What does the latest Loan Market Association (LMA) guidance tell us about the sustainable finance market and its future?
Since the publication of the first 'Best Practice Guide to Sustainability-Linked Leveraged Loans' by the LMA in 2019, the sustainability-linked loan market has grown significantly. The LMA has, over the course of this year, revised its guidance in line with market development, setting out key considerations for borrowers, finance parties and their respective advisers when linking sustainability into facility agreements. The guide aims to provide practical guidance on the application of the Sustainability-Linked Loan Principles (SLLP), but how are they being interpreted in reality?
What are sustainability linked loans (SLLs)?
SLLs incentivise a borrower to improve their performance against certain predetermined ESG related criteria. It works as a sustainability linked pricing ratchet – if the borrower is able to satisfy the predetermined Sustainability Performance Targets (SPTs), the margin on the loan is discounted. SLLs can also be structured to penalise a borrower for failure to meet an SPT by increasing the margin upwards.
Setting SPTs
SPTs measure a borrower's sustainability performance by comparing it to predefined KPIs. The SLLP state that SPTs must be ambitious and exceed both regulatory requirements and business-as-usual trajectories. This is a high bar and means borrowers must go well beyond what they would otherwise be required to do, including under legislation. KPIs must be relevant, core, and material to the borrower's business, strategically significant, measurable, quantifiable, and benchmarkable. Lenders are increasingly taking a more robust approach to scrutinising borrower's proposed SPTs to ensure that they meet the above criteria in order to both guarantee the integrity of the product and counteract accusations of greenwashing.
The result of this is that, in some cases, the lender and borrower are unable to agree the SPTs prior to completion of the loan. This is particularly the case where a borrower is at the beginning of their sustainability journey, as they will need buy-in from many different parts of its business in order to pull together the information required to calculate and monitor SPTs. In these instances, the SLLP provides for 'sleeper' SLL provisions, which will be activated when the SPTs are agreed by way of a side letter (typically within 12 months). Until the SPTs go live, neither party is permitted to refer to the product as sustainable or sustainability linked.
Reporting and verification
The latest SLLPs also have more robust verification and reporting requirements, which, for the reasons given above, we are seeing lenders adopt to ensure SPTs remain, appropriate and challenging enough for the term of the loan. Borrowers are required to provide a sustainability report including information about their SPTs, sustainability confirmation statement and verification report on at least an annual basis. It may be the case, especially in certain sectors, that a borrower is already publicly providing this information. Where possible, lenders should be encouraged to rely on the information a borrower is already producing to avoid creating additional administration on the borrower side.
A Lender's starting point for verification of SPTs is to require independent and external verification of a borrower's performance against each KPI and this is reflected in the SLLPs. This verification is to be conducted by a qualified external reviewer with relevant expertise, such as an auditor, environmental consultant, or independent ratings agency. This is a growing area and likely to become more specialist the further borrowers are pushed to come up with more challenging SPTs, especially where there are science-based targets involved. A crucial issue here is around the cost of external verification. Given the emerging market and specialist expertise required, it can be expensive to obtain and many borrowers will be put off by the additional cost involved. We do think this has the potential to be a barrier to many borrowers engaging in SLLs and a solution needs to be quickly found that is satisfactory to all parties.
Conclusion
It is clear that lenders will be taking a much tougher approach to monitoring and scrutinising SLLs and the latest LMA guidance fully supports that goal. Whilst we appreciate that lenders want to mitigate calls of greenwashing, our view is that the current approach verges on being disproportionate. The additional work and cost involved for borrowers, especially relating to reporting and verification, will likely not outweigh the benefit of any margin discount achieved. In order to make SLLs work in future we believe a flexible and pragmatic approach will be required by all parties. In particular, lenders and their ESG teams will need to adopt a more nuanced approach with regard to the nature of each borrower and what is appropriate for them in the context of their business and the status of their sustainability journey.
