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Loans linked to the environmental performance of the borrower are gathering pace. How do they work and who are they aimed at?
- Sustainability-linked loans (SLLs) offer reputational lift and lower interest rates for meeting ESG targets – or, conversely, penalties for failing to do so
- SLLs can be used to fund progress on a range of ESG goals, from gender diversity to human rights or environmental issues
- Key performance indicators need to be genuine ‘stretch’ targets on top of what the borrower is already doing
The coronavirus pandemic has boosted a fast-growing form of lending in which private equity funds and other borrowers can enjoy lower borrowing rates as a reward for making their businesses more sustainable and socially responsible.
While the pandemic has stifled many forms of economic and financial activity, it has had the very opposite effect on the use of sustainability-linked loans (SLLs), according to Caroline Haas, managing director and head of sustainable finance for financial institutions at NatWest Markets.
SLLs offer borrowers a reputational lift and lower interest rates if they meet agreed targets on environmental, social and governance (ESG) goals, or penalise them with higher rates if they fail to meet those targets.
“The pandemic has helped the whole ESG market and accelerated the market for these loans because it has given investors very clear evidence of why ESG is important,” says Haas. “People are now even more focused on what companies are doing with their sustainability strategies because suddenly, with Covid, you realise that the social elements are incredibly important and your governance structures are vital.
“SLLs give you the quantification tools and targets you need and, with all the ESG analysis that’s being done, you could see when Covid happened that the companies that had solid governance, more accountability, better supply chains and loyal employees have outperformed.”
Unlike green loans, which are aimed at specific environmental projects such as a wind farm, SLLs can be used to fund broader progress on a much wider range of ESG goals, from gender diversity to human rights or environmental issues.
Sharyn Jaques, sustainability lead for institutional banking at RBS International, says that SLLs enhance the reputation and credibility of borrowers through the setting of clear, monitored targets.
“One thing that surprises some people when it comes to setting those targets is that they have to be genuine ‘stretch’ targets; you have to genuinely improve your performance,” she says. “There’s not going to be a template of key performance indicators that you can apply across the board, and the guidance from the Loan Market Association is that the KPIs need to be stretching and on top of what a borrower is already doing. That means that every transaction is going to be different and requires a genuine conversation about how you are performing.”
NatWest has offered such loans to corporate clients since December 2017, but SLLs are well suited to private equity, too.
Swati Baheti, vice president of loan markets at NatWest, explains: “The breadth and scale of a private equity fund’s investments mean that once its ESG strategy is defined, it has much more power to influence multiple companies instead of just one company on a stand-alone basis.
“It is a genuine opportunity for us to better understand our customers, which encourages the customers to better understand their investments and accelerate the pace of improvements they will drive within them”
Jean-Paul Peters, senior director for funds banking, RBS International
“Large PE funds have demonstrated the ability to influence their portfolio companies towards their targets, even if they set their strategy before actually purchasing the assets.
“Given the focus on sustainable investing, funds can establish governance across their portfolio companies to deliver across material ESG impact areas, as well as some sector-agnostic KPIs such as gender diversity of the board.”
Focus on governance
Jean-Paul Peters, the Guernsey-based lead senior director for funds banking at RBS International, says the ‘G’ in ESG has been the natural starting point when considering SLLs in the context of a private equity fund’s subscription finance needs. This is “because, ultimately, what all funds will drive is improved governance within the underlying corporates that they own and this governance starts even before a portfolio company is acquired, given the rigour and focus of investment committee processes ”.
He adds: “When we’re talking to private equity clients, the discussion tends to start with the governance, not just in terms of investment selection but how they intend to implement change once they own their investments. Who is or will be leading the business? Is there enough diversity within that mix? How will they monitor improvements needed? But this isn’t just applicable to private equity; my team and I have had similar conversations with our debt fund clients. If they’re buying a portfolio of non-performing loans, their diligence will encompass what the underlying assets are and what ESG impacts there might be, with governance being an initial consideration.”
The EU taxonomy for sustainable activities, due to be adopted in 2021, is helping to focus minds on ESG, adds Peters. “Where I find this evolution of ESG and the advent of the EU taxonomy for sustainable activities to be really interesting is that it is bringing ESG to the forefront of our bankers’ conversations with their clients in a way that has not happened before,” he says. “It is exciting that we’re having to spend time understanding a client’s ESG approach, which then gives us a chance to tailor financing solutions to those specific needs.
“You really have to lift the bonnet and understand what they are doing. It is a genuine opportunity for us to better understand our customers, which encourages the customers to better understand their investments and accelerate the pace of improvements they will drive within those investments because we have worked together to set some really meaningful but achievable targets.
“Funds’ focus on ESG is not new; a number of our clients have been signatories to the UN Principles for Responsible Investment for a number of years. However, what has often been happening in the past is that they’ve written down what they intend to do from an ESG perspective but nobody’s really holding them accountable. Having that built into your financing will further drive that focus. We hope that, through our role as fund finance providers, we will encourage earlier implementation of improvements and force investment teams to think about ESG in their day-to-day decision-making.”
There is a growing urgency and acceptance that lenders and borrowers both have to help drive progress on ESG “because it’s not just something that is nice to do; it is something that we have to do,” Peters says. “Lenders are accepting that they are giving away an element of returns through margin reductions if the targets are met. Whilst that might eventually be recognised by markets and regulators, which could help banks mitigate the economic impact, we’re doing it at the moment because it’s the right thing to do.”
Peters hopes that lenders will eventually be able to help smaller private equity funds use similar loans.
“The limited number of fund finance-related SLLs completed in the market thus far have involved firms whose scale means that they have invested in a more advanced approach to ESG and therefore lead the conversation, rather than expect their bankers to do so. If, on the other hand, you’re a small PE firm with only a limited number of people working in your business, this becomes a tougher ask. It’s unreasonable for sustainability to sit entirely on the CFO’s desk. But if the CFO can rely on their bankers and they can work together to build ESG metrics within the financing package, it will hopefully drive a change in focus and culture. At that point, lenders become genuine agents of change.”
Caroline Haas adds that the EU’s adoption of a taxonomy to bring more clarity to sustainability issues and tools will help to avoid “sustainability washing” on SLLs. And she doesn’t expect Brexit to diminish the taxonomy’s impact.
She sounds a succinct, important message: “This drive towards embedding sustainability in finance is a global movement, and everyone is going to have to get on board with that direction of travel.”