The evolution of mid-market sustainability-linked loans

Much is made of the growing prevalence of sustainability-linked loans (SLL) in the large-cap market. But in the active mid-market, SLL terms have developed differently with certain aspects being more or less pronounced, as part of the burgeoning growth of finance that is related to environmental, sustainability and governance (ESG).

Setting sustainability performance targets 

SLL seek to improve the sustainability of businesses, but with no requirement that the proceeds of the debt be used to fund improved sustainable ESG performance or specific ESG-linked activities. 

Improved sustainable ESG performance is assessed using predetermined targets known in the market as sustainability performance targets (SPTs). These SPTs are measured during the life of the financing using specified key performance indicators (KPIs). While the selection of the SPTs traditionally falls outside of the remit of external legal counsel, certain SPT trends are hard to miss.

It has become customary for the inclusion of multiple SPTs, usually numbering between two to four. These are selected at the outset of the transaction or, if urgency of execution is particularly great, the selection is deferred as a conditions subsequent requiring the approval of all lenders. 

In practice, SPTs should grow with the business and become more challenging over the life of the financing. The actual SPTs may remain of the same type and form of measurement, but the difficulty of meeting the SPTs can increase over time by a ratchetting up or down of the underlying quantitative metrics of measurement. 

In line with the large-cap market, the SPTs in the mid-market are more likely to focus on the environmental or social, rather than governance aspects of ESG. This is particularly true in leveraged and event-driven finance, where existing management or vendors are often strategically retained for a period of time and so governance changes become a delicate matter not to be tied into SPTs.

One aspect of the SLL market that is underdeveloped is the obligation to re-evaluate the SPTs during the life of the financing so as to not fall into a "set and forget" trap, especially when the debt arrangement has a particularly long tenor. The inclusion of an obligation on the borrower to certify that the SPTs remain material, ambitious and meaningful should not be overlooked as a powerful tool to guard against ESG-related risks.

An excellent starting point with respect to the election of SPTs and monitoring KPIs is the Loan Market Association's Guidance on Sustainability-Linked Loan Principles.

ESG margin ratchet

The financial implication of meeting or missing your SPTs remains limited to a range of 2.5 basis points to 15 basis points on the margin. The ESG margin ratchet exists in addition to any other margin ratchet applicable to the loans.

Some market participants view the ESG margin ratchet amounts involved as negligible and therefore their interest in SLL is low. However, the value that is brought by a greater focus on ESG targets has been shown to regularly lead to a better overall business, in which aspects that were previously overlooked now benefit from greater scrutiny that can lead to efficiencies and improved end-client engagement. 

The most common structure for the ESG margin ratchet is downward only (that is, to the benefit of the borrower paying less margin to the lenders) with an ESG ratchet switch-off if the SPTs are missed or the ESG provisions are not complied. A minority of SLL include an upward ESG margin ratchet where the borrower becomes liable for an increased amount of margin payable to the lenders. 

In the context of downward-only ESG margin ratchets, a small minority require the borrower to apply some or all of the margin ratchet proceeds for sustainability-linked initiatives or charitable purposes. The majority of SLL in the mid-market do not include this requirement.

Popular controls

The following remain popular forms of control for parties to SLL:

• Due diligence: ESG-specific due diligence as a condition precedent remains an important first step in determining the state of play of the borrower as regards its ESG position, helping to guide SPT selection and resolve any shortcomings in internal procedures. For SLL with buy-and-build strategies, lenders should request that bolt-on acquisitions have an ESG component to the due diligence exercise.
• Non-delivery of ESG reports and certificates: usually results in an automatic switch-off to the ESG margin ratchet, but does not result in a default or event of default.
• Misreporting of SPTs and KPIs: often provides the lenders an opportunity to seek third-party involvement at the cost and expense of the borrower, or require the directors of the borrower to present their KPIs in greater detail.
• Failure to meet SPTs: usually results in an automatic switch-off to the ESG margin ratchet or, where applicable and as noted above, an upward increase to the ESG margin ratchet, but does not result in a default or event of default.

Other SLL controls that are included less often in the mid-market are ESG controversy clauses, which act as an automatic switch-off of the ESG margin ratchet and related terms in response to an ESG controversy (for example, an oil spill), and ESG most favoured nation clauses, so that if a borrower enters into different or more ambitious ESG targets, the SLL SPTs are converted automatically to reflect the most challenging position.

There is, and will continue to be, discussions as to whether a breach of an ESG provision should constitute a default and/or an event of default. The overwhelming market consensus is that this is will not be reflected in documentation anytime soon. However, if the arrangement is underwritten on an ESG basis and the underlying subject of the financing doesn’t meet the SPTs, then the saleability of the debt in the secondary markets may be impacted. 

Third-party input

An expected divergence from the large-cap market is the use of third-party ESG ratings or achievement of a recognised ESG certification or accreditation. These are rarely seen in the mid-market and are far from ubiquitous in the large-cap space. Borrower self-certification remains popular in the mid-market which, when combined with the ESG-related controls, verification and monitoring obligations, can still provide a robust framework to ensure "sustainability washing" is avoided and the SPTs exist as ambitious and meaningful.

The appointment of one lender as the ESG agent and/or coordinator is becoming more prevalent, especially where there are larger clubs or a syndicate of lenders involved. This role should ideally not be reduced to that of a post-box of an annual ESG certification. It should be an active role that helps to set the SPTs and KPIs in response to ESG due diligence before the SLL is live. During the life of the deal, the role should involve monitoring compliance, as well as coordinating lender queries on the KPIs should that be necessary.

Osborne Clarke comment

This SLL market continues to develop and it will be interesting to see how SLL evolve in 2023. 

The "green squeeze" we discussed in a previous article is only growing in pressure from all sides, as different market participants are expected (or contractually obliged) to give ESG considerations a greater focus.

The elephant in the room which sits outside of this article's scope is the regulatory position which will impact on SLL. In this regard, please refer to the following article as well as other insights on the Osborne Clarke website.