US leveraged finance: The road ahead
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A more sustainable approach to debt financing

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  • Global green bond issuance reached US$305.3 billion in 2020, according to Bloomberg data
  • Ratings agency Standard & Poor's forecasts that global issuance of sustainability-linked debt instruments will exceed US$200 billion in 2021
  • President Biden has pledged to cut US carbon emissions to at least 50 percent below 2005 levels by 2030, advancing the ESG agenda

From growing concerns around climate change and sustainable consumption to the social and political impact of the Black Lives Matter and gun control movements, environmental, social and governance (ESG) issues are being pushed increasingly into the spotlight for commercial debt investors in the United States.

No longer simply "nice to have," ESG features are increasingly prominent in deals and investments across all asset classes. In a recent study of 50 of the world's largest asset managers, with a combined US$60 trillion of assets under management, shareholder advisory firm SquareWell Partners found that all but one had signed on to the United Nations Principles for Responsible Investment (UNPRI). Of those, 60 percent are using their own ESG ratings systems and 68 percent are publishing reports and materials on ESG topics such as climate change, human capital and biodiversity.

President Joe Biden has pledged to cut US carbon emissions to at least 50% below 2005 levels by 2030—pushing ESG up the agenda for US borrowers and issuers


ESG comes to debt markets

The growing investor focus on ESG has filtered into debt markets, with lenders and borrowers looking at how to structure financings in a way that is more sustainable and supports and measures environmental and social objectives and outcomes.

A range of ESG-linked debt products have gained traction. Green bonds (which raise capital specifically for climate-linked and environmental projects) and sustainability-linked bonds and loans (which are not linked to specific green projects but are issued to incentivize sustainability performance objectives) have all seen growing investor interest through the past year.

According to Bloomberg data, total green bond issuances reached US$305.3 billion in 2020, a 13 percent increase on 2019 levels, despite a steep decline in activity during the COVID-19 lockdowns in the first half of 2020. Since 2007, cumulative green bond issuances have climbed to beyond US$1 trillion.

In April 2021, ratings agency Standard & Poor's, meanwhile, forecast that global issuance of sustainability-linked debt instruments will exceed US$200 billion in 2021. According to Bloomberg, sustainability-linked debt issuances reached US$131 billion in 2020, an almost 300 percent increase compared to levels observed just two years prior.


Ratcheting up ESG-linked lending

ESG criteria are also filtering into more "vanilla" debt products. An increasing number of mainstream borrowers are issuing leveraged loans and revolving credit facilities (RCFs) that include ESG-linked margin ratchets in their loan documents. These ratchets are triggered by pre-agreed corporate, social and responsibility metrics and adjusted based on performance against such metrics during the life of the loan. If a company achieves a certain number of these key performance indicators (KPIs), the margin on the loan decreases accordingly, but if criteria are not met, margins tick up and loans become pricier.

According to Bloomberg, Europe leads the way with these types of facilities, driven by European Union regulation and accounting for around 70 percent of the market, but the US is catching up fast. The election of President Biden—who has made climate change a policy priority for his administration and pledged to cut US carbon emissions to at least 50 percent below 2005 levels by 2030—has helped to push ESG up the agenda for US borrowers and issuers.

In April 2021, for example, General Mills renewed its five-year, US$2.7 billion RCF and included a pricing structure tied to environmental impacts through the term of the revolver. The ESG KPI metrics are linked to reductions in greenhouse gas emissions across its operations and use of renewable electricity for global operations. General Mills believes it is the first US consumer packaged goods company to put a sustainability-linked RCF in place.

The world's largest asset manager, BlackRock, meanwhile, recently agreed to a deal with a group of banks linking the costs of a US$4.4 billion credit facility to targets for women in senior leadership positions and increasing the number of Black and Latino employees in its workforce. In addition, BlackRock wants to grow the US$200 billion it has invested in sustainable strategies to US$1 trillion by 2030.

Other esoteric forms of finance, meanwhile, such as subscription line finance, which is used exclusively by private equity (PE) managers to fund deals before making capital calls to investors, have also developed an ESG flavor.

Global PE franchises such as KKR and EQT have agreed to sizable ESG-linked subscription lines in the past year. KKR's Global Impact Fund arranged a US$1.3 billion ESG line in June 2020 and, in November, EQT locked in a similar facility worth €2.7 billion. Much like the loans and credit revolvers with ESG ratchets, these subscription lines have fee or margin incentives and penalties based on achieving ESG KPIs.


Setting standards

As the uptake of sustainability-linked financing products increases, the next challenge for borrowers and issuers will be standardization, to make it possible to compare the value of deals that cover different environmental and social impacts.

Borrowers, lenders and investors are eager to build the credibility of the market, but without standardization, the transparency and verifiability of ESG across products and sectors will remain challenging.

Moves are afoot to use international regulations and environmental conventions as the basis for ESG KPIs, rather than relying on an iterative set of internally generated practices.

The US Loan Syndications and Trading Association, Europe's Loan Market Association and the Asia Pacific Loan Market Association have all published a set of sustainability-linked loan principles, while the International Capital Market Association has issued a similar set of guidelines for sustainability-linked bonds. Ratings agencies Fitch and Standard & Poor's are also now including ESG assessments in their methodologies.

These guidelines are providing a foundation for best practice and control around the issuance of ESG-linked lending and will support a more uniform approach regarding the scrutiny and monitoring expected from borrowers. Standardization will also be driven by disclosure requirements as part of legal and regulatory obligations to reduce emissions and climate change risk or to ensure a responsible and ethical supply chain, for example.

Building a coherent and uniform set of standards will bring further credibility to the market and give borrowers that can demonstrate compliance access to additional pools of liquidity while also reducing financing costs.


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US leveraged finance: The road ahead


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