Sustainability linked loans move into the leveraged market

Spanish telecoms company MasMovil has become the first borrower to include a sustainability linked loan in a leveraged loan package. The terms of its new €100 million revolving credit facility and €150 million capex line, raised alongside a €1,450 million Term Loan B, feature a margin ratchet which reduces the applicable interest rate if MasMovil’s environmental, governance and social (ESG) rating improves, or increases the interest rate if it deteriorates.

Sustainability linked loans include a mechanism to incentivise improved ESG performance (typically measured by an independent provider of ESG ratings) by rewarding a better rating with a reduced interest rate and penalising a worse rating with an increased interest rate. According to ING, the potential increase or reduction is typically between 5-10% of the unadjusted margin.

Recognition of sustainability linked loans as a distinct finance product received an important boost in March this year with publication of the Sustainability Linked Loan Principles by the Loan Market Association (LMA), the Loan Syndications and Trading Association and the Asia Pacific Loan Market Association. These principles provide a broad framework which can be applied to categorise a loan as a sustainability linked loan (find out more here).

The key difference between sustainability linked loans and green loans is that sustainability linked loans are typically available for general corporate purposes and linked to ESG performance of the borrower’s business as a whole. In contrast, green loans must be used exclusively to finance a specific project identified and assessed when the loan is established, and eligibility as a green loan is based on the sustainability of just that project. As such, sustainability linked loans offer the borrower more flexibility over use of proceeds and allow lenders to incentivise performance in respect of a broader range of ESG factors.

The volume of sustainability linked loans to large corporates in the commercial bank market has grown dramatically since the first reported loan with pricing linked to sustainability performance was issued by Royal Philips in April 2017. According to Loan Pricing Corporation, over $35 billion of sustainability linked loans have been established this year, to the end of May. However, until now, sustainability linked loans have not been seen in the leveraged loan market. Possible reasons for this include that the unlisted, sponsor-backed companies that make up the vast majority of issuance into the leveraged loan market are less likely than listed corporates to commission an independent agency to award them an ESG rating and report ESG performance. Notably, MasMovil is a publicly listed company. Furthermore, the mounting public pressure on banks to use their business to encourage positive ESG outcomes is felt less keenly by the funds that dominate the buy-side of the leveraged loan market.

However, appetite for sustainability linked loans in the leveraged market may be growing. Investors in private equity funds, the banks and credit funds financing their investments and the investors in those credit funds are all increasingly focused on the sustainability of their investments. Investors are demanding analysis from asset managers on ESG performance and the market for investments that feature ESG criteria is growing. Major private equity firms are integrating ESG considerations into their investment process, and may view improving poor ESG performance in a portfolio company as a potential source of investment upside. Recently, a number of European fund managers such as Permira Debt Managers and Fair Oaks Capital have raised collateralised loan obligation funds (CLOs) which include ESG factors as mandatory criteria for loan selection under their constitutional documents.

More broadly, governments around the world are working to find ways to encourage the financial sector to support national and international sustainability commitments such as The Paris Agreement.  On 2 July 2019, the UK Government published its Green Finance Strategy, a key objective of which is to ensure that climate and environmental factors are integrated into mainstream financial decision making, and that markets for green financial products are robust in nature.

Freshfields has advised on a number of recent sustainability linked loan transactions, including the MasMovil financing. The expansion of sustainability linked finance into the leveraged loan market is a positive development we will be watching with interest.