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August 2, 2021updated 21 Feb 2022 11:14am

New leveraged finance guidelines target KPI greenwashing

The fast-growing sustainability-linked leveraged loan market is ripe for abuse. Just-released issuance guidelines aim to crack down on weak key performance indicators, but sanctions lack teeth.

By Phil Moore

Gemma Lawrence-Pardew of the Loan Market Association hopes the guidance will help more small companies start on their “ESG journey”.  (Photo courtesy of the LMA)

  • Surging volumes of sustainability-linked leveraged loans (SLLLs) and misuse of KPIs therein demonstrate why new guidance has just been issued.
  • The document requires companies to prove the impact of lending beyond “business as usual” and may prompt more to set ESG targets and issue SLLLs.
  • But effective sanctions are still lacking because the guidelines are not legally binding.

Explosive recent growth in sustainability-linked leveraged loans (SLLLs) and high-yield bonds has led to concerns that issuers are embedding weak or questionable key performance indicators (KPIs) into these financing instruments that are tantamount to greenwashing.

The Loan Market Association (LMA) and the European Leveraged Finance Association (ELFA) have responded with new guidance that provides a tighter template for issuance of such debt. Released on 28 July, the document aims to crack down on deal structures that have little meaningful impact on ESG outcomes and provide a practical guide to the implementation of ESG principles into SLLL documentation.

“Although it only dates back to 2019, the SLLL market has mushroomed in the last nine months, such that something like half of primary leveraged loan issuance in Europe this year has been sustainability-linked,” says Fiona Hagdrup, London-based director of leveraged finance at British fund house M&G Investments.

SLLL issuance has shot up to €18.52bn ($22.03bn) for this year as of 29 July, a near-eightfold rise from €2.42bn for the whole of 2020. And as of 28 June the pipeline for the rest of the year stood at €12bn, according to S&P Global’s Leveraged Commentary & Data (LCD) division (see graph below).

It is easy to be sceptical about these soaring volumes. Most lenders and borrowers are falling over themselves to be associated with funding that ticks as many sustainability boxes as possible. And, with demand for ESG-compliant investment opportunities still outpacing supply, there is a great deal of potential for – and tolerance of – manipulation and greenwashing.

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Moving targets

Given that, until now, there has been no standardised template for ESG-linked issuance for leveraged loans, KPIs and sustainability performance targets (SPTs) have been moving targets.

“This is very much a precedent-driven market,” says Richard Lloyd, a partner at White & Case in London. Last autumn the law firm implemented a series of discussions with lenders and borrowers in the world of leveraged finance.

In less than a year since, Lloyd says, financial institutions’ expectations on everything from disclosure requirements to ESG-linked margin ratchets have changed almost beyond recognition. This is chiefly down to the relative newness of SLLLs.

The structuring of ESG key performance indicators should be carefully planned well ahead of deals being launched. Saida Eggerstedt, Schroders

Leveraged finance, historically a hugely secretive market, is having to adapt quickly to the greater disclosure demanded by ESG-focused investors. Indeed investors worry that some borrowers are exploiting the SLLL supply-demand imbalance by embedding weak and opaque KPIs.

“There can be a lack of transparency about how meaningful KPIs are, especially if companies do not show their direction of travel or how ambitious the targets are compared with what they have achieved over the last five years,” says Saida Eggerstedt, head of sustainable credit at UK asset manager Schroders.

“Companies… need to demonstrate this is not just business as usual [and] emphasise the scale of the strategic change being delivered,” she adds. “The structuring of ESG KPIs should be carefully planned well ahead of deals being launched, including a scenario analysis that would, for example, identify the macro or micro scenarios under which KPIs would not be able to be reached.”

Questionable KPIs

Measures such as the new guidelines are critical, say market participants, because often KPIs – especially in the early stages of the SLLL market’s development – have incorporated targets that are almost impossible to miss. In some circumstances they had already been met before they were set. There have even been reports of KPIs being agreed after documentation had been signed. Of course, investors are partly to blame for agreeing to such terms.

Such issues show there is all the more need for clearer guidance on best practice in the leveraged finance arena, especially given the recent surge in issuance.

The new guidelines are a natural adjunct to the sustainability-linked loan principles originally published in May last year, says Gemma Lawrence-Pardew, director of legal at the LMA.

Arguably the most important and timely part of the guidance is the one covering the selection and communication of KPIs and calibration of SPTs.

The ELFA/LMA document seeks to address this by requiring greater disclosure of “pertinent ESG information”, such as existing ESG reports, historical data, third-party verification from a rating agency or consultancy, or internal reporting provisions that can be benchmarked against regulatory standards or taxonomies. This helps the company to demonstrate a meaningful, established commitment to ESG before entering the transaction.

The guidelines, which comprise five sections, also include a glossary of terms aimed to help navigate the numerous acronyms used by market practitioners. Elsewhere they describe the specialised roles played by key market participants, such as ESG rating providers, ESG consultants, sustainability co-ordinators and external reviewers.

The document also provides advice on reporting and verification of borrowers’ sustainability targets and on documentation.

Other recommendations include that KPIs and SPTs be communicated in sufficient time for syndicate bankers to review them; KPIs are “ambitious” and go beyond “business as usual”; and KPIs are linked (where possible) to a benchmark or external reference, and are consistent with the borrower’s overall sustainability/ESG strategy.

“Strict but beneficial”

The guidelines have been broadly welcomed by investors, borrowers and intermediaries. “All in all, these are strict but beneficial guidelines which should support the issuance of ESG-linked bonds and loans,” says Schroders’ Eggerstedt.

Bankers, meanwhile, say the guidance will come as a relief to borrowers with stretched resources struggling to respond to requests for information on their ESG targets.

“The challenge for our bankers as well as our clients has been to cope with the questionnaires from investors eager to ensure that they are complying with the Sustainable Finance Disclosure Regulation [SFDR],” says Thomas Girard, global head of green and sustainable syndicate at French bank Natixis in Paris.

SMEs don’t always have sufficiently robust data management systems to respond to all these questions asking the same thing but in different ways. Thomas Girard, Natixis

“SMEs [small and medium-sized enterprises] don’t always have sufficiently robust data management systems to respond to all these questions asking the same thing but in different ways,” he adds.

The resultant reduction in paper-pushing associated with SLLL issuance is expected to attract more borrowers – particularly privately owned SMEs – to the market. Typically, such companies have less than £1bn ($1.4bn) of enterprise value and a track record of no more than three years, says M&G’s Hagdrup.

Few such corporates have drawn up ESG strategies, let alone committed themselves to formal carbon-neutrality or other sustainability targets. Tighter rules around access to sustainable finance should encourage them to set and report clear transition targets.

Some 40% to 60% of investment-grade companies have signed pledges to cut their carbon emissions to zero, but only 10% to 20% of sub-investment-grade borrowers have done so, says Raphael Thuin, head of capital market strategies at French alternative asset manager Tikehau Capital.

“We hope the clarifications in the guidelines will prompt more mid-cap companies to start their ESG journey by emphasising that the market is open and accessible,” says Lawrence-Pardew, who describes SLLLs as a “tool for transition”.

Leveraged finance sanctions lack teeth

Welcome as they are, though, the ELFA/LMA do not carry the force of law. As such, there are few – if any – effective sanctions available to bring leveraged finance abusers to book.

Margin ratchets impose modest slaps on wrists for borrowers failing to meet their KPIs or SPTs by increasing coupons by 15 or 25 basis points. But basis points don’t mean much to the biosphere, so such penalties are of limited value to lenders or investors mandated to help finance the journey towards net zero. In other words, as Lloyd at White & Case puts it, there is no such thing as an ESG default.

For the time being lenders and investors seem inclined to give borrowers the benefit of the doubt, at least publicly.

Some may dismiss SLLLs as simply another way for private equity owners of corporates to cut their financing costs by another five or ten basis points, says Hagdrup. “But that would undermine what in the main appears to be an honest attempt by young companies to communicate to their shareholders their commitment to becoming more sustainable,” she adds.

Ultimately, the market, rather than industry associations, will have to determine the price at which borrowers presenting themselves as good ESG citizens will be able to finance themselves.

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