Introduction

Recent documentary developments may provide assistance with the negotiation and drafting of a sustainability-linked loan (an SLL) in the leveraged market.

On 5 October 2023, the Loan Market Association (LMA) and the European Leveraged Finance Association (ELFA) updated their Best Practice Guide to Sustainability-Linked Leveraged Loans (the Guide). The Guide is aimed at the leveraged loan market on a portfolio company level, rather than sponsor or fund level. The Guide aims to assist borrowers, lenders and advisers on the incorporation of sustainability-linked provisions into leveraged loan facilities. The Guide was originally published on 28 July 2021 (the 2021 Guide), subsequent to which the Sustainability-Linked Leveraged Loan (SLLL) market has grown significantly. The Guide (in updated form) acknowledges that the leveraged loan market provides unique opportunities for sustainable lending in terms of the depth of relationships between borrowers and lenders due to the asset class and the focus investors give to a borrowers' assets, and the opportunity for information reporting to be bespoke and unconstrained by public securities laws. 

In a separate development in this area, the LMA has recently published a Term Sheet incorporating Sustainability-Linked Loan (SLL) drafting, to mirror the provisions of its draft SLL provisions which were published in May 2023 (LMA draft SLL provisions). This provides drafting which can be slotted into a term sheet for senior/mezzanine leveraged acquisition finance transactions (and adapted as appropriate to other types of financing), to incorporate the position that is aimed at in relation to SLL provisions at term sheet stage and to record the intention of the parties in terms of the way it is intended the SLL will work. The incorporation of the main tenets of the agreed SLL provisions into the term sheet relects the integral role that ESG considerations are being given in financings, noting the level of detail that can be expected in a term sheet on a leveraged financing generally. While such provisions have been included in term sheets for some time now, a standardised approach to such drafting (in terms of the detail to be included and the SLL provisions covered) may provide a competitive advantage to bidders in securing financing and/or may provide additional confirmation (as far as possible) to credit committees that their agreement to the loan where it is sustainability-linked will be supported by the drafting of the facility.

This article focuses on the assistance these documentary developments may provide to the negotiation and drafting of an SLL in the leveraged market. 

What is a Sustainability-Linked Leveraged Loan?

SLLLs are leveraged loans in relation to which the following have been applied/incorporated: 

• the LMA, Asia Pacific Loan Market Association (APLMA) and Loan Syndication and Trading Association (LSTA)'s Sustainability-Linked Loan Principles (SLLP)
• selection of Key Performance Indicators (KPIs)
• calibration of Sustainability Performance Targets (SPTs)
• loan characteristics (ie an economic mechanism tied to the meeting of set sustainability-linked targets)
• reporting
• verification.

A loan (originated, extended or refinanced after 9 March 2023) is required to align to the revised version of the SLLP in order to classify as an SLLL. 

The Best Practice Guide 

How the Guide differs from the 2021 Guide

The Guide sets out practical guidance on what borrowers, finance parties and their advisers need to consider when incorporating the SLLP into their leveraged loans. The updates that have been made demonstrate the significant growth in the field of sustainable financing in the context of leveraged loans. The Guide now addresses the following areas:

• Specialised roles: whilst the 2021 Guide discussed ESG rating providers, ESG consultants and external reviewers, the Guide provides a detailed description of other specialised roles in the SLLL life cycle such as the sustainability co-ordinator, second party opinion provider and an external reviewer. The Guide notes the difference in scope of engagement that can apply to a sustainability co-ordinator, depending on the transaction and the valued contribution a sustainability co-ordinator can offer in terms of awareness of market practice. The importance and value of expert input in determining how appropriate the sustainability-linked aims are is highlighted by the inclusion of reference to these roles.
• The selection and disclosure of KPIs: the Guide explains in more detail the timing and requirements of KPIs. Particular timing issues in the context of leveraged loans are highlighted in the context of KPIs, particularly where the financing relates to an acquisition bid, given that there will be no appetite to state the detail of the KPIs and SPTs in the term sheet until the outcome of the bid is clear. It is noted in this context that reference to the SLL provisions can be made in the underwriting term sheet with actual KPI/SPT selection and calibration being negotiated for inclusion in the long form documentation.
• Calibration of SPTs: the Guide explains in more detail the criteria and timing of SPTs. Timing issues are also noted in this context. We considered "sleeping SLL" structures in our previous article, noting that they should only be used in exceptional circumstances where the borrower has a clear sustainability strategy in place, time is pressured and KPI targets will be set no later than a year after origination. These structures may be appropriate in a leveraged finance context, given timing issues but should be used cautiously, and not included in a lender's sustainability calculations until "woken up". 
• Reporting and verification: the Guide discusses in more detail the requirements relating to performance against the KPIs and SPTs together with the timing for the reporting. 
• Resources and documentation: in comparison to the 2021 Guide, the Guide now provides standard drafting and documentation, including the LMA draft SLL provisions, which were also discussed in detail in our previous article referred to above.

Resources and documentation

When the 2021 Guide was produced, there were no model form provisions for SLLs and they were negotiated very much on a case-by-case basis. To assist with this, the 2021 Guide summarised certain considerations for documenting sustainability-linked leveraged deals, such as:

• Not including market flex provisions in term sheets.
• Including a sustainability-linked margin ratchet.
• Including fallback mechanisms.
• Including in a loan agreement what would classify as a "sustainability breach". 

The Guide now refers to recommended model provisions/guidance, including:

• The LMA draft SLL provisions. Such provisions are to be approached on a transaction-by-transaction basis and used as a starting point to be adapted as appropriate.
• The LMA, APLMA and LSTA's updated SLLPs.
• The APLMA's published Term Sheet (with Sustainability-Linked Loan Appendix): September 2022 and February 2023. 
• The LSTA's published Drafting Guidance for SLLs.

Draft Term Sheet provisions for SLLs

• The term sheet includes provision for several KPIs and the setting of specific SPTs in relation to the specific KPIs. The inclusion of specific KPIs and SPTs at term sheet stage means consideration will be required at an early stage to ensure that the KPIs are both material and meaningful to the borrower's business and represent a challenge to the borrower, as per the SLLP. It will also require a focus on applicable standards and will assist in clarifying the scope, standards, calculation methodology and baseline early and identifying any issues in terms of availability of external standards on which to measure the aims.
• The term sheet includes margin ratchet provisions which adjust the margin both upwards and downwards based on the number of SPTs that have been met. As currently drafted, if fewer than 2 SPTs are met than there is only optionality for no adjustment or margin increases, ie there is no option to increase the margin.
• Declassification provisions are included, drafted similarly narrowly in terms of the trigger to those in the LMA draft SLL provisions, on the occurrence of which the ESG related margin ratchet provision ceases to apply. In line with the provisions in the SLLs, the term sheet does not permit re-classification of a previously declassified SLL. This allows little flexibility in the event of a declassification, and would not assist a borrower and/or lender where an extension or re-negotiation of the SLL facility may be more attractive. 
• The rendezvous clause in the term sheet allows the borrower to be accountable for long-term targets and changes to KPIs and SPTs through discussing amendments to the KPIs, SPTs or calculation methodology on the occurrence of a Sustainability Amendment Event (SAE). This includes changes to the group structure of the relevant obligors or if the calculation methodology needs to be adjusted. The inclusion of a rendezvous clause at term sheet stage demonstrates the importance to the parties of taking an active approach to addressing events that occur during the loan's term which may have a significant impact on the original analysis undertaken in relation to the KPIs and SPTs and how much of a challenge they represent for the borrower. There is also provision in the term sheet to include further SAEs which may be useful for longer dated transactions in which it may be more difficult to set effective KPIs or SPTs from the outset of the loan.
• There are no provisions for conditions precedent in the term sheet, which also follows the drafting of the LMA draft SLL provisions. Given the differing aims of an SLL these are something that should be approached on a transaction-by-transaction basis and drafted by reference to the specific aims. 
• The timing requirements for supply of sustainability compliance certificates is incorporated, with optionality as to how frequent such information needs to be provided. The need for external review of such information is included reflecting the overall aim that any ESG targets are externally monitored and verified. 

The importance of the Guide and the SLL drafting for Term Sheets in the market

The SLLL market has grown significantly since the 2021 Guide was first published. ESG and sustainability-linked finance are gaining increasing focus within organisations. Rising ESG activism is being seen within companies and their supply chains which market participants, including regulators, are responding to. 

The FCA, in its recent findings publication, noted that market participants think that a more prescriptive framework in this area would improve market integrity, as it would offer credible transition plan disclosures that could be leveraged to inform the design of SPTs and KPIs in SLLLs. This could include more science-based ESG targets and could reduce the threat of accusations of greenwashing. This sentiment comes as a result of recent media coverage of the market, which has highlighted that there is still lots to do in relation to: 

• Credibility, greenwashing and consistency and integrity concerns across the market: firms indicated that the classification of SLLLs varies considerably between banks, such as when as an example, a firm considered that of 250 SLLL transactions completed in 2022, only 30% were regarded "fit for purpose", and that in 50% of cases, KPIs were not robust. Moreover, certain sectors of the market were deemed slow to develop.
• Conflicts of interest and weak incentives to issue SLLLs: companies face a difficult balancing act between managing pressure from investors and lenders for relevant SLLL disclosures, meaningful SPTs and KPIs and their potential reluctance to provide more disclosures on their ESG efforts and impacts than they are required to do by regulation. This reluctance comes from weak incentivisation stemming from green hushing and greenwashing accusations, damage to reputation and the potential to be subjected to civil and regulatory enforcement. 

While the FCA does not regulate the SLLL market directly, it seeks to ensure the SLLL market is consistent and acting with integrity. The updates to the Guide and the move towards standardised drafting at term sheet stage can only assist in providing a more consistent market approach to market participants in this ever-developing area.

Find out more

To discuss the issues raised in this article in more detail, please contact a member of our Banking and Finance team.