Leveraged finance: ESG sells

The USD 3.2bn loan issued to Baring Private Equity Asia (BPEA) last October, which includes interest rate breaks for the achievement of decarbonisation and diversity targets across the firm’s PE portfolio, is only the second of its kind in the region and easily the largest. Yet it reflects a surge in sustainability-linked credit activity over the past 12 months most visible at the deal level.

The private equity firm first wound ESG [environment, social, and governance] targets into a buyout transaction in August 2021 with the USD 1.2bn carve-out of healthcare-focused IT services provider Hinduja Global Solutions. BPEA’s capital markets team has explored repeating the trick on nearly every new investment since then, as well as on refinancings for existing portfolio companies.

“In most cases, banks are willing to do it – it makes sense for them, for us, and for the companies,” said Zongzhong Tang, the firm's ESG and sustainability manager.

“The mechanism is the same as at the portfolio level, but you can make the ESG targets very specific to the company’s operations. For a manufacturing business, you might focus on electricity consumption as well as climate change and diversity. For a labour-intensive technology company, you might look at how to improve employee retention.”

BPEA is not alone. Investors and advisors across the region report seeing an uptick in sustainability-linked loans (SLLs) in 2021. According to Tracy Wong Harris, head of sustainable finance in Asia at Standard Chartered Bank, last year the SLL market - for investment grade and non-investment grade instruments - grew 3x globally and 7x in Asia. Leveraged loans account for a relatively small piece, but they are on the rise.

Russell Sinclair, head of Australia debt and capital advisory at PwC, claims that SLLs have been contemplated for every leveraged deal to cross his desk in the past six months. “All PE firms want to know what SLLs look like and how they can benefit,” he added. “Lenders are equally excited. There is an alignment between what the funds want and what the lenders are willing to give.”

What emerges is an image of a feeding frenzy that is broadly well-intentioned yet lacking in maturity. Transactions are often run at speed and feature an array of highly negotiated performance metrics, incentives, penalties, and assessment protocols. The timelines and the complexities of dealing with multiple lenders may result in ESG elements being dropped and a reversion to traditional financing.

Industry participants contrast this chaos with the order of sustainable finance in the public markets, acknowledging that private SLLs remain a work in progress. There is also concern that immaturity could be exploited.

“The risk is that this becomes a tick-the-box exercise with sustainability KPIs [key performance indicators] in every term sheet without too much thought about which ones are most meaningful to the ESG issues of the company. It may just become an easy way of getting a discount on a loan,” said William Needham, a managing director in KKR’s credit business. “We need more standardisation and more engagement from lenders to ensure these facilities achieve a true impact.”

Progressive policies

SLLs have taken off in part because they represent a departure from the strictures of fixed income products in sustainable finance. Green bonds rose to prominence in the late 2000s as financing tools for projects that have positive environmental benefits, with their rigidity serving as a selling point. The proceeds can only be used for projects that meet qualification criteria at the time of investment.

This approach makes for an uncomfortable fit with ESG and impact strategies where the onus is on helping companies climb the sustainability curve, perhaps from a low starting point. In this context, the use of proceeds requirement for green bonds is limiting.

“As the field has matured, what we’ve realised we need is change over time across all industries,” said Megan Starr, global head of impact at The Carlyle Group. “Every company is impacted by energy transition: we don’t reward them based on whether they are green or brown on day one; we want to reward change over time provided it is material, ambitious, and tied to real performance.”

SLLs, by contrast, are tangible and flexible, cut across sustainability topics, and can be tailored according to the ESG maturity of the target company. And rather than link baseline sustainability to use of proceeds, it is correlated to KPIs that filter through to interest rate discounts.

“One of the challenges faced by the sustainable finance market since its inception is that it has been viewed as somewhat fluffy and niche,” said Xuan Jin, a counsel at White & Case in Hong Kong. “What we see now is hard edges forming and concepts and mechanisms that have achieved a critical mass of recognition among financial market participants, which are capable of being defined and which financial products can be built around.”

The BPEA portfolio-level facility comprises four KPIs with associated sustainability performance targets (SPTs). Two of them relate to broadly applied best practices: the implementation of ESG assessment of investment opportunities; and the introduction of a science-based target for greenhouse gas emissions that covers internal operations and portfolio companies.

The remaining two are specific to emissions and diversity, with BPEA required to ensure compliance in at least three-quarters of portfolio companies, albeit with progressive mechanisms.

For example, companies that currently do not report emissions will be deemed compliant in year one if they start. Those already reporting must set an emissions reduction target in year one, while those already with targets must meet them. For gender diversity, the goal is to reach at least 40% at the senior management level, but there is a recognition that some companies will take time to achieve this.

“A lot of facilities have targets on diversity and climate change because these are more easily quantifiable and measurable, and they can apply to all companies. There are fewer governance-related targets because those topics are more qualitative,” said BPEA’s Tang. “In general, data quality and availability are a challenge. Sometimes, we need to do capacity building at the portfolio companies and make sure they are tracking the correct metrics.”

There is more variety at the transaction level, with electricity, water, and fuel usage, treatment of hazardous waste, health and safety, and employee satisfaction among the KPIs most frequently referenced. Much depends on the target company’s business model, but the ability to capture data and to have done so for long enough to create meaningful benchmarks is a common issue.

Comfort and confidence

Carlyle has completed USD 18bn in ESG financing since 2019, starting at the transaction level and then moving into portfolio-level facilities. The way in which the latter have broadened in scope demonstrates increasing comfort with the data availability and quality.

In February 2021, the firm secured a USD 4.1bn facility tied to its Americas private equity funds with a KPI of achieving 30% board diversity among majority-owned businesses in the portfolio. Later in the year, the same board diversity target was attached to a EUR 2.3bn (USD 2.5bn) facility for Carlyle’s European private equity and real estate platform.

This time, however, it was accompanied by two additional KPIs: all portfolio companies must plot their carbon footprints; and a certain percentage of Carlyle employees who serve as board directors must undergo ESG-competent board training.

“Our European buyout portfolio is relatively mature on ESG, but in 2018, only 35% of companies knew what their carbon footprint was. You can’t set energy transition targets on that basis. Now, we are up to 100% coverage of majority-owned companies in the latest vintages in our US, Europe, and Asia buyout strategies. And when we have those data, we can potentially translate them into doing ESG-linked financing,” said Carlyle’s Starr.

BPEA, Carlyle and most other private equity firms active in SLLs are large enough to have internal resources across ESG and capital markets that work with companies on data collection and reporting and participate in financing negotiations with banks.

White & Case’s Jin notes that the spectrum of sustainability ranges from “dark greens” that pursue ESG improvement primarily as a matter of principle and “light greens” that are motivated more by the bottom line. On a general level, smaller and less public-facing institutions, as well as those not set up to be ESG focused, fall on the lighter side of the spectrum.

As a small to mid-cap player, Singapore’s Quadria Capital is an exception to the rule. The healthcare investor, which has USD 2.2bn in assets under management, became the first Asian GP to secure a portfolio-level SSL in 2019 when ING provided a USD 65m revolving capital call facility. It helped that there was an existing ESG program overseen by dedicated staff and validated by a third party.

“Sustainability and impact is one of the pillars of our thesis. We wanted that to permeate everything we do, and we have proprietary tools to measure that impact in terms of affordability, awareness, accessibility, and quality,” said Sunil Thakur, a partner at Quadria. “When raising a subscription line for our fourth fund, we wanted to be rewarded for the impact we are trying to achieve.”

The KPIs were drawn from eight ESG matrixes tracked by Quadria that are relevant to healthcare, ranging from energy usage to ethics and anti-corruption to accessibility for underserved groups. Thakur added that the interest rate stepdown on achieving the KPIs is 15-20 basis points, while there is no step-up should Quadria fall short.

Stick and carrot

This carrot-but-no-stick approach is common in the region. Harris of Standard Chartered observes that 90% of SLLs in Asia are one-sided – at the transaction level and the portfolio level – although penalty structures feature more often than before. BPEA’s facility is somewhat nuanced, with the GP required to use the increase in premium to buy carbon offsets rather than pay it to the lenders.

Several explanations are given for excluding penalty or punishment structures, such as lenders being happy enough with a company’s ESG credentials that they choose not to force the issue or financial sponsors getting nervous about these clauses because it impacts their base-case underwriting. Perhaps most plausibly in an Asian context, it is about comfort at the company management level.

“While most management teams recognise the importance of integrating both interest incentives and penalties, some may wish to be more conservative when entering these structures for the first time. In these cases, they may propose starting with a stepdown only and look to introduce a step-up later,” said Adam Heltzer, global head of ESG at Ares Management.

"It reflects one of the leverage points in a transaction – if management begins to find diminishing value in the structure they may wish to walk away, at which point lenders have the choice of whether to make such concessions.”

These dynamics underline the lack of broad market consensus on SLLs. While the Loan Market Association (LMA) and Asia Pacific Loan Market Association (APLMA) have issued guidance documents, industry participants observe that these run to no more than a few pages. The drafting is still in its nascent stages and there’s a shortage of helpful historical reference points.

Incentive and punishment structures and third-party verification are logical battlegrounds. On one side, the financial sponsors are concerned about cost, confidentiality, and timing. On the other, banks must meet internal protocols to qualify for better capital rating treatment, so they might hold their ground on issues like safeguards and testing.

“These are often large facilities with accelerated timelines, and each bank involved has different criteria, so bringing everyone together on the same page can be challenging. There have been situations where we started off intending to do an ESG-linked facility, but it proved too difficult,” said Manas Chandrashekar, a debt finance partner at Kirkland & Ellis.

EcoVadis, best known for business sustainability rankings, is one of numerous groups pushing into the verification space. Beyond discussions on what data should be verified, to what level, and how much can be disclosed, there are sometimes tensions as to what extent metrics should be top-down and applicable to all companies for benchmarking purposes rather than customised.

When conducting an assessment, EcoVadis relies on a reserve of more than 15,000 model questionnaires that vary based on size, country of origin, and industry. These are issued to target companies, the answers are crosschecked and verified, and scoring is normalised so lenders can draw comparisons. The methodology doesn’t change, though lenders could focus on certain sub-scores.

“We see more recognition of the value of consolidated and aggregated ratings versus the tracking of KPIs, which can be too narrow,” said Sophie Bertreau, vice president for new solutions at EcoVadis.

As to the structure of incentives, an interest rate stepdown of 10-15 basis points is considered typical. A 20 basis-point discount would be exceptional, although it is said to have reached around 25 basis points in the financing that supported KKR’s NZD 455m (USD 320m) acquisition of a majority stake in Education Perfect. This was the first unitranche SLL in the Australian market.

The consequences of meeting some KPIs, but not all, are heavily negotiated. A stepdown of several basis points per metric is usually offered – industry participants put it in the 2-5 basis point range – with 10-15 basis points serving as the overall cap. It is suggested that some companies take advantage of the lack of standardisation to pad out deals.

“There seems to be a trend towards quantity over quality, for example, by having multiple KPIs – perhaps a pressure to have one for each of E, S, and G – but none of which may be particularly meaningful to the specific company,” said Needham of KKR. “In these instances, I would prefer to have one KPI that is material and ambitious – that really matters to the company.”

Seeking a balance

This goes to the heart of certain deeper concerns about SLLs. While a 10-basis-point stepdown might amount to a meaningful saving in a portfolio-level facility, it doesn’t necessarily transform the economics on a transaction financing priced at 500 basis points above the bank bill swap rate.

And for private equity players, it isn’t just about the money. These financial incentives serve to encourage management teams to pursue ESG agendas that meet the wider needs of the company and the investor. In this way, they form part of a private equity firm’s overall ESG policy and its positioning as a generator of returns that deliver in terms of financial performance and sustainability.

One pan-regional manager who was approached about a portfolio-level SLL claims to have been nonplussed by the offering. The manager recognised that it would burnish his firm’s ESG credentials, but he concluded that the cost savings would be minimal. Meanwhile, the additional reporting would not be additive to what he claims is a comprehensive in-house ESG program.

“It’s great in terms of fundraising. You can say you are at the forefront of ESG, to the extent that even your financing is green, and ESG is everything right now,” the manager added. “It wasn’t for me.”

The key is balance. KPIs must meet the needs of all stakeholders – lender, sponsor, and company – by combining materiality and ambition with a dose of pragmatism. In selecting these metrics, a company is effectively mapping out its ESG journey, and this can only be achieved with detailed datasets and clarity as to what is being measured and what improvement looks like.

Heltzer of Ares notes that many businesses are still in the process of understanding how to put together ESG programs. The leap from there to true accountability based on an agreed set of metrics is substantial, but he has seen considerable progress in this area over the past few years.

Even as regulators and industry associations add flesh to the bones of policies and best-practice principles, helping to eliminate more reckless behaviour, a lot of experimentation is happening. This will add to the pool of knowledge and experience, and ultimately, help SLLs move towards greater standardisation and wider usage.

“Not all these things are going to work, and we need to be okay with that,” added Carlyle’s Starr. “We must experience failure, and then learn and progress from it. Sustainability-linked loans principles have been useful in outlining what makes a valid ESG-linked financing, and we see the sophistication and ambition ramping up with each financing.”

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• Topics
• Financing
• Buyouts
• GPs
• Asia
• Baring Private Equity Asia
• KKR
• The Carlyle Group
• White & Case
• Quadria Capital
• Ares Management
• ESG
• Leveraged finance