2021 saw a surge in ESG-linked margin ratchets, reflecting a stronger sustainability focus across Europe’s leveraged loan market, according to Reorg’s annual review.
The European leveraged loan market saw a tremendous shift in its approach to sustainability in 2021. Investors are increasingly including an evaluation of ESG factors in their assessment of credit risk. There has been a dramatic growth of ESG-linked margin ratchets in leveraged loans: 43% of syndicated leveraged loans have included such ratchets this year. This is a far cry from 2020, when ESG provisions first appeared in just a handful of loans.
Last year, we wrote about the evolution of this seismic development, highlighting the key themes that were emerging in the then nascent space. Since then, the prevalence of ESG-linked leveraged loans has held strong and the architecture of the salient clauses has evolved.
EMEA Covenants by Reorg has closely monitored this development, tracking more than 30 ESG-related data points for European leveraged loans, taken from term sheets and senior facilities agreements (ESG deals). There is no doubt that ESG provisions in leveraged loans are still in their infancy, but several trends are beginning to take shape as the market heads into 2022. This article provides a high level overview of the key trends from ESG deals in 2021.
Notable highlights from the year include:
- KPIs were the preferred method to evaluate ESG performance although a hybrid option is on the rise as of late;
- Two-way ratchets were common, with an automatic increase on the failure to deliver relevant ESG compliance certificates/reports appearing in two-thirds of loans;
- The range of margin adjustments increased in the second half of the year; and
- Only half the deals with ESG requirements called for external oversight of reporting, though Q3 and Q4 saw divergent trends.
The incorporation of ESG standards in loans is a means to incentivise borrowers to improve their performance in these areas against preset criteria. Specifically, the incentive comes in the form of pricing – a margin adjustment mechanic (often referred to as an ‘ESG margin ratchet’) is built around certain criteria and the borrower’s performance will result in either a reduction or an increase to the margin based on how well it performs against the criteria.
In 2021, nearly half of all European leveraged loans included ESG margin ratchets. This is a very substantial increase from 2020. The prevalence of ESG margin ratchets increased steadily from 31% in Q1 to 71% in Q4 to date (15 December), with borrowers in the consumer goods and industrial sectors using them the most. In more than 80% of the ESG deals in 2021, the ESG ratchet applied to both the term loan B and the revolver.
ESG margin ratchet adjustments: impact on economics
Depending on whether the ESG margin ratchet has a one-way or two-way function, the margin can decrease if the borrower satisfies the preset criteria and/or increase if the borrower falls short of the criteria or fails to provide the requisite ESG information. In a continuation of the trend noted earlier in 2021, the vast majority of ESG deals adopted a two-way mechanism, as the underlying objective of ratchets is to incentivise borrowers to improve their ESG performance.
Similar to a traditional margin ratchet, a borrower is granted a premium or a discount to margin ranging from a cumulative +/-5 basis points or less to +/-15 basis points.
No standard margin has been established yet. Among the 2021 ESG deals, +/-7.5 bps has been most popular, although a range of +/-10 bps has become increasingly common. The ratchet adjustment range has been increasing over the course of the year. In a select few deals, starting Q2 onwards, maximum adjustment ranges of 11.25 bps, 12.5 bps and even 15 bps were seen. ESG pricing adjustments are a key issue for lenders, who consider whether the economic adjustments are high enough to incentivise a borrower to make a real change.
Almost two-thirds of ESG deals (less for those backed by private equity sponsors) included an automatic margin increase if the borrower failed to provide the relevant KPI/target reporting or ESG score. The inclusion of this punitive provision has been inconsistent over the course of the year, appearing in 75% and 83% of ESG deals in Q1 and Q3, but slipping down to 56% and 50% of ESG deals in Q2 and Q4, and no clear trend has emerged. This variance would seem to be at odds with what the leveraged loan lender community wants. In a survey of 170 investors conducted by the European Leveraged Finance Association in July, 82% of respondents said they wanted a margin step-up to be applied if a company did not provide an ESG or sustainability report or third-party confirmation.
ESG triggers: sustainability KPIs and ESG ratings
Reorg’s research shows that 81% of all ESG deals have used key performance indicator targets as a benchmark of margin ratchets, with a small minority opting for external ESG ratings or a blend of ESG ratings and KPI metrics.
The mechanics of ESG margin ratchets vary significantly. The premium or discount to the margin can depend on the number of sustainability KPIs to be attained. So far, most companies set their margin reductions on achieving two to three KPIs, with a pricing reduction permitted for every KPI achieved. In other cases, the first pricing reduction is permitted only when two or even three targets are achieved. More complex structures adopt a tiered approach, with bespoke adjustments for each of the KPIs or at different time periods.
The extent of disclosure on sustainability targets can vary. We have seen some deals at the term sheet stage, with little or no disclosure on the types, numbers or levels of the ESG targets to be met for a margin reduction, merely containing a statement that ESG related provisions would be added after the deal has syndicated. The Loan Market Association and the European Leveraged Finance Association recently updated their Best Practice Guide to Term Sheet Completeness (which Reorg contributed to) to support greater ESG transparency at the term sheet stage and combat the risk of greenwashing.
In contrast to KPI-based margin ratchets, a small number of ESG deals adjusted their margin ratchet based on a hybrid approach of KPIs and an ESG score. The hybrid approach has typically had two formulations: either the documentation outlines a framework for both KPIs and an ESG score, with borrowers given the choice which to pursue; or the margin ratchet is KPI-based, but with an ESG score rating functioning as one type of KPI. The latter formulation has appeared in 30% of ESG deals in Q4 to date, up from 2% in the first three quarters – a signal that it might be gaining in popularity.
One concern among lenders about sustainability-linked loans is whether the KPIs are ambitious enough. It is not enough to set meaningful targets at the outset, they say, arguing instead that targets must remain ambitious throughout the life of the loan. KPI target levels in some sustainability-linked loans can either be static, staying at the same level for the life of the facilities, or dynamic (as described below). Loans with dynamic targets are more effective to encourage borrowers to improve their ESG performance, and therefore to continue to benefit from improved pricing.
In order for KPIs to be dynamic and meaningful, the facilities agreement needs to allow for adjustments to the targets or the methodology. Most senior facilities agreements in 2021 did not provide for an express regime for amendments to ESG targets. In the absence of an express provision, amendments to a facilities agreement would require majority lender consent.
The consent threshold level for amending ESG related provisions could be an area where borrowers seek to improve their position in 2022. A deal recently allowed the borrower to unilaterally change KPIs, requiring the majority lenders to object if they disagreed with the changes. Putting the onus on the lenders to object, instead of seeking their consent, would make it a much easier process for a borrower to push through amendments.
Disclosure, reporting and external verification
The rapid growth in ESG-related issuance has raised the risk of greenwashing and the measurement and reporting of KPI compliance is an area of concern for lenders, who believe greater rigour and oversight is needed.
Seventy-one percent of investors polled by the European Leveraged Finance Association called for a third-party ESG rating or ESG coordination agent to be initially involved in KPI setting. A third of investors wanted their input incorporated into setting KPIs. Almost nine in 10 loan investors (87%) want KPIs audited by external parties annually.
The data from 2021 reveals a different picture.
The percentage of ESG deals with independent verification of reporting, i.e. the stipulation that an independent third party reviews and confirms the borrower’s compliance certificate/report of their performance, has gradually increased from 55% in Q1 to 60% in Q2 to a remarkable 80% in Q3. However, in Q4 to date, there was a significant reduction. It will be interesting to see if this latest development is an anomaly and if independent verification requirements become more prevalent in ESG deals in 2022.
Other documentary considerations
Less than a quarter of ESG deals required interest savings to be donated to charitable causes or reinvested in sustainable initiatives and this level has remained stable across quarters. Whether or not the borrower is required to confirm that the savings have been donated or reinvested remains open to negotiation, as do the consequences for a failure to make such a charitable donation or reinvestment.