ESG and the leveraged loan market

Investor attention to environmental, social and governance (“ESG”) considerations has steadily increased in recent years. The leveraged loan market has largely escaped this growing ESG focus, but leveraged loan investors are increasingly integrating ESG factors into their credit investment analyses. In early February 2020, the Loan Syndications and Trading Association (“LSTA”), a trade association representing the $1.2 trillion leveraged loan market in the United States, released its first ESG due diligence questionnaire to facilitate the improved sharing of ESG information from corporate borrowers. . Across the Atlantic, the European Leveraged Finance Alliance (“ELFA”) is developing a standard set of material ESG disclosure topics on which borrowers and issuers can be held publicly accountable. . Given the growing recognition that ESG issues can pose significant risks to credit investments, corporate borrowers in the leveraged loan market should expect this trend to continue and be prepared to provide lenders with more detailed ESG information in the future.

ESG and the leveraged lending landscape

The past decade has seen the launch of a host of sustainable finance initiatives designed to encourage the integration of ESG factors into investment decisions and corporate behavior. A short list of some of these global initiatives includes the UN Global Compact, the UN Sustainable Development Goals, the European Commission Action Plan for Financing Sustainable Growth, the Equator Principles, the International Finance Corporation’s Sustainability Framework and the Central Banks Network. and regulators for greening the financial system. Significantly, there are now over 2,200 signatories to the United Nations’ Principles for Responsible Investment (“PRI”), an initiative comprised of asset owners, investment managers and service providers (including including credit rating agencies) accepting six voluntary principles to integrate ESG criteria into their decision-making and investment practices. In 2016, PRI launched a Credit Risk and Rating Initiative, which is backed by signatories with nearly $30 trillion in fixed income related assets under management. As part of this initiative, the PRI has published a number of guides on how investors can take ESG issues into account when evaluating fixed income instruments and their issuers.1 Most recently, in September 2019, more than 130 banks launched the United Nations Principles for Responsible Banking to provide a global framework for a sustainable banking system and to accelerate the banking sector’s contribution to achieving the goals of the United Nations. Paris Climate Agreement and United Nations Sustainable Development Goals.

Along with the proliferation of global sustainable finance initiatives, the sustainable finance market has seen substantial growth, including green, social and sustainability bonds and loans, as well as funds with ESG mandates. The LSTA, the Loan Market Association and the Asia Pacific Loan Market Association have also collaborated to launch the Green Lending Principles and Sustainability Linked Lending Principles designed to promote consistency and best practices across green lending products. and durable, thereby increasing investor confidence in these vehicles. In 2019, sustainable debt issued globally was approximately $465 billion (up from $261 billion in 2018).2 The first green bond was issued in 2007; in 2019, the global green bond market was $271 billion (up from $182 billion in 2018). The first sustainability-related loan was issued in 2017; in 2019, the global sustainability-related lending market was worth $122 billion.

Until recently, the growth of ESG-oriented fixed income products was largely confined to the investment grade market, as opposed to the leveraged loan market, which involves higher levels of debt, higher credit ratings low and higher spreads, and often involves the financing of mergers and acquisitions and leveraged buyouts by private equity sponsors. Also, unlike in the area of ​​investment grade, ratings-based pricing is relatively rare in leveraged loans. Europe’s first sustainability-linked leveraged loan (an ESG-based margin ratchet as part of Masmovil’s $1.7 billion debt package) didn’t happen until May 2019. The slow adoption of ESG in the leveraged loan market may result, in part, from the lack of ESG data on leveraged borrowers, who are typically private, middle-market companies. Historically, these companies have been under less pressure to collect and publish ESG metrics, and may not have captured the attention of ESG assessors, such as MSCI.

The lack of ESG data for many leveraged borrowers has presented a challenge for credit investors conducting ESG investment analysis in the leveraged finance market. An ESG investor survey conducted by ELFA in November 2019 found that while 72% of European investors surveyed already take ESG considerations into account in their investment processes for at least half of their fixed income assets, 49% of investors believe that there is not enough data available on ESG factors. for high yield issuers and leveraged borrowers, especially small cap and private companies not covered by external data providers. Many of these credit investors are themselves under pressure from their LPs to report on ESG issues associated with their portfolios. To fill the data gap, many credit investors attempt to conduct their own proprietary research or send out bespoke ESG questionnaires to companies, potentially adding substantial work for both credit investors and borrowers. Credit investors who use ESG criteria in their investment analysis are beginning to push for more standardized ESG disclosure.

Credit rating agencies have started to take note of credit investors’ requests for more ESG information. About 20 credit rating agencies (including Moody’s Corporation and S&P Global Ratings) have signed a statement supporting the PRI credit risk and rating initiative designed to improve the systematic and transparent consideration of ESG factors in the assessment of solvency. Additionally, over the past year, Moody’s3 and S&P Global4 have acquired ESG data companies with the aim of improving their capabilities to provide ESG data to market participants.

LSTA ESG Due Diligence Questionnaire

As the need for ESG information on borrowers is increasing, the LSTA has launched the ESG Due Diligence Questionnaire at the request of and in collaboration with its Buyer Members with the aim of standardizing and streamlining ESG disclosure in the lending market. leveraged loans. . In developing the questionnaire, the LSTA was aware that (i) the questionnaire should be applicable to borrowers across all sectors, (ii) many borrowers are just beginning their ESG journey, and (iii) the initial version of the questionnaire should be manageable in scope. Given these considerations, the ESG due diligence questionnaire asks eight fundamental questions, including:

  1. Do you have a formalized ESG policy? If yes, please provide. If not, what ESG intentions or concepts have you identified as relevant to your business?
  2. Who oversees ESG issues in your company and what is the level of board oversight?
  3. Is ESG a factor in performance evaluation or executive compensation?
  4. Do you participate in any ESG frameworks, such as the Global Reporting Initiative and the Sustainability Accounting Standards Board (“SASB”) standards? If yes, please provide reports and notes.
  5. How does your company address, track and measure ESG issues? Please describe ESG-related business issues, using the SASB materiality map5 as a point of reference for guidance on financially material business risks and opportunities by sector.
  6. What is your company’s approach to board, management and workforce composition, including the percentage of independent directors and female directors?
  7. If desired, provide additional information on your company’s overall approach to ESG.
  8. Indicate the percentage of revenue from certain activities, such as businesses related to alcohol, tobacco, cannabis, gambling, thermal coal, controversial military weapons, firearms, GMOs and prisons private.

The ESG due diligence questionnaire, which is voluntary, is designed to be completed by the borrower during the due diligence phase of the loan origination process and posted in the public side data room for review by potential lenders. The LSTA also suggests that the completed questionnaire may be included in the confidential offering memorandum.

ELFA Development of the ESG standard

ELFA, a trade association created in 2019 for investors in the European leveraged finance market, has prioritized ESG data disclosure as one of its 2020 goals and is developing a standard set of material ESG disclosure topics for use in leveraged loans. . ELFA engages with issuers, private equity sponsors, deal arrangers and other stakeholders in a collaborative approach to developing practical standards. ELFA’s commitment has been included in the UN PRI initiative on ESG in credit risk and ratings. The Loan Market Association, an association of the syndicated loan market in the EMEA region, has joined ELFA in the initiative, and the associations plan to organize a roundtable with the PRI in London, with a follow-up session including credit agencies credit rating later in the year.

Conclusion

At this early stage, it is unclear whether the LSTA ESG Due Diligence Questionnaire, the ESG Disclosure Standards being developed by ELFA or another more widely applicable ESG Disclosure Framework6 will become the primary ESG framework adopted by the market. leveraged loans. Nonetheless, borrowers should expect the demand for increased and standardized disclosure to continue. In particular, private equity sponsors should consider the need to incorporate an ESG component into their due diligence process in order to be prepared to provide ESG information that may be required by their lenders as part of their efforts. acquisition financing.

Priscilla C. Carnegie