COP26 made sustainable headlines last month, with a host of initiatives agreed, covering methane reduction, coal to clean power transition and the end to deforestation, among others. A detailed overview of the event and how it may impact the HY universe can be found in our analysis ‘COP26 - Lukewarm pledges; hot planet’. 

In terms of the financial sector, the UK led the way during COP26, with plans to create the “world’s first Net Zero financial services centre”. UK finance minister Rishi Sunak proposed greater requirements for financial institutions and listed companies to publish Net Zero transition plans that detail how they will decarbonise, as the UK moves towards a Net Zero economy by 2050. The International Financial Reporting Standards (IFRS) Foundation also created a new anti-greenwashing taskforce to provide more guidance to investors around credible decarbonisation strategies. 

The EU Commission's Sustainable Finance Disclosure Regulation (SFDR) was delayed for a further six months, from 1 July 2022 to 1 January 2023. Initially introduced on 10 March this year, SFDR’s function is to make disclosure of financial products’ performance on ESG issues compulsory for asset managers. The Commission’s statement explained that due to the ‘length and technical detail’ of the directive, the six month postponement was deemed necessary. The SFDR and other regulations being implemented worldwide will dramatically increase overall reporting demands, so the use of technology to track and assist with this reporting will be critically important.

November Bond Highlights

A new month generally means a new SLB feature. This time Kem One experimented, adding an ‘Intermediate Sustainability Performance Target’ (SPT), the first of its kind in European High Yield. The target relates to a 1.6% per annum reduction in Scope 1 and 2 emissions which will be tested annually, but unlike the common coupon step-up feature, a 25bps additional redemption premium will apply. Itelyum debuted this novel concept back in September, whereby the step-up applied only to the redemption premia, not the coupon. You can read our take in full, in “Dude, Where’s My Coupon Step-Up?”. The longer term SPT, which involves reducing GHG emissions by 22% by 2025, carries a 25bps semi-annual margin step-up.

Fallen angel Accor meanwhile increased its €500m SLB deal to €700m, on the back of a €2.3bn book. Although the group, which operates Ibis and Sofitel hotels, has reported promising environmental credentials in the past, we uncovered various social and labour concerns in our ESG QuickTake. Hotels being used as detention facilities, and migrant workers left with no work and poor living conditions during the Covid-19 crisis have been some of the recent blows affecting the company’s reputation. Since the SPTs don’t relate to social issues, it is unclear whether the sustainable financing mechanism will encourage the group to tackle these issues in the future. 

Israel-based Teva pharmaceuticals pushed into ESG territory this month issuing a record $5bn (equivalent.) sustainability-linked bond, with KPIs linked to an increase in access to medicine in poor and middle-income countries and the reduction of its greenhouse gas emissions. According to the company, they became the first SLB issuer in the generic medicines industry, possibly paving the way for industry peers to attempt in the future. Teva also set new achievements by becoming the first High Yield issuer to incorporate three SPTs - Reno De Medici joined this trend later in the month.

Some investors pushed back on the deal, saying minimal consequences for the failings of the target - 12.5 basis point per SPT or ~$10m in additional interest. Besides the ‘sustainability-linked’ tag the bonds hold, ESG minded investors were wary of the group’s long lasting opioid complications. This questions whether these types of firms have a place in environmental-focused funds.

As we highlighted in our QuickTake, allegations of misleading marketing of opioid medicines are still ongoing, with the group recently forking out $85m to settle a lawsuit in the state of Oklahoma in 2019, a $250m settlement in cash and the provision of $23bn of the drug, Suboxone, free of charge. On top of this, litigation related to price-fixing in the generics industry also surrounds the company. To Teva’s relief, the company, along with Johnson & Johnson, Endo International and Allergan, won a California court case during bookbuild. The judge deemed that the companies didn’t make false or misleading statements in connection with marketing prescription opioids in the state. Nonetheless, S&P believes Teva has capacity for an incremental $4-6bn of litigation liability on top of their current estimate of $2.5-3bn. 

This deal puts a spotlight on companies with troublesome ESG credentials issuing sustainability-linked products. Investors want to understand the structure of a SLB deal but in principle they don’t question what the proceeds are being used for.

Leveraged Loans

As issuance volumes began to wind down for Christmas, there was still time for ESG concerns to sow seeds of doubt during syndication for some of this month's largest deals. Dominated by the blockbuster buyout packages of Ultra Electronics and T-Mobile Netherlands, sustainability-linked leveraged loan volumes had a strong month, hitting north of €5.5bn and pushing total sustainability linked issuance for the year to ~€50bn.

Ultra was on the defensive during syndication, with the sector under fire from media in recent weeks regarding its ESG credentials. The defense sector suffers from the duopoly of the obvious ‘S’ concerns of contributing to and benefiting from armed conflict, and carbon intensive manufacturing processes (‘E’ concerns).

The deal was one of the few in recent months that certain fund managers we spoke to were passing on from the get go, entirely due to ESG concerns. The deal hits against a common ESG restriction for CLOs, with some funds restricting potential investments in defence, or in issuers earning a certain revenue proportion from weapons. The deal was reportedly still oversubscribed however, indicating that a broad swathe of buyers were able to get involved. Even managers whose CLO vehicle stipulations may have stopped them buying for that pocket may still have bought the deal in SMAs or other loan funds with looser limits. With ESG-linked CLOs on the march, and credit funds trumpeting their sustainability policies, we will be keeping a close eye on who shows up in the holdings data for this deal.

Of course, the crux of the issue for this credit is the nature of its operations. Investors still open to the deal were unconvinced with the firm’s disclosure over its client list and specific product revenue breakdown. Just 6% of revenues are from ‘Rest of the World’ (as per its Sustainability Report - the rest from ‘Five Eyes’ nations, being the US, UK, Canada, Australia, New Zealand, and mainland European nations), and we were unable to find more granular information on which nations make up this 6%. The breakdown of non-offensive products (such as radios), vs offensive products (e.g. submarines) is also unclear, with one buysider noting that from his research, the product mix is heavily biased towards offensive weapons. Ultra’s governance is also in question, with a 2018 investigation opened into alleged corruption relating to activities in Algeria.

Ultra’s 2020 Sustainability Report (here) does little to allay investor concerns with quantifiable ESG targets, instead offering assurances that the company does not engage in the most egregious of activities, as investors would hope (e.g. the supply of weapons to countries subject to UN Security Council Sanctions, production of ‘controversial’ weapons such as cluster munitions and nuclear weapons - although the group provides components for nuclear submarines). 

The company does provide a breakdown of its emissions by scope (85% scope 2), but again offers little in the way of long term reduction targets (10% GHG emission reduction vs 2019, 20% single use plastic reduction targets for 2021). Although the Group states that they are working towards raising the proportion of female board representation from 25% to the Hampton-Alexander target level of 33% (a relatively mundane target to begin with), there is little explanation of when this will be completed or the steps being taken to achieve this. For Diversity & Inclusion, the company states that “the Parker report recommendation to have at least one Director from a non-white ethnic minority is met” (the company currently has one board member from a BAME background). 

Furthermore, the firm's commitment to ESG again appears flimsy when considering the deal terms. The 10 bps ESG margin ratchet (cut from 15 bps) is optional with the associated KPIs remaining unspecified during syndication. If the ratchet is called into action, as a company operating in the defense sector investors may have hope for a targeted set of KPIs revolving around its operations and areas where the firm may be lacking, notably D&I as we discussed. A more constructive ESG package could include targets surrounding increasing the proportion of non-offensive weapons in the product mix, for example. Publicly disclosed emissions targets are also relative to total revenue, giving Ultra more room if revenues increase YoY (tCO2w/£m).

T-Mobile Netherlands offered a far more straightforward ESG package, although the terms were slightly disappointing. The initially ambitious 15 bps ratchet (in line with the largest we have seen come to market), was reduced to 10 bps during syndication, and the accompanying KPIs, GHG emissions and employment of 25,000 “disadvantaged people”, are not particularly robust. GHG emissions are measured as net, allowing the company to meet targets with the purchase of offsets, without altering business operations to cut gross emissions. The definition of “disadvantaged people” was also questioned by ESG-minded buysiders, and without a third party ESG reviewer disclosed, this KPI may also prove flimsy.

In the wider market

Following on from EQT’s pioneering introduction of firm & portfolio science based targets in October (covered in our previous wrap here), other active sponsors were keen to follow suit. Six firms (HG Capital, Astorg, Bregal, FSN, ICG and InvestIndustrial) have had a list of Science Based Targets approved by the Science Based Targets initiative (SBTi), including a 50% reduction in direct emissions (scope 1 and 2) by 2030, and ensuring all portfolio companies have adopted science based targets by 2040. The targets largely mirror EQT’s structure but are less ambitious (EQT has committed to ensuring science based targets for all its portfolio companies by 2030).

Selected 9fin ESG Highlights

9fin’s ESG filter has brought to light some important social and governance related news from the previous month which are worth highlighting:

• Following recent plans to build a £350m holiday resort in West Sussex, Conservation groups claim Center Parcs are destroying protected Woodlands
• Thames Water fined £4m after it allowed raw sewage to leak into two Oxford streams in 2016, 3,000 fish were killed. This is the third major fine for the company this year
• The Competition and Markets authority (CMA) said it is considering whether the takeover of Air Europa by British Airways owner IAG could lead to substantial reduction of competition in the UK
• Four former employees of The Hut Group have accused the online beauty retailer of firing them for trying to blow the whistle on health and safety breaches at one of their manufacturing and distribution facilities in Kentucky
• Drax was back in the news with plans to invest £3bn in bioenergy growth opportunities
• Adler defied calls for response to fraud allegations
• Juventus had their offices searched in connection with potentially false information provided by management regarding revenue received from player transfers
• Morrisons has ditched soya for insects in chicken feed to hatch carbon neutral eggs

ESG QuickTakes

As part of 9fin's developing High Yield coverage, we will be producing more detailed ESG analysis for a number of credits. We have published a number of ESG QuickTakes in the past month. You can request a copy by clicking on the link below and completing your details.

• Teva - ESG QuickTake (9fin)
• Kem One - ESG QuickTake (9fin)
• Lottomatica - ESG QuickTake (9fin)
• Graphic Packaging International - ESG QuickTake (9fin)
• Accor - ESG QuickTake (9fin)
• UGI International - ESG QuickTake (9fin)
• Reno De Medici - ESG QuickTake (9fin)