Guidance seeks to give fund finance a clearer sustainability path

Four industry groups have released new guidance that aims to enable wider adoption of sustainability-linked loans in fund finance. It’s meant to address several hurdles for extending SLLs to funds, which have ranged from incongruencies with certain funds’ operational structures to the difficulty of formulating the key metrics a fund must abide by to benefit from SLLs.

The quartet that produced the document is comprised of the Fund Finance Association, the Loan Syndications and Trading Association, the Loan Market Association and the Asia Pacific Loan Market Association.

SLLs are designed so that borrowers who meet bespoke sustainability performance targets, or SPTs, can benefit from a lower spread (or be punished by a higher one) on the interest rate they pay, says Deborah Low, a Haynes Boone partner who worked the document in her role on the LSTA’s ESG working group.

Specific key performance indicators provide a means of measuring whether a borrower is meeting those targets or not.

This type of debt previously received guidance in 2019 with the release of Sustainability-Linked Loan Principles. The new document offers some solutions to consider, although Low notes that the suggestions are not comprehensive.

Adoption hurdles

Low estimates that SLLs issuance accounts for only a fraction of the combined new-issue sub line and NAV facility markets.

But the guidance notes there are barriers that make more widespread adoption of SLLs challenging.

Firstly, measuring fund-level performance is difficult because funds have light operating footprints for things like offices and staff.

“They’re not a manufacturing company,” Low said.

And many borrowers that may wish to take out SLLs may not have established sustainability practices and programs, making it difficult to construct appropriate goals and metrics for them.

Lenders can examine a manager’s other funds to decipher whether an SLL is appropriate in the first place, but different funds often have different strategies, making it difficult to construct a coherent basis for structuring an SLL.

While portfolio-company KPIs can be formulated, lenders obviously can’t predict what investments a fund will make in the future and whether those KPIs will be appropriate for them. To mitigate that risk, lenders can conduct deeper due diligence than they do for regular credit facilities by reviewing a fund’s selection and administration processes for assets.

But sub lines issued early in a fund’s lifecycle, as most are, present a particular challenge, since the lack of investment history makes structuring the right KPIs and SPTs all the more difficult.

Funds may also face “cost-prohibitive” verification processes when they have large, diversified portfolios – and in obtaining data from portfolio companies that they don’t have control over.

And the short tenors of fund finance instruments – often one to three years – means funds have a very limited time to gather enough data to make an SLL viable and worthwhile. And pricing adjustments based on KPIs often don’t kick in until a year after origination.

One mitigating strategy here is “to expand the SPTs out to the latest possible contemplated maturity,” the guidance says.

SPTs generally work off the assumption that they will be extended after initial maturity, Low explains. If an extension isn’t used, then the facility would simply function as an ordinary one.

If the borrower and lender decide to reevaluate a facility’s SPTs when the initial term ends, “lenders should not contemplate a reduction in requirements absent compelling market or transaction-specific circumstances,” the guidance cautions.

SPT calibration

The new guidance gives a non-exhaustive list of solutions that touch on areas such as applying KPIs and giving enough time for short-tenor facilities. However, the document leaves it up to funds and lenders to negotiate, and it caveats that the choices presented may not work for every fund.

One important area to address is SPT calibration – identifying specific thresholds to meet for each KPI.

For this process, parties should look to the original 2019 SLLP, the authors of the new guidance say. That document suggests that KPIs represent improvements on “business as usual” for the borrower; that SPTs be benchmarked to some external reference, such as to peers or to the borrowing GP’s past performance; that SPTs follow a pre-determined timeline; that they be consistent with the borrower’s sustainability strategy, if they have one; and that they be devised in dialogue with any applicable sustainability coordinator.

Calculating KPIs

The guidance gives ways to calculate and apply KPIs.

Those include devising a KPI as a set of goals tied to a percentage of a fund’s investments, or linked directly to portfolio companies’ operations. KPIs can also be determined based on fund-wide metrics or a subset of portfolio company milestones that are aggregated at the fund level.

Indicators can be phased in early in a fund’s life, and the eligibility criteria for determining SPTs can be employed for prospective investments before they are acquired, the guidance notes.

Third-party verification

The document calls for verification of SPTs performed by outside third parties – and touches on how to address two related challenges.

To mitigate the cost of verifications at the portfolio company level, the guidance says that lenders and borrowers can decide ahead of time on a verification’s scope and nature.

This approach can also be applied to verifying non-control investments. Here, lenders can use a “negative conclusion” standard – essentially verifying a borrower’s success by concluding there is no indication that the data collected from such portcos is erroneous.

This approach differs from a “positive conclusion” standard, in which a lender verifies “that the data is correct in all material respects.”

The guidance also states that borrowers should brief their lenders at least annually on their SPT oversight.