Legal development

The Sustainability Linked Loan Market

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    Driving or reflecting sustainable behaviour?

    The loan market has long been a solution provider. It is innovative and bespoke – witness the emergence in the Global Financial Crisis of the ''forward start'' structure which helped solve many a struggling borrower's liquidity issues at the time. Move forward in time and you now have an evolving sustainability linked loan ("SLL") market allowing companies of all hues, including brown and light green, to benefit in monetary terms from hitting certain ESG linked targets. Now it's not just the pure play green use of proceeds bond or loan issuers who can dabble in helping the planet and its inhabitants overcome the many challenges it faces; environmental, social and governance, but those considered dirty or in transition can also do their bit.

    The SLL market is gathering pace – volumes in Q1 were double that of Q1 2020. We are in a COP year, the USA has re-joined the party and COVID and other events of 2020 have focused minds on wider social issues in addition to climate change; the S in ESG. It is fair to say that much of the year's refinancing activity will be sustainability or ESG-linked and there is a growing likelihood that loans not including the features of Key Performance Indicators ("KPIs") and associated margin movement will be the exception rather than the norm in years to come.

    To help and sustain this growth, banks are building experienced and multi-faceted/talented sustainability finance teams and there are a whole host of external consultancies only too willing to lend a hand in terms of standard setting or verification of KPIs.

    So where do we go from here?

    The big news a week or so ago was the various loan industry bodies (LMA/APLMA/LTSA) jointly releasing revised SLL principles ("SLLPs") with a view to tightening up the architecture of the product. The new principles and associated guidance build on those released in May 2020 and have been updated no doubt to seek to address several of the issues and challenges that the product has faced over the past 12 months.

    The document cites the need to 'promote the development and preserve the integrity of the product' and 'sustainable development more generally' and focuses on five core components/messages:

    • Selection of Key Performance Indicators – KPIs are the cornerstone upon which the product is based and there is no doubt that their selection is getting greater focus as the product evolves and experience allows greater sophistication from both lenders and borrowers alike. The SLLPs recognise the need for clarity and rigour encouraging debate around material risks, relevance and strategic alignment. Somewhat helpfully, the SLLPs also provide a non - exhaustive list of possible KPIs as an appendix.
    • Calibration of Sustainability Performance Targets (SPTs) – perhaps more important that even the selection of the KPIs are the associated targets borrowers are setting during the life of the facility. The SPTs are key to driving behaviours and it is here the industry bodies have encouraged ambition and cite a need for SPTs to represent a material improvement in the KPIs and go beyond a business as usual trajectory.
    • Loan Characteristics – this is effectively a recognition that margins can go up or down depending on borrower performance vs KPIs/SPTs. No mention is made of whether monies saved or paid should be applied to ESG causes which has been a welcome development in some recent deals but I can understand that commenting on how the money is spent would be considered to be beyond the remit of the industry bodies whose responsibilities centre around safeguarding the integrity of the product.
    • Reporting – loans are generally private transactions and few details are publicly available so it is encouraging to see a reference to greater transparency in reporting with borrowers encouraged to provide information on both calculation methodology and performance with an emphasis on maintaining the relevance and ambition of KPIs and associated SPTs. Easier said than done but at least it's been said.
    • Verification – to be badged as an SLL borrowers must now obtain independent and external verification of performance for each KPI/SPT at least once a year and that verification should be made publicly available. Again, on the face of it, a welcome development but perhaps easier to say than deliver.

    All looks good – volumes are up; finance is playing its part in helping encourage sustainable behaviour; the loan markets are evidently leading the way and sustainability conscious borrowers can see their efforts rewarded by way of a decrease in their cost of borrowing; lenders, borrowers and advisors now have further guidance in how to structure SLLs; and we are moving (albeit slowly) towards a market where greater reporting and annual external verification will be the norm.

    There is no doubt that these revised SLLPs are a hugely positive step in the right direction and the industry bodies are clearly in tune with the market, and indeed public, mood.

    Looks good but can it look better?

    My concern remains that, despite the increased rigour and talk of ambition, SLLs will continue to, in reality, just reflect sustainable behaviour rather than drive it. To my mind there are a couple of key challenges that need to be faced before we can say the opposite.

    The first is the very essence of the structure – the KPIs (and associated SPTs). I suggested in January 2020 (further information here) that more focus was needed on setting of KPIs and, whilst progress has been made and I am encouraged by the ambition and relevance called for by the SLLPs, I'd venture we are not yet in a place where all SLLs are actually encouraging, driving or motivating an incremental focus on sustainability.

    I am drawn to the mention in the guidance notes that ''SPTs should not be set at lower levels or on a slower trajectory to those already adopted internally and/or announced publicly by the borrower''. Should this not be same or lower levels? Just lifting previously disclosed targets from a borrower's annual report, and dropping them into a loan agreement is surely not the answer. The borrower is already committed to these targets. Yes, its rewarding sustainable behaviour but certainly not driving it.

    The second challenge and another regular negotiation point is how the underlying cost of borrowing is altered as a result of outperformance by the borrower, i.e. if KPIs are met/beaten or indeed, if the KPIs are not met and crucially what happens to the money saved or paid in either case?

    'I love ESG-linked loans, they decrease my cost of borrowing' is a quote I heard at a seminar some 18 months ago. Politely put, from a sustainability perspective, isn’t this completely missing the point?

    • Let's not make this about the money
    • Let's not make this about how many basis points can be saved if already disclosed targets are met
    • Let's not make this about banks competing for mandates
    • Let's make this about individual actions adding up for the collective good. The money saved as a result of outperformance should be channelled to sustainable causes creating a virtuous cycle that the industry can point to as the finance markets doing their bit.

    So a B+ for effort and attainment for all concerned. What we need now is a further leap of faith and increased resolve with stronger (even more ambitious) and genuinely stretching KPIs, margin benefits being directed to sustainable causes and perhaps a little more jeopardy in terms of information provision would all enhance the SLL product even more.

    The real game changer would be more effective disclosure and I note that one or two recent SSLs have seen KPIs and SPTs outlined in associated press releases. The need for verification outlined in the new SLLPs will probably help but the end game should be full visibility which would afford the opportunity for targets and associated benefits to be subject to effective scrutiny.

    As I said in January 2020, if you have kids, ask them what they think.

    I will take another look in 12 months' time when I think the innovative and bespoke loan market will have moved to the top of the class.

    Author: Dave Rome

    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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