Fund Finance 2021 - The rise of ESG and green fund finance

Introduction

In recent years, green and environmental, social and governance (“ESG”) financing (also known as sustainability linked lending) has been increasingly popular across a wide range of asset classes, and the fund finance market is no exception. This general market movement towards cleaner and greener investing through either a use of proceeds-based approach or an overall ESG metrics approach has limited partners (“LPs”) increasingly interested in ESG factors. For funds and fund managers, this has resulted in an increasing inclusion of ESG provisions/obligations in side letters entered into with LPs. With more rigorous ESG obligations entering into force, particularly as a result of key ESG regulatory developments, this is likely to evolve to become a core element of limited partnership agreements in the near future.

One of the key aspects driving this change is new regulation that has been introduced in Europe and which sets ambitious objectives in reorienting capital towards more sustainable investments. The regulatory drivers will have a significant impact on funds and fund managers, how ESG factors and risks are incorporated into investment decisions, and subsequently the financings entered into. As the pressure for funds to focus and report on ESG metrics increases, the question for funds will no doubt arise as to how this may flow through into their financing documentation.

Likewise, lenders are increasingly keen to be at the forefront of driving green and ESG change through financing products, and increasing the amount of lending linked to green objectives (also known as use of proceeds lending) or ESG objectives (also known as sustainability linked lending) is becoming a board-level imperative for financial institutions as market participants realise that financial stability is intrinsically tied to sustainability and ESG risks. For a lender thinking about its own ESG strategy, there will be an awareness that funds with sustainability on their agenda are arguably those that are more likely to be better prepared for future risks and opportunities and perhaps, therefore, a better credit risk.

2020 and COVID-19 have influenced green and ESG lending, with the events of this year pushing the market to consider not only the “E” but increasingly the social (or “S”) element, with various healthcare-related “S” financings already in the market. It remains to be seen whether the fund finance market will follow this trend and move towards a stronger emphasis on “S” financings.

Elements of an ESG or green financing

Green or use of proceeds financing

While much of the focus on ESG lending in the fund finance market focuses on “ESG” lending, we should not discount green lending as also having a role to play in the fund finance market. Green loans are loans made for a specific green purpose that do not necessarily have pricing mechanics attached to them but rather a specific (usually green) commitment to make investments meeting this purpose.

While being lent for a specific purpose has the potential to make them less flexible than their sister, the ESG loan, this does not prevent their use in the impact or green fund space, where the loans can be utilised to invest in “green” investments that meet the criteria set out in the loan agreement. For example, funds with a particular green or sustainable strategy (e.g. investment in renewable energy) may be well suited to a green loan.

ESG financing

ESG or sustainability linked lending is the provision of (usually) a revolving credit facility which includes certain ESG-related key performance indicators (“KPIs”), achievement of which links to a pricing toggle. In a nutshell, ESG or sustainability linked lending is like any other loan to a fund, except with an additional layer of reporting (whether by a third-party verifier, auditor or the fund itself) on specific ESG/sustainability KPIs developed in respect of that fund or its investments. This expands the universe of borrowers and industries that can access the sustainable finance market by enabling funds that do not have an eligible project to still incorporate ESG considerations into their financing.

To date, much of the green or ESG financing we have seen in the fund finance space has been linked to an ESG financing, as it provides funds and fund managers with the ability to retain a revolving credit facility at the fund level similar to that that they may have otherwise had in place, and rewards or (sometimes) penalises them for general ESG performance or performance against specific KPIs (rather than linking them to a specific investment/ limiting the fund to making specific approved investments).

As ESG finance becomes increasingly popular, we have no doubt that market norms will emerge; however, at this stage, no substantive market norms as regards documentation and practices have been established, although some trends are beginning to come to light.

Margin adjustment

A margin discount goes hand in hand with ESG or sustainability linked finance (unlike green loans/finance which do(es) not necessarily offer a pricing adjustment), but consideration will need to be given as to whether just a discount or a discount and premium should be applied.

Generally, the market appears to have started from a position where a simple discount is applied when the relevant fund hits the requisite KPI, and the discount is then disapplied when the relevant KPI is not met. However, as the market becomes more sophisticated, the spread for the margin incentive linked to KPIs becomes wider. In particular, an upwards and downwards margin ratchet linked to KPIs is now trending in certain markets, and we have already seen it appear in a number of ESG financings in the fund finance market. This means that there is a downwards movement if the KPI is met, while if the KPI is not met then the margin goes up.

Thought should also be given to what the fund will be encouraged to do (if anything) with any discount achieved. We have increasingly seen examples in some markets of borrowers agreeing to donate any discounts achieved to environmental charities or to demonstrate that such savings are applied to ESG purposes, and we expect this to also become a feature of fund finance ESG or sustainability linked financings.

Key performance indicators

KPIs are at the heart of an ESG financing and will be unique for each financing in the fund finance market; as such, they will need to be discussed and considered in context. In the fund finance space, the underlying investment strategy of the fund and what it would like to change within its business will also be an important factor in this discussion. While discussions regarding ESG finance often focus on the environmental gains to be made, consideration should also be given to the social and governance aspects – are there, for example, gender, diversity or governance improvements that could also be measured?

Similarly, while there is a tendency to focus on KPIs at the investment level, consideration should also be given as to whether fund-level KPIs may be appropriate (i.e. governance or social), or potentially even higher up the structure.

Regardless of what they relate to, we expect KPIs to take into account considerations such as:

• The term of the loan – the longer the term of the loan, the more consideration that should be given to the suitability of the KPIs towards the end of the loan. Should the KPIs be incremental, increasing year on year? Or is a mechanism required to revisit the KPIs periodically to reassess their suitability?
• Number and nature of KPIs – where there are numerous or complex KPIs, thought should be given to whether these are likely to be better monitored by third parties with appropriate knowledge of the complexities of said KPIs. Consideration should also be given to the administrative burden (for both the borrower and lender) resulting from including numerous KPIs and whether quality should be preferred over quantity.
• What is being measured – is it just the investment portfolio that should be tracked against KPIs, or are there other fund-level metrics that should be considered whether ESG-related (e.g. a recycling target, reduction in energy use, moving away from single-use plastics, or diversity KPIs)?
• How should it be measured – should there be weighting given to the ESG score of the fund depending on the percentage of investment of the fund in a company against the fund’s total portfolio? Should consideration also be given as to the timing of when the investment is made when calculating the relevant ESG score?

• What are the consequences of non-compliance with that KPI – while the obvious answer here is some upwards adjustment to the margin, it is important to question whether that should be the only consequence. Should some KPIs be hurdles (i.e. have to be achieved before any other discount flowing from KPI achievement can be unlocked)? Could KPIs be included that are not linked to margin adjustments, but rather aimed at reputational motivation? This will likely require public disclosure of the relevant KPIs but, to the extent that funds are simultaneously making public commitments to ESG goals, funds are being increasingly held to account by stakeholders.

The unique challenge of setting KPIs for the fund finance market

One of the unique challenges the fund finance market faces with ESG financing is how to set appropriate, challenging KPIs for those financings put in place early in the life of a fund when few or potentially no investments have been made. While previous fund performance on similar ESG metrics may help to inform this process, thought should be given to whether there is a requirement for an ability to review KPIs on a regular basis (e.g. every 12 months to consider whether they remain appropriate and sufficiently challenging). Other ways in which to approach this may include an ability for either the borrower or finance parties to bring the parties to the table to discuss certain KPIs should they feel they are no longer set at an appropriate level (with a right to disapply a KPI if agreement cannot be reached on any necessary amendments).

Will there be regulatory drivers for KPIs 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 has sought to set out its own reporting obligations and create an objective and harmonised standard as to what can and cannot be deemed to be “environmentally sustainable”.

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

The second piece of the jigsaw puzzle is the Disclosure Regulation, which seeks to harmonise provisions on sustainability-related disclosures by imposing requirements on so-called financial market participants (e.g. alternative investment fund managers, UCITS management companies, and investment firms or credit institutions carrying out portfolio management) in relation to financial products. Importantly, the Disclosure Regulation has some extra-territorial effect and can apply to non-EU fund managers who market their funds into the EU.

The 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 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.

Taken together, these Regulations are likely to shift behaviour in the fund market and consequently 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 by the data flow requirements that fund managers will be subject to as a result of the Disclosure Regulation.

Reporting obligations

Discussions will also need to be had as to the reporting obligations of the fund, i.e. whether reports produced internally by the fund that are provided to investors will be sufficient for the finance parties, and whether there should be an audit of internal ESG reporting or whether a third party should be engaged to provide an ESG report. Ultimately, there are a number of factors that will feed into this discussion, including:

• Existing practices of the fund – does the fund have a track record of disclosing ESG information to investors? Is the information disclosed sufficiently detailed to provide the requisite comfort to the lenders and measurement of the proposed KPIs?
• Underlying investments – depending on the fund, it may be that there are already reports being obtained from third-party providers, in which case, can these reports be made available to the lenders? Do these existing reports cover all the KPIs in sufficient detail?
• Cost-benefit analysis – if third-party reports are to be obtained, are the costs associated with obtaining such reports reasonable in the context of the transactions, or, more importantly, will the cost of procuring such a report exceed any gain in margin reduction? This will be a particular focus for the fund finance market where, unlike a corporate group, reporting might need to be done on an investment-by-investment basis. Particularly for funds with a large number of investments, this may put the possibility of third-party reporting out of reach.
• Timing of reports – at present, reporting obligations are usually on a semi-annual or annual basis. There may be consideration of increasing the frequency, but this will have a corresponding effect on cost, as identified above.
• KPIs – what is being measured and can that information reliably be reported on by a third party?

Thought should also be given to whether the failure to provide an ESG report should trigger an Event of Default. Many will argue that failure to provide a report should trigger an Event of Default in the same way that a failure to comply with any other reporting obligation would under the facility. Alternatively, there is an argument to be made that failure to provide a report should have no more severe a consequence than delivering a report that shows a failure to meet the relevant KPIs (i.e. a margin premium/removal of discount applied).

Where to from here?

As the market for ESG loans is still in its infancy, our view is that ESG loans will become a core feature of the fund finance market. The next 12 months may well bring a renewed focus on the social and governance elements of ESG, but we also expect that the environmental focus will remain strong.