benchmark administrators as to ESG considerations for various different benchmarks. It also creates two new categories of benchmarks – the Paris-aligned benchmark and the climate transition benchmark – which will help fund managers measure performance against the Paris Agreement climate targets, if that is the objective of the fund.

    One further development that is currently being considered at EU level is a proposal for the regulation of ESG rating providers, who may be brought within the EU’s regulatory perimeter (in the same way as credit rating agencies) and will be required to be authorised for firms to use their ESG rating products.

    UK position

    The UK has lagged behind the EU in terms of the introduction of bespoke sustainabilityrelated disclosures, instead mandating Task Force on Climate-Related Financial Disclosures (TCFD) reports for the largest UK asset managers.

    More recently, we have seen some progress in relation to the UK’s introduction of its own UK Taxonomy (although it has some way to go) as well as Sustainability Disclosure Requirements (SDRs), which will create an integrated framework for “decision-useful disclosures on sustainability”. The SDRs will apply to asset managers and asset owners of retail funds.

    The UK’s approach to SDRs is in contrast to the EU Sustainable Finance Disclosure Regulation. Despite the name on the tin, the current proposal is that the UK SDRs are a labelling regime with three categories of labels available:

    a) sustainable focus – products that invest predominantly in assets that can be deemed to be sustainable;

    b) sustainable improvers – products that aim to improve the sustainability of the portfolio over time; and

    c) sustainable impact – products that seek to achieve impact through the provision of finance, typically to underserved markets.

    To meet any of these classifications, a product will need to meet:

    d) five overarching principles, referred to as general criteria, which will cover: sustainability objective; investment policy and strategy; KPIs; resources and governance; and/or investor stewardship;

    e) a number of key cross-cutting considerations; and

    f) certain key category-specific requirements.

    Compared to the EU regime, the UK SDRs will provide a sustainability framework that inscope asset managers and owners will need to embed within their processes for all aspects of the investment lifecycle. The UK will also implement its own taxonomy that will be largely based on the EU Taxonomy, although the underlying eligible economic activities may differ to take into account the distinction in the UK economy and industry focus. The UK Taxonomy classifications will in time flow through into the disclosures to be made under the UK SDRs.

    Taken together, these EU and UK regulations are likely to shift behaviour in the fund market and in the fund finance market. With more focus on fund managers’ own ESG approach, there is a likely impact on the fund finance market with respect to the characteristics set out above. KPIs and reporting in particular are likely to be highly impacted with the data flow requirements that fund managers will be subject to as a result of the EU Sustainable Finance Disclosure Regulation and UK SDRs once these are in force. Both the UK SDRs and the UK Taxonomy proposals have suffered significant delays in their development. Separately, we have seen similar proposals launched by the UK government to bring ESG ratings into the regulatory perimeter with the requirement to be authorised if such ESG ratings are used in a financial product in the UK.

    Current market conditions

    2023 saw another year of challenging macroeconomic conditions for funds, marked by high costs of borrowing, challenges in attracting investors and fundraising generally due to reduced liquidity, and difficulties in exiting investments. At the time of writing in late 2023, the Bank of England Monetary Policy Committee forecast that the Bank Rate in the UK would remain higher for longer, remaining above 4% through the end of 2026.1

    Against this backdrop, it comes as no surprise that, despite the progress made in the ESG sector generally since the late 2010s, LSEG LPC reported that EMEA SLL volumes for Q1– Q3 2023 were down 29% from 2022 volumes and 39% from 2021 volumes. Global SLL volumes painted a sobering picture for Q3 2023 in particular, being down 65% compared to Q3 2022 and the lowest quarterly total since Q3 2020.2

    While lower lending volumes are being experienced across sectors due partly to decreased fundraising, the stark reductions lead us to question whether enough is being done to ensure that SLLs are an attractive financing solution when facing economic headwinds, or if they are just a “nice to have” when the good times roll. In particular, there have been a number of factors expressed, including:

    • Cost of ongoing third-party verification – with KPI and SPT setting becoming more bespoke and complex in the fund finance space, there is no doubt that verification costs will continue to rise especially where ESG performance is required to be verified on an investment-by-investment basis. Additionally, costs will no doubt further increase with the UK government recently announcing plans to regulate agencies evaluating ESG performance of companies following consultation earlier in 2023.While the long-term impact of this is unclear, there is a strong possibility that these increased compliance costs will be passed on to funds rather than be absorbed by the agencies themselves. This leads us to question whether, in light of investors becoming more attuned to a fund’s ESG performance, greater thought should be given to aligning lender reporting requirements with the reporting requirements of limited partners in order to drive cost savings and efficiencies.
    • Intensive monitoring and compliance requirements – with sustainable finance facilities becoming more complex from a reporting, monitoring and compliance perspective, funds and managers are spending more and more time managing their financing arrangements. It may be that in a challenging economic environment with eroding returns and suppressed fundraising, these increased monitoring and compliance requirements are seen as an unjustifiable burden for some smaller funds.
    • Margin reductions – to date, margin reductions as a result of achieving or exceeding SPTs has been limited to a relatively low amount, between 5 to 25 basis points. This amount has stayed relatively constant despite the increases to interest rates globally over the past two years. In a high interest rate environment with lenders under increasing pressure to improve their green credentials, we query whether an upward movement of margin savings would be justified in order to balance the increased monitoring and compliance costs experienced by funds in putting sustainability and green financing arrangements in place.

    Concluding remarks

    The past few years have seen rapid growth in the sustainable and green lending space with market norms beginning to emerge. Recent industry developments, including formulation of the SLLP, GLP and model provisions, have accelerated this growth.

    This growth, however, is at risk of being constrained by a number of challenges that are facing the fund finance market in particular, including in relation to ongoing challenges of setting of KPIs and SPTs, the increased costs of monitoring compliance, the current unfavourable market conditions being experienced globally and the ever-changing regulatory landscape.

    While funds are ultimately motivated by their own ESG strategy and their investors’ expectations regarding ESG performance, our view is that all market participants should be continually balancing and reassessing factors that are emerging as challenges or barriers to execution of loan products to ensure that sustainability-linked and green lending remain usable tools that can be deployed by a wide range of funds in line with their ESG strategies.

    Finally, forward to 2024, we expect that specific areas of focus in the ESG lending space will include:

    • Greenwashing concerns – there is renewed focus from regulators on greenwashing, which brings with it regulation risk but also the risk of reputational damage or greenwashing litigation for fund managers and lenders alike. For fund managers and lenders, the focus on greenwashing risks in the next 12 months will factor into the setting and ongoing assessment of KPIs and SPTs, particularly on transactions that are being refinanced. Additionally, the structuring of sleeping SLL facilities will continue to be subject to close scrutiny by lenders in order to ensure that these facilities are not used in a way that could give rise to greenwashing concerns.
    • Capital treatment – providing beneficial capital treatment for lenders in relation to green or SLL financings has long been a topic of discussion, the argument being that if the underlying fund/business is more sustainable, the credit risk is likely better. While we do not expect movement from a regulatory perspective in the near future, capital treatment continues to be a worthy consideration as there is little doubt that favourable changes would encourage more green or SLL financings.
    • ESG litigation – as ESG disputes and litigation become more prevalent, there is a question of what impact this will have in the fund finance market. While we do not expect any direct impact, there is no doubt that ESG litigation will form part of the risk assessment undertaken by fund managers and lenders in KPI and SPT setting, particularly in relation to greenwashing concerns.

    Further Ashurst ESG-related articles and publications can be found at

    Authors: Lorraine Johnston, Partner; Robert Andrews, Partner; Briony Holcombe, Partner; Edward Grant, Senior Associate

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    2. Loan volumes reported by LSEG LPC at the LMA Sustainable Finance Conference on 9 November 2023 and confirmed by LSEG LPC to Ashurst LLP.

    NB: This article was first published in GLI Fund Finance Laws and Regulations 2024.

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.


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