ESG loans – The next big wave of fund financing | Cadwalader, Wickersham & Taft LLP

The appetite for funds for sustainability linked loans (SLLs), often referred to as “ESG linked loans” or “KPI loans”, has increased significantly, an appetite that is expected to continue to grow in the years to come. This article provides an overview of SLLs, along with some key structuring considerations.

What are SLLs?

SLLs are loans that incent the borrower to commit to sustainability through pre-determined Sustainability Performance Objectives (SPTs) that are measured using key performance indicators (KPIs). ). When these KPIs are met, the borrower can benefit from a discount on the pricing of their loan. It’s not always the case. In certain circumstances where a rebate is granted, the parties may choose to donate the rebate to environmental charities or other environmental, social or governance (ESG) purposes or projects.

Are SLLs the same as green loans?

SLLs are not the same as green loans. Green loans should be used to finance green projects, while the use of loan proceeds is not a determinant for SLLs, although it is possible that an SLL is also a green loan.

Why are borrowers interested in SLLs?

Today, companies are developing more and more sustainable, diversified and green strategies, which are inevitably part of the funding criteria. SLLs help achieve these objectives by making the fund concerned more accountable and by offering greater transparency to investors. Borrowers and lenders can also benefit from building stronger value-based relationships with investors / funds that value ESG investing, and both parties can also benefit from a positive impact on reputation as defenders of these ESG objectives.

Definition of SPTs and KPIs

Borrowers and lenders will negotiate SPTs and KPIs and typically a “sustainability officer” or “sustainability coordinator” will be appointed and lead the negotiations on behalf of the lender group. While there is no market standard for SPTs, SPTs will be tied to one or more ESG considerations that support the borrower’s existing sustainability strategy. General examples of SPT categories include board diversity, a healthy living environment, and low carbon emissions.

When determining SPTs and KPIs, it is important to consider the following:

(1) The life of the loan

SPTs should apply throughout the life of the loan, so it is important to consider the length of the loan when determining the feasibility of the SPT. Depending on the length of the loan, the parties may wish to set the KPIs incrementally or, failing this, the parties may wish to include a mechanism to periodically review the KPIs to assess their relevance.

(2) The amount and complexity of KPI

While it is extremely important to properly monitor and measure the SPT through the use of KPIs, it is also important to consider the administrative burden on the parties when using KPIs. multiple and / or complex keys. Quality is better than quantity. If multiple KPIs and / or complexes are used, a third party reporter may be preferable, if that third party is aware of the complexities involved and / or is in a better position to properly monitor the KPIs.

(3) Reporting obligations

Borrowers should report on the SPT at least once a year, and parties should also consider whether more frequent reports are needed depending on the nature of the SPT. SPTs can be internal and defined and reported by the borrower, external and assessed by an external reviewer, or a combination of both. To determine who is best suited to report on KPIs, it is important to consider the following:

  • Existing Fund Reporting Requirements and Practices

Parties should check existing fund practices and existing reporting requirements, and whether the fund in question is better positioned and able to provide sufficient detail in such reporting. There may already be synergies that parties can build on.

  • Cost / benefit of external reporting

If third party reports are to be obtained, the costs associated with obtaining these reports must be weighed against the margin reduction that would be obtained from SLL.

Depending on the nature of the SPT, there may be an external metric that can be used to measure the SPT. For example, for an environment-related SPT, the Paris Agreement provides existing regulatory objectives that the fund may wish to align with.

What happens if a fund fails to meet a KPI?

Failure to meet a KPI will result in inability to access the Incentive Discount and will not generally result in an Event of Default. The price triggered by such a failure will generally apply until the next loan price adjustment date, and if the KPI is met on the next reporting date, then the price will be updated on the loan adjustment date. next price. It is common for a default event to be triggered by a misrepresentation in KPI compliance reporting, especially when there is an element of fault on the part of the borrower for such misrepresentation. Such fault events can also act as a deterrent against lasting washing.

What is sustainable washing?

Sustainability washing is a term used when the sustainability credentials in question are inaccurate, misleading or exaggerated, and can occur, for example, when fund managers make exaggerated statements about their ESG information for the purpose of strengthen itself in the market. To avoid the sustainability washout, funds need to ensure that they are transparent and, in particular, that SPTs are sufficiently ambitious and meaningful and that they are properly monitored and communicated. A negative impact on the reputation or serious damage to this product are some of the main risks associated with sustainable washing.

Closing remarks

In light of the events of 2020 (global protests against institutionalized racism, the COVID-19 pandemic and social crises, and environmental disasters triggered by global warming), it is natural that socially conscious investment is increasingly gaining ground. momentum. Quite simply, SLLs encourage funds to achieve their ESG objectives while offering greater transparency to investors and greater accountability within them. While they are in a nascent (but growing) phase at the moment, we expect SLLs to be part of the common landscape of Fund Finance going forward.

About Deborah Wilson

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