Why isn't every loan sustainability linked in the UK?

Sustainability-linked loans (SLLs) were much discussed in the UK debt markets coming out of the Covid-19 lockdowns. The expectation of many was that SLLs were not only here to stay but had the momentum to form a sizable part of the market and become a ubiquitous part of loan documentation. However, it is clear to see that this has not been the case.

So why have SLLs declined in popularity in the mid-market, especially given the initial momentum of the product combined with the Loan Market Association having published user-friendly template drafting that is widely regarded as a helpful starting position to negotiations?

Why doesn't every loan agreement include sustainability-linked provisions? Below we highlight six  issues which shed some light on this question.

Priorities: costs and resource allocation

Transactional activity in the UK mid-market had been buoyant prior to 2023, having spiked in 2021. Interest rates were low. Inflation was stable. Cheap debt was readily accessible. Creditors had overwhelmingly acted supportively during the worst of Covid-19. From this position of relative comfort and security, market participants were allowed the space to explore SLLs and how they could benefit transactions.

However, when economic headwinds began to be felt, the costs and efforts relating to negotiating the terms of the sustainability provisions and resource allocation to monitor and report on the sustainability obligations, became a victim of competing commercial priorities.

The focus of "C-suites" became meeting higher interest payments, temporary covenant loosening, diversification of underperforming assets and profit accretive actions such as bolt-on acquisitions and capital expenditure. Coinciding with this period also came greater lender focus on scrutinising sustainability provisions to ensure they earned their name and that the underlying circumstances were compatible with more rigorous requirements around monitoring and labelling.

Greenwashing risk

In 2023, the UK’s Financial Conduct Authority published a letter raising concerns with the SLL market that ranged from a lack of trust to potential conflicts of interest: “we also noted a general sentiment among banks that the ‘relationship’ may matter more than the borrower’s sustainability credentials – the former may therefore disproportionately drive the bank’s decision to participate in the loan.”

Lenders had been put on notice. Greenwashing is now a watchword for SLLs. All parties have had to become very aware of not making unsupported claims about the positive impact that they, their products or their services have on the environment and other sustainable endeavours. Loan documentation should not be publicised and classified as sustainability linked unless – based on the facts of the transaction and the business – it is genuinely deserving of this status.

As regulators such as the Financial Conduct Authority take a tougher stance, appetite for the SLL product has been checked, especially in respect of transactions where speed and certainty of execution are paramount.

Socio-political attitudes

The Association of Investment Companies' annual environmental, social and governance (ESG) tracker found in 2024 that the percentage of investors and advisers considering ESG was 48 per cent, having fallen from 53 per cent in 2023, 60 per cent in 2022, and 66 per cent in 2021.

SLLs are intrinsically linked to ESG issues and attitudes. Underperformance of numerous ESG funds in the stock markets combined with the rising anti-ESG sentiment in the US and other European countries has contributed to SLLs shrinking in popularity. ESG is also associated by some with diversity, equity/equality and inclusion (DEI) issues. DEI has likewise, and with even more fervour, been under the critical spotlight by certain politicians and media outlets.

Stakeholder engagement

Several investors in credit funds, pension funds and equity funds have mandated requirements for those investing on their behalf that certain ESG and sustainability-related conditions have to be met. These vary from investor to investor. Some conditions are as simple as ESG-related due diligence and reporting across specific investments and/or portfolios, whereas other conditions are more prescriptive and limit investments into Article 8 and/or Article 9 funds of the EU’s Sustainable Finance Disclosure Regulation. By promoting sustainability (or other ESG ambitions) some lenders and businesses will attract investment from a wider pool, albeit a forensic examination of the investor conditions is recommended.

Improved performance

There is oft-quoted evidence that supports the notion that integrating ESG information into corporate operations and decision-making adds value that translates to better managed companies and better corporate financial performance.

However, this assertion can be easily inverted and it can be argued that already better-run profitable companies have the luxury of focusing on ESG to enhance existing operations. Given plenty of businesses have been experiencing greater stresses over the last few years, the de-escalation of ESG and sustainability from C-suite agendas is a natural outcome.

Financial reward

At the core of SLLs is the notion that with improved ESG performance comes decreases to the interest rates charged. However, many market participants view the variations to interest as too minimal to warrant any serious consideration; as such, with one of the main components of SLL deemed insignificant, there is, in some cases, little hope of borrowers and lenders giving it much consideration at the mandate and term-sheet stages of a transaction.

A result of this is that having the debt product as a SLL is an afterthought, with an inelegant solution often being the introduction of a condition subsequent to agree the sustainability provisions post-closing, which has challenges and issues of its own.

Osborne Clarke comment

The most successful proponents of SLLs are those placing both the financial and sustainability impact goals at the heart of the decision-making. For example, credit funds with dedicated impact strategies, which can provide bigger margin discounts than have been traditionally seen in the SLL market, will be at the forefront of driving more impactful behaviours and be best placed to reap the rewards alongside those sponsors and businesses that have a clear need for tailored SLL debt products. 

Until the economic rewards are more significant and the impositions on the resources are able to be absorbed better by businesses, it will likely be the case that an appetite to structure a debt package as an SLL will remain for the few and not the many.

Not every loan should be an SLL. However, there remain opportunities for participants in the mid-market to distinguish themselves from the herd. The answer does not lie in trying to introduce sustainability into all transactions but rather in adopting a more tailored approach to capital deployment that focuses on businesses in which sustainability is an apparent part of their strategic growth.