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Sustainability/ESG-linked loans are the plats du jour of the European leveraged loan market. We know of 17 European borrowers that have included sustainability/ESG-linked margin ratchets in their leveraged term loans so far in 2021 (plus one currently in market), representing €19.6bn in volumes to date. These borrowers operate in industries as diverse as packaging, telecom, healthcare, pharmaceuticals, grocery, software and manufacture of construction materials.

What defines these deals as 'sustainability/ESG-linked' is some mechanism to adjust the term loan’s margin based on certain defined ESG and/or sustainability criteria. As there is no standard form for how these provisions are drafted, there has been significant variation across the deals we have seen. In this report, we dive into how these provisions operate and key differences we’ve noticed across sustainability/ESG-linked leveraged loans this year.

The ESG Tags are based on deals that have been publicly announced/marketed as sustainability-linked or green. This report includes additional detail derived from private term sheets / SFAs, so we have aggregated and anonymised some of the data to preserve confidentiality.

The figures in this report is based on the latest available information we have but may not be complete or reflect the final deal terms in all cases. If you have any questions or would like to discuss any points, please reach out to loans@9fin.com (we’ll need to verify your access to the deal docs to discuss the terms of any specific loan).

Of the sustainability-linked loans we’ve seen this year, the maximum margin reduction permitted under the ESG margin ratchet has ranged from 5 to 15bps, averaging 7.8bps. In several instances, the ESG margin ratchet has step-downs based on multiple KPIs / target thresholds, in increments of 2.5 to 5bps for each KPI / threshold achieved.

All of the ESG ratchets we’ve looked at this year have been 'two-way' ratchets, meaning that failure to meet KPI targets would give rise to a corresponding margin increase. Typically, the ESG margin ratchet mechanism is symmetrical, with the margin able to shift up or down by the same number of basis points. However, as reported by LPC News, Belron’s div recap loan earlier this month featured an asymmetrical ESG margin ratchet. Under Belron’s formulation, the margin could decrease up to 7.5bps if two KPIs are met, or increase up to 10bps if neither KPI is met.

The ESG margin ratchet introduced in UPC’s Facilities AX and AY (available on the SEC website, see Facility AX accession agreement here) is also not quite symmetrical. The margin on those facilities will increase or decrease up to 7.5bps depending on whether two KPIs are met, and the documentation provides for an additional permanent 3.75bps margin increase if the company fails to publish an ESG strategy (to contain a materiality analysis, KPI definitions and measurable targets) by 30 June 2022.

We’ve seen five deals that impose some level of obligation on the borrower to apply some or all of the ESG margin savings towards ESG investments or charitable donation. In four deals, this obligation was subject to the company’s reasonable endeavours; in UPC, there was no ‘reasonable endeavours’ qualifier on this requirement, but the documentation states that failure to apply the savings in such manner will not be a default or event of default under the Facilities Agreement. Borrowers that aren’t subject to such a requirement can use the margin savings however they like.

We would question whether ESG margin ratchets are significant enough to hold borrowers to account? For example, on a €1bn loan, a 10bps margin reduction is €1m. That’s much less than the banks’ fees on the financing transaction, and probably less than the basket for annual sponsor fees under the borrower’s covenants. And if (as we have heard posited) borrowers are getting a pricing benefit by marketing their deals as sustainability-linked, then a 5-15bps step-up for failing to meet KPI targets may not be much of a ‘stick’.

The criteria for ESG margin ratchets range as widely as the borrowers’ businesses. Sometimes the ESG margin ratchet is linked to an ESG Agency Rating (e.g., Asda - as described in the bond OM on p.243). In other cases, borrowers and their advisors have set their own criteria based on KPIs tailored to the company. This has ranged from one to four separate KPIs per borrower in 2021, with an average of around two KPIs.

So far in 2021 we’ve seen KPIs relating to (among other things - # of deals in parentheses is likely understated, as we haven’t had sight of the documentation for all deals):

Greenhouse gas emissions (nine deals, including one in market)

Renewable/sustainable energy (three deals)

Recycling/recycled material (three deals)

Waste reduction (two deals, including one in market)

Gender diversity in employees/management (two deals)

Patient satisfaction levels (two healthcare deals)

Presence of a sustainability board champion

Even if two borrowers’ KPIs relate to the same theme - for example, reduction in greenhouse gas emissions - there are several different ways that the company’s performance might be measured, depending on the specific drafting in the loan agreement.

Some borrowers have set their targets relative to a static baseline. For instance, they can meet their greenhouse gas emissions target if they achieve a % reduction relative to historical emissions in a recent year (per €/$ of revenue), with the % increasing each year. Others have based their targets on year-on-year improvement.

A static baseline means that the company could in theory race ahead and meet all the targets in the first year and then just maintain that level for the rest of the loan term. Job done, ESG ratchet unlocked. On the other hand, year-on-year improvement might encourage the company to pace their initiatives more slowly in order to leave scope for future KPI improvement in future years.

In either case, it probably matters more that the KPI target levels are sufficiently ‘ambitious’, as the voluntary guidelines in the Sustainability Linked Loan Principles indicate they should be.

One deal we reviewed had a KPI target based on reduction of greenhouse gas emissions from co-locating manufacturing facilities, versus the hypothetical emissions that would have resulted from off-site manufacturing/transport. It appears cheeky to measure a sustainability target relative to the hypothetical emissions from an alternative business model - particularly when there are likely other cost savings and benefits to be had from the borrower’s mode of operating.

Although KPIs for ESG/sustainability-linked loans are intended to be ‘ambitious’, it’s in the borrowers’ interests to set quite conservative targets. In some respects, it can be viewed as the reverse of borrowers’ incentives with respect to EBITDA adjustments. To keep borrowers honest, one suggestion is to peg covenant flexibility to the level of ambition shown in the borrower’s ESG initiatives and ratcheting the margin up or down depending on whether they achieve their projected EBITDA synergies.

Some deals have baked into the loan agreement the ability to adjust their KPI targets for the impact of acquisitions / investments, or else to exclude their impact and calculate the KPIs on a ‘like-for-like’ basis. While it’s logical that ESG targets may need to be adjusted if the borrower acquires another business, some of the loan documents we’ve reviewed have not specified how these new targets would be calculated or required any external verification for the new targets -- leaving the adjustment entirely to the Company’s good faith determination.

And if the loan agreement says that the borrower may adjust KPI targets for acquisitions / investments (as we’ve seen in multiple deals), then it seems to follow that the borrower does not have to adjust those targets if the acquisition has a positive effect on their KPIs. So if the company being acquired is greener or more gender-balanced, etc. than the borrower, then the company could have a much easier time of meeting their KPI targets.

One loan agreement we looked at in March permits the company to amend its ESG targets for any reason (not just acquisitions / investments), so long as, ‘to the extent applicable’, an industry specialist / other firm elected by the borrower confirms to the company such amendments ‘maintain equivalency’ with the levels set out in the loan agreement.

While it’s maybe somewhat helpful that these amendments cannot be made unilaterally by the company, the requirement of an ‘industry specialist’ or any ‘other firm’ is still very loose (why not specify an independent auditor or qualified environmental consultant?), particularly as that loan agreement does not require any third-party reporting, verification or diligence with respect to its ESG targets.

We’ve also seen one loan agreement that, while it did not contain an ESG margin ratchet day one, included the ability for the borrower to add a 15bps ESG margin reduction mechanism with Majority Lender consent. Typically a margin reduction would require consent of all affected lenders.

Segueing into ESG reporting requirements, these also vary significantly across deals.

Some deals require as little as an annual ESG compliance certificate, which simply states whether the relevant KPI target(s) has/have been met and the corresponding ratchet adjustment, without any additional detail or third party diligence / verification.

On the other end of the spectrum, we have seen more robust reporting requirements for an annual sustainability report to be delivered alongside the ESG compliance certificate, accompanied by a verification statement by the auditors or another independent qualified reviewer.

We’ve also seen several approaches that split the difference, with some degree of external review short of an explicit verification statement, or without any external review but providing more granular detail than a simple compliance certificate. Of the ESG-linked loans we’ve reviewed in 2021, there’s a 50/50 split as to whether any third-party verification/review is required.

If the borrower fails to meet the ESG reporting requirements, this typically won’t give rise to a default under the loan agreement -- the only consequence for failing to deliver the required reports will typically be an increase in the margin to the highest ESG ratchet level.

Selected Examples of ESG Margin Ratchets in European Leveraged Loans YTD 2021

If you would like more information about 9fin, please contact team@9fin.com 

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