Little more than a year ago, there were but a handful of green shoots in the market for ESG-linked fund finance facilities. First came sustainability: Singaporean healthcare-focused private equity giant Quadria Capital laid the first seed in October 2019, followed by French firm Eurazeo in January 2020, with the first EMEA facility. KKR then kicked off the US market with a use-of-proceeds subscription credit line for its $1.3 billion global impact fund in June, and Sweden-based EQT Partners made something of a name for itself as a market leader by closing on two lines: one in June and another – reportedly the biggest yet, at €2.7 billion – in November. Then, this February, The Carlyle Group took out the first known entirely social-linked facility, for its US corporate buyout funds.
A trickle of other deals have been done quietly, and while these deals in aggregate represent only a fraction of the wider subscription lending market, leaders in the space say it is fertile ground for fund finance in 2021, especially in light of the events the last year, chief among them the death of George Floyd and the worldwide protests against institutionalized racism, as well as the covid-19 pandemic and the environmental and social crises it has precipitated.
“It’s been the one thing in this market that’s generated a huge amount of interest,” says Tom Smith, partner at Debevoise & Plimpton in London, who helped organize EQT’s two green lines. “After we did the EQT deal, we’ve had a load of reverse inquiries from sponsors wanting to know how it works and thinking about whether to do it.”
ESG-linked deals, though bespoke, are generally structured to give the manager a discount to its market margin if certain key performance indicators are met at predesignated intervals over the life of the facility. In some cases, a discount may be applied per KPI, in others, only if all outlined KPIs are met, says Smith. In some cases, an incremental penalty might be added to the rate if such KPIs aren’t met. For Eurazeo’s line, failure to hit its targets results in extra fees, which the lending banks promise to direct to greenhouse gas-reducing projects (EQT’s lines also see the interest rate increase if targets are not met). Discounts and penalties aren’t disclosed publicly, but some market participants have said the former can range from 10-20 percent of a sponsor’s market margin.
The discount/penalty structure is a great way to incentivize deal teams to pursue strategies important to senior management, according to some market participants. “Senior management often want to focus the deal guys on the things they care about. How do you incentivize your deal team? One way is to have a capital call facility that allows them to make savings at an institutional level if you improve ESG. That effectively institutionalizes this focus,” says Debevoise’s Smith.
EQT’s head of treasury, Magnus Lindberg, echoes that sentiment, saying that while “sustainability is an integral part of the strategy within EQT’s portfolio companies,” the pricing model “is an excellent way of further incentivizing their performance in ESG-related areas.”
“The partnerships make it possible for EQT to set more ambitious goals and incentivize portfolio companies to become even more sustainable,” he adds. (EQT’s lines have a pre-set margin that is decreased if KPIs are met, increased if not. Some KPIs are assessed quarterly, others annually, Lindberg says.)
Others suggest the discounts are not substantial from a sponsor’s point of view, but that other factors create a greater incentive to pursue their ESG goals. “From a manager perspective, a few basis points discount or penalty is a consideration,” says Fi Dinh, director at ING Bank in Singapore, which acted as lender to Quadria on its $65 million ESG-linked line. “But if the targets are not met, the more meaningful consequence is having to explain to their investors why they didn’t meet their targets.
“Potentially having the whole ESG-linked structure yanked from them and having to explain that to investors is a real incentive to set ambitious, yet realistic, KPIs, and to meet them,” adds Dinh.
Of course, the larger the facility, the more the potential absolute savings. Carlyle expects its $4.1 billion, three- year facility, which is tied to diversity targets on portfolio company boards within its US corporate buyouts funds, could save it $5 million-$6 million in interest expense.
Shades of green line
Shelley Morrison, senior investment director of fund financing at Aberdeen Standard Investments, invests in ESG sub lines passively alongside lenders, and says that some lines frontload a penalty rate above market margin from the outset. “In those cases there’s more of an incentive to deliver underlying improvements in the portfolio companies,” she says.
However it’s structured, Morrison says, she and her investors see these lines as being overdue. “It’s driving the right behaviors, because as long as you can show a clear improvement or clear progress against these objective measures, there’s a financial benefit for you,” she says. “And I like that managers are finally putting their money where their mouth is – it’s no longer just lip service to ESG; there’s an actual penalty for not delivering.”
Fertile ground for ESG sub lines, but it comes with challenges
With more LPs focusing on ESG criteria and funds reportedly holding off on fundraising, the market for ESG-linked subscription credit facilities may see a boost in the near future.
But market participants also warn there are challenges that need to be met.
“As LPs focus on ESG investment, this product is and will become a very useful marketing tool for sponsors in fundraising,” says Debevoise and Plimpton partner Pierre Maugüé. Tom Smith, also a partner at the firm, adds that “there are plenty of sponsors out there who didn’t do any fundraising in the last six months of the year.”
“I think we’ll see more activity in this market this year because many of the sponsors to whom ESG financings appeal will be coming to the fundraising market this year, and the outset of a new fund is the right time to put in place the capital call line,” Smith adds, saying that the firm has received interest on ESG lines even from credit and secondaries funds. Those would require ‘softer’ ESG tests, due to lack of control investments, or some form of credit picking, he says.
“There a lot more players and people interested in exploring this market further, but they have different capabilities,” says Fi Dinh, director at ING Bank in Singapore. But, “there have also been more concerns raised by LPs about the lack of a standard framework for measuring progress, and resultant fears of greenwashing. For this year and the next few years, I think the focus of the market will be crystallizing what is actually considered sustainable financing and what is more ‘ambition.’”
Market players are split on the future for a standard framework or metrics for measuring ESG progress, with some saying that even if possible, it might not even be desirable. In the ESG sub line market, “metrics will only standardize if lenders/borrowers choose to simply piggy-back off the thinking done by the first sponsors in the market,” says Smith. “However, every fund has a nuanced ESG approach, and sponsors invest in different types of assets, so logically sponsors should be tailoring their metrics to their investment approach, strategy and ESG focus.”
Still, some criteria are too vague, says Dinh. “I am aware that there are facilities out there that are marketed as promoting the UN SDGs. But still, it’s important to know what specific actions or drivers are underlying the facilities. Just saying that the investment activities are in line with UN SDG goals is a little bit wishy washy.”
If the market is to grow, it will need some standardization. “If lenders are going to be offering a pricing discount, there needs to be the ability to compare how one manager is performing against another so that you can offer fair pricing to the market,” says Shelley Morrison, senior investment director of fund financing at Aberdeen Standard Investments.
Vicky Du, global head of fund finance at Standard Chartered, says there has been progress, pointing to the release of the UN Development Program’s SDG Impact Standards for private equity firms: “There is no uniform standard out there, but we think that will change, and we’re trying to be part of the leading force, contributing to this process.”
There are, broadly, two structures for ESG-linked facilities, whether traditional corporate revolving credit facilities or fund-level subscription credit lines. Most publicly announced deals are modeled after sustainability-linked loans, in which performance targets are set, such as specified improvements on energy efficiency in firm operations or across portfolio companies, diversity targets, or the future ability to attain certain ESG ratings. These are often used by firms to boost their ESG credentials.
Dinh outlines two basic approaches to SLL-style ESG-linked lines, depending on the maturity of a sponsors’ ESG framework. Sponsors that already have a framework in place might take the ratings-based approach, in which the borrower and lenders agree on baselines and targets based on existing ESG ratings assessments. “The external ESG rating provider then validates, scores and benchmark performance of the fund’s portfolio companies, then a fund-level rating is computed taking into account the characteristics and dynamics of the portfolio,” says Dinh. With this approach, she says, there is little ongoing reporting work for the manager to do themselves.
“The second approach is more relevant for those that are still early in their ESG journey, and is more linked to a specific, customized set of KPIs,” says Dinh. “Here, the bank sits down to look at what the fund has compared with their peers, the asset classes, investment strategies, etc, and use potentially a number of third-party methodologies along with materiality assessment to come up with typically less than 10 KPIs that can be applied across the portfolio on an ongoing basis.” This model requires the third party to verify those tailored KPIs, typically annually (quarterly, for some KPIs).
“Whilst this method may be less straightforward, the cost is easily offset by the discounted margin, and the framework can then be replicated to the other funds that manager manages, and help shape the development of their own ESG framework,” adds Dinh.
The alternative to SLL-style lines are those modeled after traditional green loans. These ‘use of proceeds’ facilities differ in that funds drawn from the line must be used for investments that meet predefined criteria, making them much less flexible than the ‘general corporate purpose’ style of most revolvers.
Private Funds CFO is aware of only two fund-level ‘use of proceeds’ ESG facilities, and only one of the sponsors involved. KKR placed the first US proceeds-linked subscription line in June, according to Standard Chartered, which was sole sustainability co-ordinator, sustainability structuring agent and co-lead arranger on KKR’s line (the bank was also behind the line announced in May of last year for an undisclosed fund manager, whose facility it says was the first use-of-proceeds sub line ever).
Vicky Du, global head of fund finance at Standard Chartered, says these types of facilities are structured with a maximum threshold on the amount of money that can be drawn for purposes outside of ESG investments. If the relevant covenant in the loan agreement is breached, the sponsor can either no longer draw on the line, or it must be declassified as a sustainable facility, she says.
Because these kinds of lines are less flexible than SLL-style ESG lines, they are more useful for ESG-dedicated funds, although Du says that for funds not focused on ESG investments, the bank would structure such a facility so that only drawdowns designated for eligible investments received a discount on the interest due.
Carlyle sets new bar on social-linked sub lines
The firm says the sub line, which is tied to board diversity in its portfolio companies, is the largest ever ESG-linked line in the US. And it anticipates doing more.
The ESG-linked fund finance facility market hit another milestone in February when The Carlyle Group announced what it says is the first-ever ESG-linked private equity credit facility tied entirely to social key performance indicators, and the largest ever such line in the US.
The three-year, $4.1 billion revolver’s pricing is linked to the firm’s goal of having 30 percent diverse directors on the boards of Carlyle-controlled portfolio companies within two years of ownership; a goal it set for itself in 2016. All of the firm’s US corporate private equity funds are eligible to draw on the line, with targets ratcheting up over time to the 30 percent goal, according to Megan Starr, Carlyle’s global head of impact, and Kara Helander, chief diversity, equity and inclusion officer. The discount is applied on a fund-by-fund basis. Carlyle will regularly assess and assure the data in conjunction with its lenders.
The firm estimates that the line may save the firm $5 million-$6 million in interest expense. Bank of America was lead on the deal, as well as global sustainability agent.
In 2016, 38 percent of majority-owned US corporate private equity portfolio company boards had at least one diverse member. That has risen to 88 percent and 100 percent in Carlyle’s flagship US buyout funds. In 2020, the firm expanded the goal to 30 percent of all directors in corporate private equity-controlled companies globally by 2023. “Having a target makes a difference,” says Helander. She noted that last year, 56 percent of the new directors added to the boards of controlled companies held for at least two years were diverse.
The idea for the line originated with Carlyle, according to Starr, who said the firm had in the last year done a number of ESG-lined financings at the portfolio company level: “As we were coming up for renewal for this line of credit, we got the idea that this is a really helpful way of saying, ‘We know these dimensions of business excellence are indicative of better performing businesses.’
“We were thinking of the range of metrics on diversity initiatives that Kara has led on, it’s been something that she has been working really hard at in the last few years. We have good data and we knew the trajectory we were on.” So Carlyle brought a term sheet to its lending syndicate and negotiated terms, including ESG KPIs.
The diversity initiative has been proven to make its own business case. “We know that our portfolio companies that have at least two diverse board members have 12 percent faster annualized earnings growth than our companies that don’t have any diverse directors,” says Starr. “We already have the financial rationale. This adds another layer of financial incentive to push further impact.”
Carlyle anticipates using the structure again in other regions, Helander adds. And Starr has “a lot of things in the works in terms of using ESG metrics more broadly.”
“We love the idea of using the tools of private capital to further incentivize progress on environmental issues, and I think this is just the beginning for us,” says Starr, adding that the firm has done more than $6.5 billion in ESG-linked financings and is open to doing more. The firm estimates its ESG-linked financings completed thus far will save it more than $15 million. “We’re using every tool we can to drive progress, and it’s exciting: when you start engaging people within the organization in that effort, opportunities like this manifest, and we’re taking full advantage of them,” Helander says.
The process for taking out a use-of-proceeds ESG facility can be more complex and resource intensive than the SLL alternative. Du expands: “For dedicated impact and ESG funds, we transact our due diligence at the fund level, starting with looking at what the criteria they have for investment are and the in-house governance process they have for the investment framework.”
“Typically our sustainable finance team would go in and measure that against Standard Chartered’s internal principles that we have set out, making sure that we think it’s sufficient, robust, and meets the question area that it says that it’s trying to achieve.”
As sustainable loan co-ordinator, the bank also validates fund claims as to progress made on a quarterly basis, while also getting third-party validation from auditors and consultants on all criteria and investments, Du says.
Can anyone go green?
Given the additional resources and time involved in obtaining an ESG facility, are they only practical for large sponsors with already-established ESG programs? EQT’s Lindberg says turning a traditional sub line into an ESG-linked one will require internal resources and additional costs, like those associated with the third-party auditors that assess portfolio companies’ progress on relevant KPIs. But the savings from the margin discount can help to offset those costs, says ING’s Dinh.
Firms earlier in their ESG journey may have trouble getting ESG-linked lines, at least the use-of-proceeds kind. Standard Chartered’s Du says: “We have been in situations where we look at viability of a green loan or sub line for a fund, but the fund is at a very early stage. In those cases, it can be that the fund’s governance is not sufficient to meet requirements, or not robust enough to deliver the results.”
But in those cases, “we are able to work with the sponsor, give our advisory services to bring them up to standard. We are doing this across the board with many sponsors hoping to achieve a certain set of standards,” Du says.
And while it appears that those active in the space are primarily managers who already have well-developed ESG frameworks in place, Aberdeen’s Morrison thinks more managers can and should look into taking them on. “Our investors like the idea of ESG-linked sub lines, they like the sector, they like the structure, but the banks aren’t writing enough ESG-linked transactions to satisfy the demand.”
Morrison adds that the pricing discount mechanism “is a powerful tool to incentivize managers to look for ways to realize environmental or social benefits in unexpected or hard-to-reach places.
“I think, therefore, that it would be counterproductive to reserve loan pricing incentives to a certain part of the market,” she says. “Impact focused managers are already highly motivated to deliver change. It’s the non-impact focused managers or investments that may need that little extra push.”
Asked what advice he would give sponsors looking to take out an ESG-linked line, EQT’s Lindberg replies: “Do anticipate some extra work in getting this done, but if you believe in making a positive impact, it is definitely worth it!”