What will ESG in Fund Finance look like?

Introduction

As you will have seen from our previous articles, green and environmental, social and governance ("ESG") linked finance is something we at Ashurst have been working on for quite some time now in various product lines and we are increasingly seeing an ESG focus for all types of finance products in the market.

Following on from our Singapore team working with ING on the  first sustainability performance linked fund financing, 2020 is certainly shaping up as the year of ESG for the fund finance market. Accordingly, we thought it an optimal time to take a look at the drivers for ESG financing in the fund finance / subscription finance market and the issues to consider when looking to put in place an ESG linked fund finance facility.

Key drivers

As we are all no doubt aware, there is a general market movement towards cleaner and greener investing and limited partners are increasingly interested in ESG. For funds and fund managers, this has resulted in an increasing inclusion of ESG provisions / obligations in side letters. We expect this will evolve to more rigorous ESG obligations being included in side letters and expect that these provisions may even move to be a core element of limited partnership agreements in the near future (please take a look at the following article from our Investment Funds team for further consideration of the drivers for funds and fund managers -  ESG… Something private funds simply cannot ignore). As the pressure for funds to focus and report on ESG metrics and to strive for cleaner and greener investments 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. While the potential for a pricing reduction does squeeze the lenders, increasing the amount of lending linked to ESG objectives is becoming a board level demand for financial institutions as financial stability becomes more closely linked with sustainability and ESG. 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, therefore, perhaps, a better credit risk.

Issues to consider when documenting your ESG Facility

As ESG finance becomes increasingly popular, we have no doubt that market norms will come to light but at this stage no substantive market norms as regards documentation and practices have been established. The following are some of the provisions we have seen discussed and approached differently to date:

Margin adjustment

A margin discount goes hand in hand with ESG finance (unlike green loans/finance which does not offer a pricing adjustment) but consideration will need to be given as to what the appropriate level is to which this discount should be applied.

Generally the market appears to have started from a position where a simple discount applies when the relevant fund hits the requisite ESG score. Conversely, the discount is then disapplied when the ESG score is not met. However as the market becomes more sophisticated, the spread for the margin incentive linked to ESG rating becomes wider. In particular an upwards and downwards margin ratchet linked to ESG ratings is now trending in certain markets. This means that if the ESG score is met, then there is a downwards movement and if the ESG score 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 the market of borrowers donating any discounts achieved to environmental charities or to demonstrate that such savings are applied to ESG purposes or projects internally.

Reporting obligations

There will also be a discussion to be had as to the reporting obligations of the fund and whether reports are (a) to be produced internally by the fund and the same as those which are provided to investors or (b) whether a third party should be engaged to provide an ESG report. Ultimately there are a number of factors which 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 sufficient detailed to provide the requisite comfort to the lenders and measurement of the propose 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 this 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?

• Timing of reports – at present the reporting obligations are mostly on an annual basis. There may be consideration of increasing the frequency which 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?

• Which third party report provider? – as we are all aware, third party report providers use different approaches to their reports/metrics so consideration should be given to whether the report to be provided is appropriately targeted to the fund/investments.

Thought should also be given to whether the failure to provide an ESG report should trigger an Event of Default. Many will argue that the failure to provide a report should trigger an Event of Default in the same way 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 a no more severe a consequence than delivering a report that shows a failure meet the relevant KPIs (i.e. a margin premium / no discount applied). There is however a market movement expressly stating that whereby providing incorrect information in order to facilitate a more favourable ESG score should trigger an Event of Default (rather than just relying upon the general information catch-all provision).

Key performance indicators

The key performance indicators ("KPIs") for each facility will be unique to the fund and the finance provider and accordingly 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?

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

• the term of the loan – the longer the term of the loan, the more consideration should to 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. Consideration should also be given to the administrative burden (for both the borrower and lender) from including numerous KPIs and if 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 environmental, social or governance related (e.g. a recycling target, reduction in energy use, moving away from single-use plastics or diversity KPIs).

• how should it be measured – there should be a weightage 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. Further consideration should also be given as to whether the timing of when the investment is made should be taken into account as to when calculating the relevant ESG score.

An ESG market snapshot

We have considered a sample of ten ESG facilities documented by the Ashurst Global Loans team across various markets recently to give you a flavour of the current market approach to the points discussed above (although as you will see from the below – no settled approach currently exists). We anticipate that these provisions and KPIs could apply equally to the fund finance market:

Conclusion/final thoughts

As the market for ESG loans is still in its infancy, it is a great opportunity for both funds and lenders to drive market direction and become market-leading in this area. With one of the largest fund finance practices in the City and global expertise in the area, Ashurst is well placed to assist on ESG fund finance to place you at the forefront of the market. Please do get in touch if you would like to discuss.

Our numerous publications on all aspects of green and ESG finance can be found  here.

With special thanks to Kishen Vora, Solicitor, for his contribution.