The end of a dark era: Leveraged finance is now embracing ESG
Privately owned companies are integrating ESG disclosure into their financing agreements at the fastest rate on record as new sustainability regulations and shifting investor demand push one of the most secret market segments to come out.
European ESG-linked leveraged finance volumes jump from $6.7bn in 2020 to $25.2bn year to date, according to data provider Dealogic.
Greater disclosure, clear target setting and KPI margin ratchets to help drive climate transition in private companies.
Limited partners (LPs) push private equity firms to integrate ESG standards while regulation forces high-yield investors to report on impact of holdings.
Less subject to the scrutiny of public market investors and with fewer resources to dedicate to sustainability reporting, leveraged finance – whereby companies, typically private equity (PE) firms, load up on debt to finance expansion or acquisitions – is a segment of the financial sector that has been slow to integrate ESG standards.
No longer it seems. Deals once shrouded in secrecy are now subject to greater scrutiny. Companies that don’t report or integrate ESG into their financing arrangements will find funding options drying up as private market investors and PE sponsors increasingly integrate their own ESG standards.
Laying your cards on the table
Inherent in this shift is the need to incorporate ESG reporting into the financial engineering of the deals. Sustainability-linked loan and bond arrangements require annual updates against KPIs – in order to penalise or incentivise companies on their progress with a margin or coupon ratchet – compelling companies to establish and disclose transition or decarbonisation plans.
As such, rapid growth in the issuance of sustainability-linked leveraged loans and high-yield bonds looks set to make 2021 a transformative year for the asset class. The market has already grown to $25.2bn of European ESG-linked leverage finance deals recorded in the first half of 2021 from just $6.7bn in all of 2020. Just $1.9bn of deals were recorded in 2019, according to data firm Dealogic. To give perspective, in 2020, $46bn was raised in global leveraged debt capital markets, with $68bn already raised in 2021.
One bank keen to capitalise on this development is Deutsche Bank. Capital Monitor spoke to Trisha Taneja, Deutsche Bank’s head of ESG advisory for origination and advisory, about why integrating ESG into leveraged finance will have a positive impact on the race to net zero. Taneja joined the bank last year from ESG ratings agency Sustainalytics, where she was global head of green and sustainable bonds.
“Companies that would not previously be disclosing this data are doing so now,” she says. “The first step to creating impact for transition is measuring what you are doing now, and then once it is measured and disclosed you can work out what your footprint is and how you are transitioning.”
ESG leveraged finance is central to Deutsche Bank’s plans to grow its group-wide sustainable financing commitment to €200bn by 2023.
In a deep dive into its sustainability commitments delivered to stakeholders last month, the German lender revealed its ambition to leverage its strong connections with European corporates and global PE firms and to grow market share. At the end of Q1 2021, it was number one in ESG leveraged finance in Europe and globally, holding a 10.1% market share in global ESG leveraged finance issuance, according to Dealogic.
A bumpy start
While green issues from speculative-grade companies are not new, the market only really started to pick up in January this year. Investors attribute this to a couple of early hiccups. In 2014, Spanish renewable energy and engineering firm Abengoa issued a €500m equivalent high-yield green bond, but a year later started insolvency proceedings after a potential investor pulled back from a fresh capital injection into the stricken firm.
In 2015, wind turbine manufacturer Senvion issued €400m of senior secured green bonds before filing for insolvency in 2019 with more than €1bn of debt.
But with increasing demand from the investor side for greater ESG disclosure, and societal and financial pressure for businesses to hit sustainability targets, issuance of ESG-linked leveraged loans this year was up 14-fold to €19bn by May compared with the whole of 2020. Transactions with ESG-margin ratchets were seen in 40% of European-syndicated leveraged loans in 2021, according to data firm Reorg.
Sarah Mackey, who runs the leveraged finance team at UBS, says that in 2020, deals with ESG disclosure or ESG ratchets were previously the exception to the rule but that in 2021 most companies looking to raise leveraged financing will include ESG disclosure as a minimum.
Private equity sponsors, which make up the majority of leveraged finance issuance, are being pushed by their limited partners to think about ESG.
One of the major drivers is a large shift in the PE industry, says Taneja. PE sponsors, which make up the majority of leveraged finance issuance, are being pushed by their limited partners (LPs) to think about ESG in their valuation and asset selection.
“I think this is feeding into the setting up of ESG reporting structures within PE firms or their portfolio holdings,” she says.
“High-yield investors have picked up ESG and are looking at how to report on the impact of their holdings as well as how to integrate ESG into their decision-making, so that increases demand,” she says.
Bigger ESG impact
Arguably, ESG leverage finance deals can have a greater impact than ESG use of proceeds bonds in investment-grade markets. Highly leveraged companies typically only raise funding to expand or acquire other businesses, rather than to refinance existing debt, so this capital can have a more transformative impact.
In addition, ESG requirements bring greater disclosure to one of the most secretive corners of the market. Many high-yield companies are privately owned and aren’t subject to the same disclosure requirements as publicly listed companies, while loan arrangements tend to be entirely private.
For example, Lonza Specialty Ingredients, a chemicals manufacturer, is owned by both Bain Capital Private Equity and Cinven, but because it issued a high-yield bond, its targets are publicly available, reported annually, and third-party verified.
On the loan side, while sustainability-linked leveraged loans are still private and not subject to the same public disclosure requirements as high-yield bonds, the 200 or so investors to which highly syndicated loans are sold will be privy to much more detailed information about the future direction of the company than previously.
“You're talking about small to mid-cap companies that are private equity-owned or otherwise that are really just starting to understand the implications of ESG,” says Taneja.
Leveraged loans are structured with ESG ratchets that will either lower or increase the margin of the loan depending on whether or not certain KPIs are met. The financing for Carlyle’s $1.32bn leveraged buyout of wind turbine gearbox manufacturer Flender in January, for example, included a 10 basis points (bp) ratchet based on Flender hitting a KPI of 5% year-on-year growth in new installations of wind power capacity containing its gearboxes.
The KPIs also encourage companies to move more decisively on their transition plans, Taneja says. “If your KPIs are credible, it doesn’t just mean that five years from now you’re looking at whether the company is meeting its carbon emissions reductions target – the investors get the chance on an annual basis to see how the company is progressing.”
UBS’s Mackey agrees that setting out sustainability ambitions in initial financing packages should incentivise companies new to the game to make the targets a reality.
Mackey adds that the introduction of voluntary standard guidelines on disclosure – outlining how ambitious ratchets and targets should be applied – will aid the development of the market.
The Loan Market Association (LMA) is working with the European Leveraged Finance Association to publish guidance on the application of sustainability-linked loans to leverage finance in July, though its existing sustainability-linked loan principles already apply to the sector, the LMA says.
In March, Deutsche Bank acted as joint global co-ordinator and sustainability structuring adviser on shipping company Hapag-Lloyd’s €300m sustainability-linked senior bond. The deal was the first sustainability-linked note from a container liner shipping company. The 2.5% coupon will increase by 25bp in October 2025 if the firm fails to prove it will meet its target of a 60% reduction in the average efficiency ratio (carbon intensity) of its owned fleet by 2030.
“We were advising the issuer on understanding market expectations and developing a credible framework,” says Taneja. For a company like Hapag-Lloyd, which is aiming to reduce its emissions by changing the older vessels in its fleet, the CO2 reduction story will not be linear, she says.
“It’s something that requires an upfront investment in new assets over the course of the first two to three years, but that really creates impact in the medium to long term as your new assets in the fleet becomes operational and starts to really impact emissions reduction,” she says.
Not only will integrating ESG into leveraged loans and high-yield bonds help 'hard-to-abate sectors' – those with high CO2 emissions, such as paper and packaging, heavy industry, oil derivatives, plastics and shipping – think about and set targets, but it’s essential for their future funding capabilities.
“If companies in difficult sectors want to raise financing going forward, it is going to be really important for them to make ESG disclosures, so that the investors that we are selling their loans can actually invest in their company," says UBS’s Mackey
“If you don’t do this, you may end up in a situation in three to five years’ time where you won’t have access to the capital markets.”
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