03 Oct 2022
The past, present and future of sustainability linked loans
We examine some key considerations for borrowers and fund managers when using sustainability linked loans.
In a funding landscape where stakeholders are increasingly focused on ESG performance, sustainability-linked loans (SLLs) are driving environmentally and socially conscious business performance.
From private equity to real estate, infrastructure and private debt, SLLs are applicable across the alternative finance space and enable funds to link financing to their environmental, social, and corporate governance (ESG) targets.
“Over the last decade there has been more pressure on fund managers to align investment activity with a low-carbon economy,” explains Bradley Davidson, ESG lead for RBS International. “We are seeing increased demand for sustainable finance structures.”
The Sustainability-Linked Loan Principles (SLLPs) set out by the Loan Market Association (LMA) provide a framework to structure SLLs on a deal-by-deal basis, enabling ESG-focused economic activity and growth through the achievement of sustainability performance targets (SPTs).
“A key benefit of SLLs is linking financing to defined targets in a way not possible before,” says James Hamelin, director, Institutional Banking, Jersey for RBS International. “Achieve them and you typically see a margin benefit – but if the SPTs aren’t achieved, you can incur an increase to your margin. This ‘stick’ helps focus the mind on achieving the targets and creates accountability.”
Another asset of SLLs is signposting stakeholders to the fund’s ESG principles, and efforts undertaken to meet them.
“By entering into an SLL, the fund manager is demonstrating commitment to tackling ESG issues, something increasingly valued by investors, employees and regulators,” points out Hamelin.
Before: What you need to enter into an SLL
Prior to taking out an SLL, an achievable, clearly designed ESG strategy should be formulated. This allows the SPTs agreed with the lender to be aligned to existing ambitions, says Davidson.
“It’s important to understand the motivations behind fund managers’ ESG strategies to identify the most material, stretching targets to embed into the facility,” he says.
Discussions should also include investor preferences to ensure alignment with stakeholder ambitions.
As SLL agreements are bespoke, there is no required checklist of KPIs to meet. Relevant SPTs could be common benchmarks such as renewable energy or diversity and inclusion goals, but many will differ across industries and between organisations.
“An SPT of gender proportion on boards of portfolio companies is relevant for PE [private equity] funds, but not applicable for real estate funds,” says Hamelin. “Different borrowers can influence different ESG factors in different ways. It’s better for the lender to engage with the client and understand where they can make a difference, as opposed to providing them with a menu of targets.”
“By entering into an SLL, the fund manager is demonstrating commitment to tackling ESG issues, something increasingly valued by investors, employees and regulators”
James Hamelin, Director, Institutional Banking, RBS International
Davidson does see themes emerging across the funds industry, however: portfolio decarbonisation for private equity; improving energy efficiency of property portfolios through retrofit for real estate; and increasing renewable energy supplies for renewable and infrastructure funds.
“More social SPTs are being set by funds as the industry acknowledges the benefits of diverse thinking and equal opportunities – but environmental remains top of the agenda,” he says. “This is unsurprising, given the immediacy of the climate emergency and focus from investors and regulators.”
The LMA requires SPTs to be ambitious, so the borrower needs access to benchmarking data that proves the scope of the targets and demonstrates progress towards them.
The SLLPs recommend targets be based on a combination of processes, including performance over time, relative positioning versus peers, and reference to science or official targets such as the Sustainable Development Goals.
“SLLs are a transition finance instrument, so SPTs should drive ESG performance beyond the current trajectory,” states Davidson.
In addition, the LMA recommends borrowers seek a “second party opinion” from an external reviewer to assess the relevance and reliability of selected KPIs, rationale and ambition of SPTs, relevance of baselines and benchmarks, and credibility of the overall strategy.
Potential borrowers should recognise that it may not be possible to structure an SLL if their ESG strategy or data management is insufficient to facilitate it. In this instance, lender-borrower discussions should offer a clear view on the barriers to an agreement, in order to map a path to future success.
After: Requirements once an SLL facility is entered into
The SLLPs encourage transparency to combat the often opaque nature of ESG reporting. Once the facility is in place, robust reporting should demonstrate whether STPs are being met. A regular testing date is part of the SLL structure, requiring fund managers to submit performance evidence against SPTs.
“If fund managers do not include SLL structures in their audited sustainability or financial reporting, then lenders should work with borrowers to outline how best to communicate with investors and the market,” says Davidson.
The format and frequency of reporting will depend on the SPTs selected, term of the facility, and frequency of data collection to report against.
“As a minimum, we would generally see SPTs reported on annually, but this can be increased to semi-annually if appropriate,” says Hamelin. “There’s no specific reporting template – different clients report on the data in different ways.”
Funds which don’t already undertake comprehensive ESG reporting may meet early data challenges in providing and analysing SPTs.
“Data availability will likely be the number one barrier to increased reporting for fund managers, so it’s important to address any gaps with a clear action plan which includes downstream entities and assets,” says Davidson.
Independent verification of progress is a requirement of SLL agreements, with an external third party auditing each SPT at least annually, adding an extra layer of authenticity.
“The assurance provided aims to safeguard both fund managers and lenders from greenwashing claims and uphold the integrity of the product,” explains Davidson. “The third-party compliance certificate is issued to the lender alongside benchmarking data to evaluate overall performance.”
The future: what’s next in the SLL space?
The Bank of England’s Climate Biennial Exploratory Scenario has highlighted how lenders’ policies need to evolve to include climate risk, and favour borrowers that are taking meaningful action. As a means for both parties to demonstrate their commitment to sustainable finance, the future of SLLs looks assured.
“The opportunity to deliver both financial and ESG performance is widely recognised, with fund managers wanting to do more,” says Davidson. “As external expectations and pressure builds, SPTs will need to match the pace of change, with increased ambitions to meet the requirements of the LMA SLL principles.”
As SLLs evolve, a broader set of SPTs is likely to be employed, predicts Hamelin.
“I see SLLs becoming the market norm. Banks are readjusting strategies and looking to deploy more capital to areas which align with their purpose. To date, we’ve seen the majority of SPTs focused on the environment. Going forward, we may see more focus given to the social category.”
With SLLs becoming a central pillar of alternative finance, more regulators are setting disclosure requirements for the facilities. Transparency is emerging as the key concern for regulators holding entities to account where they are trading on ESG commitments, says Davidson.
“Recent moves, such as the SEC [Securities and Exchange Commission] emission disclosure proposals, indicate that fund managers will be required to expand the scope of sustainability reporting and validate the accuracy of data to avoid litigation or reputation damage,” he says.
As regulations tighten, reputation, rather than financial benefit, is likely to remain the primary driver for SLL agreements. For funds looking to advertise their proactive ESG performance, an SLL spotlights their environmental and social targets, while utilising the credibility of banking partners to bolster their sustainable finance ambitions.
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