December 2, 2021 - by Tess Virmani. “ESG” is dominating conversations in financial markets and the loan market is no exception. “ESG” refers to the environmental, social and governance factors which contribute to a company’s sustainability profile and overall performance. However, ESG can be adopted in a multitude of ways from integrating ESG in investment decisions to structuring financings to include sustainability components. This article focuses on the growth of sustainability linked loans, the most widely used of ESG-related loan structures, and associated challenges.
Sustainability linked loans are loans which identify key performance indicators (KPIs) and incentivize borrowers, typically through margin ratchets, to make ambitious improvements in their sustainability profiles against those KPIs. If a borrower meets the predetermined sustainability performance targets (SPTs), there is a step down in the loan’s margin; if a borrower fails to meet the SPTs, there is often a step up in the loan’s margin. Because the loan is not tied to use of proceeds, like green loans and social loans are, the SLL structure can be used across corporate lending. SLLs first emerged in Europe in 2017 before migrating to global markets in 2018 and volumes have grown dramatically in four short years. In the first three quarters of 2021, Bloomberg recorded over $1.2 trillion in global green and sustainability linked finance activity across bonds and loans. Of that global activity more than $370 billion came from sustainability linked instruments with sustainability linked loans accounting for the vast majority at nearly $300 billion. This growth in volume has brought in borrowers from a growing number of industries, ranging from energy to fund finance, chemicals and industrials to REITs. What is more is that SLLs are no longer only creatures of the investment grade market. Refinitiv LPC has reported global leveraged SLL volume of $88 billion YTD. There have even been a handful of middle market SLLs this year. It is expected that these trends will continue into 2022 and beyond.
Along with the excitement for SLLs and the increased number of SLL participants, concerns of greenwashing have also grown. The Sustainability Linked Loan Principles and related Guidance are explicit that the KPIs included in an SLL must be material and core to the borrower’s business and that the SPTs must be set at ambitious levels; the borrower’s performance needs to be verified by a third party. ING, one of the market pioneers of this structure, recently published a paper highlighting the importance of preserving the integrity of the sustainability linked loan structure and specific ways that can be accomplished. In September, the loan trade associations presented a webcast on recent developments and important considerations for protecting the integrity of SLLs which builds on the Gibson, Dunn & Crutcher webcast presented to LSTA members this summer.
This article is the second in a two-part series. The first part of this series looks at ESG integration.