The 10 main elements to take into account when structuring your ESG facility – Finance and banking
ESG-focused investment funds raised a record amount last year – estimated at over $ 50 billion from new investors. This trend should not only continue but accelerate over the next few years. Some commentators have even noted that over time there may be no distinction at all between traditional investing and ESG investing, as the latter reinforces its status as the new normal for our modern society.
Green initiatives and social impact are often the center of attention. Despite the pandemic and market volatility experienced in 2020, the social and political agenda has set a clear message in favor of societal change and investing for the greater good. A sustainable future that we can be proud of shaping has become a priority in the business and investment world.
Fund financing is no exception. Since last summer alone, we have closed 6 ESG fund financing facilities at Cadwalader, including the
Fund financing is no exception. Since last summer alone, we have closed 6 ESG fund financing facilities at Cadwalader, including the largest ever closed and syndicated.
the largest ever closed and unionized.
ESG technology is entering loan documents more and more frequently. Although a basic framework has been established, the lender and the borrower have a great deal of latitude in structuring considerations. Below is my selection of the most important things to consider when launching your next ESG installation:
1. Type of establishment: use of funds
Typically, the use of a product-based facility will require that all investments financed by the loan proceeds meet specific sustainability criteria. LSTA, LMA, UN and others have issued guidance on green lending and lending principles linked to sustainability. The borrower will typically have investment guidelines that synchronize with these principles and align with their overall investment strategy. The guidelines should be reviewed and agreed upon prior to the closure of the facility in order to establish an objective set of criteria that must be met when the product from the facility is used for investment purposes. The borrower will provide representatives and certifications related to the use of the product and meeting sustainability criteria whenever borrowing for an investment. The asset class and the intended use of the fund must obviously align for this type of structure to work. It is generally favored over green facilities, such as a fund that uses a facility only to invest in renewable and alternative energy sources.
2. Institution type: performance-based results
Another popular method and approach that can be employed for a variety of different fund borrowers, regardless of asset class or investment direction, is to measure the borrower against certain criteria of performance goals – often referred to as “KPIs” or key performance indicators. Key performance indicators should be established upstream and aligned with sustainability guidelines. Meeting or not meeting the KPIs will trigger a positive or negative outcome, as the case may be, under the facility. Triggers can be negotiated and lead to a variety of results, but must be put in place in a way that motivates the borrower to achieve real results.
3. Price adjustment
This has become the most common outcome for performance based installations, but it is not a requirement and certainly not seen in all installations. Achieving the agreed KPIs under this structure will result in a reduction in prices – typically 5 to 25 basis points. The reverse can also be true with the failure to meet KPIs as a trigger for a price increase by a corresponding amount. Pricing results can also be prioritized based on key performance indicators achieved. This type of framework provides a strong incentive for borrowers to work towards sustainability goals and also gives lenders a corresponding way to put some skin in the game.
4. How to define key performance indicators
The agreed key performance indicators should be both ambitious and meaningful to the borrower’s business, but also achievable at certain time intervals of the facility. KPIs can be measured monthly, quarterly, semi-annually or annually and will give the negotiated trigger results. There is a great deal of latitude to establish specific KPIs, and care must be taken to ensure that the objectives are tailored and aimed at real change to drive the investment forward. KPIs can be measured at the holding company or investment level or also at the fund level. Targets can include things like reducing greenhouse gas emissions or board diversity. Longer installation times may also be ripe for KPI adjustments or the ability of parties to review goals or request changes upon the occurrence of significant events or at defined time periods.
Once you have defined the KPIs or the use of the product objectives, how will you ensure compliance? What reports will be needed and from whom? Like the KPIs themselves, there is no market standard for reporting. These are usually negotiated and will be specific to the borrower. Many times, reports will be provided quarterly and self-certified by the fund. This may be similar to the declaration provided to investors and may also require the completion of a previously agreed certificate of compliance form provided by the borrower on the declaration date. Third-party reporting and certification may also be desirable, especially if it is not too expensive or if the borrower uses an external review provider. Much will depend on current fund practice, investor requirements, the complexity of the key performance indicators and the frequency of reporting required.
6. Audit and dispute resolution rights
Even when reports are provided entirely by the borrower, negotiated audit fees are an option to provide a check – either as of right by the lender in the event of a dispute, or annually by the borrower as part of their program. regular reporting. Another option is to avoid specific KPIs altogether, but require a third-party sustainability rating company to rate the borrower. The score can then be used to trigger the same results as the KPIs. The frequency and costs of audits are all negotiated points. When a third party provides the report, the audit right may not be required.
7. Role of the sustainable development agent
Will the lead bank alone or other banks collectively serve as a sustainable development agent? Will a fee be paid for this role or will the benefit be a right of ownership and discretion over the negotiation and approval of changes in ESG criteria? Who will receive and monitor compliance with the reports? These are all questions that should be asked and are usually roles managed by the lead bank and all union co-directors for a large facility. The role of sustainability officer should be defined in exculpatory clauses similar to other officer roles.
8. Default values
What happens if the borrower fails to meet the KPIs? Will this trigger a fault event? When a pricing toggle is tied to KPI satisfaction, there is usually no corresponding default for non-fulfillment. The borrower would not benefit from a reduction in his margin or would face an increase in his margin. For a function of product use or that does not provide a price swing, non-compliance can trigger a number of things which could include, but not be limited to: default events (usually after a period of healing); repayment obligations, in particular in situations where investments are no longer eligible (materiality thresholds may apply); early maturity of the facility or the right of the lender to restructure, in particular if the parties are unable to agree on appropriate amended criteria if breaches of existing criteria cannot be remedied; or automatic switch to a non-ESG facility with pre-agreed terms and the loss of the ability of the parties to further promote or make public statements regarding the facility as being related to sustainable development. It should be noted that, on the one hand, having an EOD can be helpful in deterring bad behavior such as lasting washing. However, a DOE can also have the effect of reducing a significant impact by making the borrower reluctant to agree to take on ambitious sustainability goals.
9. Marketing benefit
Parties may wish to consider certain changes to the privacy sections that would allow them to publicly disclose certain elements of the facility, promote the common good, and market their roles. This should be discussed early in the transaction so that everyone is on the same page. In some cases, the parties may consider paying the benefits over time and donating any net income from reductions or price increases to charities and causes related to sustainability goals.
10. Avoid long-lasting washing
Sustainable washing can happen with false statements, exaggerated claims or inaccurate reports, which are ways in which parties can take advantage of the market. It is important to have the right level of transparency and to make sure that the objectives are genuinely meaningful and that the reporting and compliance are strong. Reputational risk considerations could come into play if material events occur that call into question the quality or veracity of the achievements. The parties may seek to use protection clauses that would unwind the ESG nature of the transaction if there is a material probability of washout behavior or if a triggering event occurs, which could cause serious inconvenience to the parties. These clauses are often difficult to negotiate and therefore concerns are usually alleviated by other factors, such as selection of sponsors, background, audit rights and third party verification.
Ultimately, there is no secret sauce to structuring an ESG facility. The parties retain immense flexibility but must keep in mind the desired environmental or societal objectives and put in place real significant means to achieve and measurably reward this behavior. After all, doing good is good.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought on your particular situation.