Direct lending and ESG

Managers of private capital are becoming more aware of environmental, social and governance (ESG) concerns and direct lenders are no exception. Richard Normington, legal director, discussese how this emergent trend is developing and what to expect in the future.

How long have ESG-linked loans been a feature of direct lending in Europe?

Richard Normington: It's still relatively new. People first started talking about it around three years ago and then the documentation began coming through. More recently there's been some press coverage around deals, such as Ares' USD1 billion sustainability-linked loan to RSK last summer.

Before this trend really got started, we were having conversations with direct lenders around what they thought others might be doing, but it was relatively slow to develop into terms actually going into documents.

What we saw reflected in documents was fairly generic and some might say tokenistic, although these institutions do take this very seriously and are very keen to do something about it. Initially, however, there wasn't necessarily a clear idea of how to approach it because it was so new. Funds started putting relatively small ratchets on the pricing if certain ESG criteria were met. Certainly, a couple of years ago those criteria tended to be quite broad.

"These institutions take ESG very seriously and are very keen to do something about it."

- Richard Normington, DLA Piper Legal Director, London

What do these terms look like in practice?

Normington: The most common approach from the outset has been direct lenders looking to apply a relatively small margin ratchet of somewhere between 5-15bps for delivering a certificate showing compliance with certain specified KPIs - for example a specified percentage of women on the board of directors or in management positions, or the business having a policy around reducing carbon emissions.

It can be relatively high level and produced in a way that's applicable to any business in any sector, the intention being that they can essentially roll out relatively standardised provisions across their portfolio.

How has this evolved since it first emerged three years ago? Are the terms still generic?

Normington: Over the last 12 to 18 months, sponsors have started formulating their own thoughts around ESG in debt documents, taking into account the nature of their assets, and there's a move towards these provisions being more tailored to their portfolio companies. There's been some pushback from sponsors on purely generic provisions that don't reflect the KPIs that they themselves are pushing for the businesses to achieve. You'll see this increasingly become a bespoke product. We're not there yet but we'll begin to see meaningful conversations around whether these ESG provisions are simply a cherry on top that might save 10bps, or whether there's agreement that the asset has a genuine ability to drive change.

What is this driven by? Is it a commercial decision to back better, future-proofed businesses? Or does this come from the limited partners (LPs) investing in their funds?

Normington: It seems to be led by the conversations that the private debt community has been having with their investors, so it's very much LP driven. The PE houses are having the same discussions with their investors and looking at assets with their own criteria. So, the debt funds want to be seen to be working with the sponsors that have similar pressures from their LPs and a similar ethos. There's also a marketing perspective in terms of not just appeasing existing LPs and promises made to them, but actually when investors are looking at placing funds this is becoming increasingly relevant to their decision-making.

How common are these loans today would you say? Is this still in the minority or is it mainstream already?

Normington: There are debt funds out there that actively push for the ratchet to go into every transaction now. Some of those are still relatively generic and offered on a somewhat take it or leave it basis, but there is a strong desire to include these terms now.

It's no longer in the minority. It will be interesting to see how prevalent this becomes, how it develops and how committed private debt and equity both really are to making sure these provisions are included.