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The growing importance of ESG in leveraged finance

Posted: 02/11/2021


With COP26 now underway and the importance of ESG (Environment, Social and Governance) factors being promoted on the global stage, green finance has received a renewed focus in recent months.

This has been further highlighted by the fact that the EU has made the largest ever offering of green bonds. The green bond, with a 15-year maturity, will raise €12 billion, and is reported to have received more than €135 billion in demand, making it the largest green bond launch to date. This followed the news that the UK Government had issued the largest amount ever of sovereign green bonds, and a total of £16 billion has been raised by UK Government debt . Banks and lenders now offer financial incentive for loans which contain an ESG element, whether the project itself is eco-friendly, or the borrower helps the lender to meet internal ESG standards and quotas.

This same development has been felt from within the leveraged loan market, which has witnessed an increased focus in making sustainability the core of strategic planning. The rise of Sustainability Link Loan Principles (SLLP) in the financial discourse has set a path for change in the practice of securing debt finance.

Perhaps the most significant change to the green finance movement in recent years has been the increased awareness in so-called ‘greenwashing’ (the use of buzzwords to create the illusion of sustainability). The leveraged loan market has responded to the perceived threat of greenwashing with an introduction and use of ESG ratings in the prospective stage of the loan transaction process. ESG ratings can be obtained from third party providers (a growing market in and of itself), and they aim to rate the borrower’s capacity to mitigate and manage key sustainability issues within their sector. We can expect this system to grow in importance, with ESG ratings used along side credit ratings to provide key indicators to lenders on the performance of any potential borrower.

Whilst the “E” in ESG has inevitably received more attention, and sustainability occupies a significant place in the public dialogue, the remaining elements also play a key role in the ESG analysis of a potential borrower. Lenders have an increased interest in a borrower’s internal policies on a wide range of key social issues, including modern slavery, bribery and anti-corruption (with many lenders including specific requirements in both their onboarding requirements and their facility documentation). Ethical investment policies also take centre-stage here. The shift towards assessing not just the presence of these policies, but the monitoring, functionality and effectiveness of them, is a crucial element of SLLP due diligence.

Within the facility itself, ESG factors in Sustainability Linked Leveraged Loans (SLLLs) play a key role in the mechanism of the project finance. SLLLs typically include a margin ratchet which is determined by the borrower’s performance of ESG focussed KPIs. A margin discount can be awarded if KPIs are hit, but these provisions will also provide for a premium if targets are missed. The result is a continued, long term assessment of a borrower’s ESG performance, as well as a long term commitment by the borrower to create realistic and ongoing ESG strategy. 

Sustainability within the leveraged loan market is certainly not a novelty, and the ESG factors are not in themselves new concerns for lenders when assessing potential buyers, but with the increased standardisation of methods to assess borrowers by way of third party ESG ratings, as well as increased expectations of the borrower to commit to long-term sustainability planning, the trend of green finance can be expected to become the norm.

To read more about the issues that can arise from greenwashing, read Harriet Vidot’s article here.

 

This article was co-authored by trainee solicitor Alice Campbell


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