In March, the Loan Market Association (LMA) in consultation with the Loan Syndications and Trading Association (LSTA), Asia Pacific Loan Market Association (APLMA) and Fund Finance Association published its Guide to the Application of the Sustainability Linked Loan Principles in Fund Finance (the Guide), in keeping with the LMA's ongoing Sustainable Finance initiative.
With the growth in adoption of sustainability-linked loans (SLLs) across financial markets, the Guide is intended to assist practitioners and market participants alike with what remains a developing area of practice subject to much debate and negotiation. In brief, the Guide acknowledges the sector-specific challenges that arise in the context of attaining compliance with the Sustainability-Linked Loan Principles (the SLLPs) in the fund finance space and offers some practical insights as to how these might be addressed. Critically, the LMA has noted that whilst the Guide is reflective of prevailing market practices, the bespoke nature of SLLs and unique requirements of each fund's financing structure mean that there are no one-size-fits-all solutions.
Sustainable Finance in Fund Finance: why SLLs?
The Guide covers in brief the difference between SLLs, Green Loans and Social Loans, and why SLLs have emerged as a favoured choice in funds finance transactions. Flexibility, the LMA notes, is the key consideration for market participants; Green and Social Loans are "use of proceeds" products, which require that the proceeds of the loan are used entirely on a project meeting the criteria of a Green or Social Loan, as set out in the LMA's Green Loan Principles and Social Loan Principles. These products may be suitable for a fund in the context of the acquisition of a specific compliant asset but are unsuited to a fund which requires the ability to deploy funds for working capital. In contrast SLLs do not dictate the manner in which loan proceeds are deployed, and instead are structured to financially reward borrowers meeting ambitious Sustainability Performance Targets (SPTs) if they can demonstrate compliance with Key Performance Indicators (KPIs) set out in the loan agreement.
In considering the question of why a fund might choose a sustainable finance product at all, investor demand is a key factor. Market demand for funds to differentiate themselves remains consistent, and whilst there have been fears of a retrenchment from ESG practices amid allegations of greenwashing, the work of the LMA, LSTA and APLMA should provide comfort to market participants that generally accepted standards of best practice are coalescing into standardised guidance to follow.
In the context of current market conditions, the choice of an SLL over a Green or Social Loan makes operational sense; against the backdrop of rising interest rates and subdued M&A activity, fund finance solutions have increasingly been deployed for the purpose of pushing funds down into portfolio companies facing difficulty servicing or refinancing external debt, or which have been held longer than anticipated by sponsors. The unrestricted use of proceeds permitted by the SLLPs is therefore the more attractive choice for a fund seeking a product that will enable it to "defend the portfolio".
Challenges for SLLs in Fund Finance
The Guide recognises a number of challenges that market participants and practitioners have identified in negotiating fund finance products which are compliant with the SLLPs. Whilst the SLLPs have always acknowledged that the negotiation of an SLL is intended to be a bespoke process, this is further complicated by the nature of fund financing. A fund will typically have limited administrative operations, and the stage of the investment cycle that the fund has reached at the time of entry into an SLL will be critical for setting KPIs. Where an early stage fund has yet to acquire a portfolio of investments, KPIs may have to be set at sponsor level, which may be difficult where a sponsor already has robust ESG policies in place that may prove hard to improve upon in the manner required for an SLL. At the other end of the spectrum, a more mature fund may more feasibly set KPIs at investment level but will need to consider the level of control that the fund is able to exert over portfolio companies to ensure KPIs are met and will need to carefully calibrate the time horizon of SPTs as against the intended holding period for each investment.
Costs and managing investor sentiment will be key issues to manage; independent verification, particularly if required to be carried out across a range of investments with senior management who may not be familiar with the data collection and audit requirements needed to verify this type of KPI compliance will be an expensive exercise if targets are set at portfolio level, and funds will ultimately be answerable to investors for these costs. Similarly, investors will also need to fully understand and be on board with the potential for particularly ambitious targets to limit the scope of a fund to invest in a target entity that meets an investment policy but is not compliant with (or cannot be made compliant with in an economically feasible manner) the requirements of an SLL.
LMA Guidance
The Guide notes that increasingly KPIs are set at investment level in fund finance transactions, with maximum impact for SLL products being most likely to be delivered at this level. With this in mind, the LMA has further explored how market participants might practically apply the SLLPs to negotiations to deliver a compliant end product. One proposal is to calculate KPIs as a percentage of investments that have stated goals meeting the agreed upon criteria, in the interest of encouraging compliance over time. In the same vein, allowing for a mechanism by which investments become eligible to have their performance considered as against KPIs will provide borrowers with the breathing room to exclude newly acquired investments until sufficient time has passed to enable policies to be put in place to begin to work towards SPTs.
With respect to the selection of SPTs, the Guide notes that in selecting industry standards to make reference to when negotiating SPTs, it may be practical in the funds finance context to use the historic performance of prior funds sharing the same sponsor entity as the proposed borrower, or alternatively external funds of similar size and strategy where such data is available. The availability of comparative data in the space will only increase as jurisdictions implement various legislative regimes around ESG reporting, which should serve to make access to data to select SPTs an easier task as time progresses.
The LMA flags various reporting and verification considerations, which relate largely to the provision of information by portfolio companies up to fund level. To address these, it will be necessary to consider how frequently investments are expected to report back to fund level in order for the requisite information to be shared with lenders on the schedule set out in the loan agreement. With respect to the data being shared, the LMA notes that it may be appropriate to agree that the scope of third party verification will be limited to limited assurance such as a confirmation from such third party that no matter has come to its attention that would indicate a material misstatement, rather than incurring the expense of extensive verification of the accuracy of all data provided by each portfolio entity.
Conclusion
SLLs as a product are still in their early years, and their application in the fund finance space is very much still taking form. The LMA's guidance is welcome in this context, and whilst substantial challenges arise in formulating an SLL that achieves both compliance with the SLLPs and meeting the needs of a fund at the present stage of its life cycle, it is clear that interest in this space is ramping up and will only grow from here.
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To discuss the issues raised in this article in more detail, please contact a member of our Banking and Finance team.
