January 18, 2023 - Last week the LSTA hosted Betty Huber, Global Co-chair of ESG Practice and partner of Latham & Watkins, and Christian Fundo, Director, Legal Counsel at SVB Securities, for the “Sustainability Linked Loans: Key Considerations for in the US SLL Market” webcast. (The slides and replay are available.)

Sustainability linked loans (SLLs) are loans which tie a borrower’s interest margin to its sustainability performance. Certain key performance indicators (KPIs) and related targets are predetermined at the time the loan is originated and a borrower often receives a discount in the interest margin if the sustainability performance targets (SPTs) are met and a premium if the SPTs are missed or the borrower’s performance deteriorates. Presenters pointed out, however, that a recent Clean Energy Fuels term loan did not include the customary two-way pricing and instead only provided a premium if the targets were missed. SLLs have proved very popular. They are attractive sustainable financing products because the structure is flexible and adaptable. Even Borrowers in hard to abate sectors may be able to participate and borrowers can be in different stages of their sustainability journey. Looking at 1-3Q22 SLL volume, LSEG/Refinitiv LPC reports that Manufacturing, REITS, Financial Services and Utilities (in ascending order) are the industries most represented. Furthermore, unlike most sustainable financing products which are use of proceeds based, SLLs are typically used for general corporate purposes.  Finally, SLLs require the borrower to report on its performance against the predetermined KPIs to the lender group. In an environment where lenders are hungry for ESG reporting, this is particularly attractive. (See here for the market initiative on ESG disclosure – the ESG Integrated Disclosure Project.)

The Sustainability Linked Loan Principles maintained by the LSTA, LMA and APLMA set out the core components of an SLL – Selection of KPIs; Calibration of SPTs; Loan Characteristics; Reporting; and Verification. The presenters shared that negotiation around the selection of the KPIs and the setting of the SPTs continues to be a main focus of discussions on SLLs. Selected KPIs must be material and relevant to the borrower’s business and the related SPTs must be ambitious, i.e., a “reach”. As the SLL space is in a nascent stage of market development, care must be taken. In many circumstances a sustainability coordinator may assist with these discussions (and/or a third-party consultant is engaged). The sustainability coordinator is often the lead left arranger, but in many cases is also a different party. Similar to an arranger’s role, a sustainability coordinator assists the borrower with certain aspects of the transaction.  Despite the prevalence of sustainability coordinators, there can still be confusion over the sustainability coordinator’s role. The sustainability coordinator is not an advisor to the borrower or to the lenders. Moreover, each lender is responsible for making its own determination regarding the relevance and ambitiousness of the KPIs and SPTs and the loan’s alignment with the SLLP. The LSTA is developing model engagement letter provisions for the sustainability coordinator role to educate market participants.

In closing the presenters highlighted one of market participants’ main concerns – greenwashing. Where first generation SLLs were limited to a syndicate of relationship banks and investment grade borrowers, the market has evolved. SLLs are now seen in private credit transactions and are being pursued by sponsors. Greenwashing risk can increase with less sophisticated borrowers who may need additional assistance in structuring an SLL. While greenwashing risks are a key concern for lenders, borrowers face risks as well, including regulatory, litigation and reputational risks if KPIs are not material or the targets are not ambitious. The presenters also offered some tips for lenders to mitigate their greenwashing risks as well as a hypothetical illustration which offers further discussion on greenwashing (starting at minute 39:30 of the replay).

For information on sustainable finance, please contact Tess Virmani.