The new normal
It has been a long time since a brand new product appeared in the loan market — apart from new ways for private equity firms to erode covenants. But in April 2017, two deals arrived in a single week that have changed the loan market. Sustainability-linked loans offer a structured way to tie pricing to ESG performance, on a whole company basis. One day, they might change the bond market too. Jon Hay reports
The syndicated loan market is not going through a happy period. Global volume is down 26% this year; EMEA lending has shrunk 30%. The one bright spot keeping loans bankers from gloom is green loans — or to be more precise, sustainability-linked loans.
This product, launched only in April 2017 when deals for Unibail-Rodamco and Philips came in the same week, has grown with the speed of an invasive weed.
“Sustainability-linked loans are going to be the new normal,” says Maarten Biermans, head of sustainable markets at Rabobank in Utrecht. “They will be part and parcel of every offering of any bank to any company. How quickly borrowers pick up on it will depend a bit on the sector and type of company. But I see tremendous growth there in the short run.”
Compared with use of proceeds-based green loans, sustainability-linked loans are usually easier administratively. The simplest format is to use the company’s rating from one of the environmental, social and governance (ESG) rating agencies, such as Vigeo Eiris or Sustainalytics. A base margin is agreed, based on ordinary credit considerations. This can be lowered if the borrower’s ESG rating improves to a certain level. In most deals, there is an equal and opposite interest penalty if the rating deteriorates.
Other borrowers devise their own targets, based on key performance indicators (KPIs) in their operations. In 2018, Renewi, the UK waste management group, obtained a €550m loan whose margin can fall if it raises recycling and recovery rates, avoids more carbon emissions, increases fleet efficiency, changes to low-polluting vehicles and cuts the rate of workplace accidents.
Barbara Calvi of the sustainable finance team at Morgan Stanley in London believes both green loans and sustainability-linked ones “have great potential to continue growing fast in the near future”, having surpassed $100bn of annual issuance. “We might also start seeing some incentives for green borrowing as a result of regulation under development,” she adds.
Each of the products has attractions for different borrowers. It is not the chance to save a few basis points, though — or even, as with bonds, a hunt for new investors.
“It’s the communication that is of great value,” says Biermans. “It enables companies to show their sustainability strategy, their commitments. It offers them a platform to show everybody and to further embed sustainability in their operations, by saying, although it’s not much, ‘it’s now not just words, there’s money involved’.”
Credibility is crucial
Bankers are conscious, however, that the market is vulnerable. The structure of the product, its self-regulated nature and the often merely token size of the financial incentives leave it open to the risk of being used as a figleaf: good publicity without much true environmental or social benefit.
In any commercial negotiation, there is a tension: the two sides have opposite interests and agree to meet in the middle. But in an ESG-linked loan, the banks have no direct incentive to make the performance target difficult for the borrower. They will not benefit from any improvement — the environment or society will.
The margin cut the banks suffer if the reward rate is earned is often, on investment grade loans, only 2bp. Since many loans are undrawn the banks are only getting paid perhaps a third of the margin as a commitment fee. So the lenders are not particularly afraid of this being triggered — keeping the client sweet is worth much more to them.
“This is of course where the issue of greenwashing stares you right in the face, and it’s nowhere more present than with sustainability-linked loans where you are working with KPIs,” says Biermans. He says Rabobank always tells clients there are two guiding principles when selecting KPIs: they must be achievable and meaningful. “It cannot be a very minor achievement, there has to be some work in it.”
At the moment, the banks’ own desire to husband the market is urging them to keep it honest.
“You do not want people to say ‘this is meaningless’,” says Biermans. “The accusation of greenwashing is not only bad for the client, it’s bad for us. I notice now that banks also keep each other sharp. Sometimes the fiercest discussions are among the banks. This is definitely something that needs to be worked on diligently because the threat of introducing meaningless KPIs is very much present.”
Up to now, there has been nothing like sustainability-linked loans in the bond market. But a deal in June by Dürr, a German mechanical engineering company, brings that prospect much closer. The €200m deal, tied to its EcoVadis rating, was a Schuldschein — a halfway house between loans and bonds.
Like bonds, Schuldscheine are sold to diverse investors that have no relationship with the borrower — so there was no ulterior motive for them to accept the margin ratchet. This hints strongly that bond investors might go for the same thing, if offered it.
Calvi says the idea of transferring it to the bond market has been discussed for a while. “Increasingly there seem to be good premises to consider such a move,” she says. “The green and sustainable bond market has evolved quite a lot over the past couple of years, and we see some degree of openness from investors to start considering more innovative types of issuance — provided we keep the focus on transparent processes and demonstrable impact.”