The market for ESG-linked subscription credit facilities is new. Singaporean healthcare-focused private equity giant Quadria Capital opened the door just over a year ago, in October 2019.

French firm Eurazeo followed in January 2020, with the first EMEA facility. KKR kicked off the US market with a green line for its $1.3 billion global impact fund in June, and Sweden-based EQT Partners became a market leader by closing on two lines: one also in June and another – reportedly the biggest yet, at €2.7 billion – in November.

A trickle of other deals have been done quietly. And while these represent only a fraction of the subscription lending market, leaders in the space say it is set for significant growth in the year ahead, especially in light of the events of 2020; chief among them, the death of George Floyd and worldwide protests against institutionalised racism, and the pandemic.

“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 organise 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.”

ESG-linked deals, though bespoke, are generally structured to give the manager a discount to its market margin if key performance indicators are met at predesignated intervals over the life of the facility. An incremental penalty might be added to the rate if such KPIs are not met. In Eurazeo’s case, failure to hit its targets results in extra fees, which the lending banks promise to direct to greenhouse gas-reducing projects. Discounts and penalties are not disclosed publicly, but market participants have said the former can range from 10-20 percent of a sponsor’s market margin.

Incentivising performance

The discount/penalty structure is a great way to incentivise 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,” says Debevoise’s Smith. “How do you incentivise 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 institutionalises this focus.”

Magnus Lindberg, EQT’s head of treasury, says that while “sustainability is an integral part of the strategy” in its portfolio companies, the pricing model is a way of further incentivising their performance in ESG-related areas: “The partnerships make it possible for EQT to set more ambitious goals and incentivise portfolio companies to become even more sustainable.”

Shelley Morrison
Morrison: “I like that managers are finally putting their money where their mouth is”

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.”

Shelley Morrison, senior investment director of fund financing at Aberdeen Standard Investments, invests in ESG sub lines passively alongside lenders. She says some lines front-load a penalty rate above market margin: “In those cases there’s more of an incentive to deliver underlying improvements in the portfolio companies.”

Walking the talk

However they are structured, Morrison says she and her investors see these lines as being overdue.

“It’s driving the right behaviours, 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.”

But are ESG-linked lines only practical for large sponsors with established ESG programmes? Lindberg says turning a traditional sub line into an ESG-linked one requires internal resources and additional costs, like those associated with the third-party auditors that assess companies’ progress on relevant KPIs.

Nevertheless, the savings can help offset those costs, says Dinh. She outlines two basic approaches. Sponsors that already have a framework in place might take a 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 benchmarks performance of the fund’s portfolio companies,” she says. “Then a fund-level rating is computed, taking into account the characteristics and dynamics of the portfolio.” With this approach, she says, there is little ongoing reporting work for the manager to do itself.

“The second approach is more relevant for those that are still early in their ESG journey, and is more linked to a specific, customised 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 a 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 KPIs, typically annually (quarterly, for some KPIs). “The cost is easily offset by the discounted margin,” says Dinh. “The framework can then be replicated to the other funds that manager manages, and help shape the development of their own ESG framework.”

However, Vicky Du, global head of fund finance at Standard Chartered, which was co-lead arranger and sole sustainability co-ordinator and sustainability structuring agent on KKR’s line, says: “We have been in situations where we look at the viability of a green loan or sub line for a fund, but the fund is at a very early stage… It can be that the fund’s governance is not sufficient to meet requirements, or not robust enough to deliver the results.

“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.”