Taking the Credit - Private credit ESG gets lender friendly

Josephine Shillito

30 March 2023•3 min read

For months now, private credit funds have been asking for tighter documents, but sponsors have not necessarily provided them. However, there is one area to which this stand off does not seem to apply: environmental and social governance. When it comes to the ESG margin ratchet, both parties seem happy to get a little stricter.

“We’re seeing an increase in the number of two-way ESG margin ratchets written into documents, even while the tired old debate of two covenants or three [between lender and sponsor] drags on,” said a market participant.

“ESG mechanisms, terms, ratchets, what to focus on in and around reporting. On this, all parties seem able to agree,” said a second source.

The change is to the direction of the ratchet. ESG margin ratchets have typically worked on the ‘carrot’ principal, ratcheting down the margin as the borrower meets pre-agreed ESG criteria. The more frequent inclusion now of ‘stick’, a two-way ratchet that ratchets up when those criteria are not met, is welcomed by lenders.

“I feel like it’s great when a business does well — but I also feel that when the margin remains higher for a period — I also like that,” a third market participant candidly confessed.

For private debt funds, the matter is not purely financial. As definitions under Sustainable Finance Disclosure Regulations (SFDR) get more sophisticated, private debt funds are losing out on the coveted ‘Article 9’ classification. According to this 2022 report and its 2021 predecessor, funds domiciled in Luxembourg (by and large Europe’s domicile of choice for the asset class), and classed as Article 9 under SFDR accounted for only 2% of the funds that responded to the 2022 survey, when in 2021 the percentage was 6%.

Meanwhile, the percentage of ESG-unfriendly Article 6 funds grew from 61% of debt funds in the 2021 period to 75% in 2022.

Article 8 funds – those that claim at least to promote ESG characteristics – also shrunk year on year from 33% in the 12 months to June 2021 to 23% in the same period 2022.

Now, these are survey results and thus an inexact science — then again, so is SFDR in its current format and before better data transparency and industry standardisation. But at a time when fundraising in alternative assets, including private credit, is stalling, then throwing in a tighter ESG margin ratchet on a deal may act as a carrot to get a deal over the line.

All’s quiet on the primary front

Perhaps due to the aforementioned terms mismatch, the only primary actually appearing in European private credit remains upsizes and add-ons.

There are two schools of thought on this point, depending on who you ask: One, private credit lenders are asking too much: too many terms, too much pricing, too little hold. Or two, sponsors are being unrealistic: valuations are too high and documents too loose.

Large deals like Ambassador Theatre Group’s reported £1.2bn refinancing, VetPartners’ reported LBO and Access Group’s €500m add-on remain quiet.

Bain Capital Credit and Macquarie Capital, however, have provided an upsized debt facility to German insurance broker MRH Trowe, and Muzinich Private Debt has provided additional debt to London-based news and information provider Market News International. Both deals follow on from LBO financings in 2021 and 2022, respectively.

Perhaps the inclusion of lender-friendly ESG terms heralds the beginning of a shift in sentiment from sponsors — but it could of course be just an easy concession in order to paper over the gap in expectations. Want your deal included? Contact me directly at Josie@9fin.com