ESG criteria frequently used in LBO unitranche financings: Incentive for margin reduction upon achievement of clearly defined, measurable targets
ESG will become a norm in the debt capital markets pretty soon
Environmental, social and governance (ESG) is a hot topic in the finance market as well as amongst management, sponsors and institutional investors. While market participants are testing different strategies internally and with their capital providers, it can be expected that ESG will become a norm in the debt capital markets pretty soon. A well thought-through strategy regarding this matter paired with the conviction to execute it may, in some cases, even be a differentiator as demonstrated by selected credit funds already at the forefront of this topic.
This article focuses on unitranche financing for LBOs which is a reasonably new phenomenon. The article utilises publicly available information as well as Clearwater International’s experience from recent transactions. So far, banks have been very active in implementing ESG criteria in corporate loans and TLB financing for LBOs but are reluctant to do the same for midcap LBO bank clubs.
The ratchets are not a reflection of an assessment of a borrower in the ESG categories but rather an incentive to improve.
Investors are increasingly using ESG criteria in their investment decisions. Transactions that have been criticised in this matter appear to be primarily those with ethical issues in the business model or product, are inappropriate in terms of their businesses’ behaviour towards their clients or employees or involve relationships with countries which are perceived as difficult. In addition to these fundamental considerations, ESG aspects are finding their way into margin ratchets in LBO financings, not being limited to specifically green sectors but covering among other things a broad range of industrial, packaging, healthcare, or software companies. The ratchets are therefore not a reflection of an assessment of a borrower in the ESG categories but rather an incentive to improve. While debt funds and CLOs are reasonably fast in applying these ratchets driven by their LPs, they are still not used in midcap bank club LBO financings, in contrast to corporate financings.
Generally, there are three ways to reflect ESG features:
- Margin reduction for environmental capital expenditure through a dedicated tranche or an earmarked portion of a facility – this is more a corporate feature and rarely used in LBOs. Margin reductions have been up to 10bps
- Margin adjustment in line with an external ESG rating – this is more a feature for bond-financed LBOs, while general scepticism regarding a broadly accepted external ESG rating methodology remains.
- Margin adjustment according to pre-defined KPIs – this is the norm in LBOs
- The majority of unitranche financings uses three KPIs, however, the number of criteria ranges from one to five
- The margin adjustment
- can be both ways ranging from 5bps in total to the rare maximum of 30bps; the delay of ESG reporting may result in a margin premium
- can be staggered to the number of ESG criteria being fulfilled e.g., 5bps per KPI
- only remains applicable if the criteria are fulfilled in subsequent quarters
- There may be even a significant margin premium during a ramp-up period until the first ESG reporting is delivered to pressure the sponsor to focus on ESG related matters; thereafter the premium falls away and a margin reduction on top of the leverage ratchet may be applicable
- On the other hand, there are deals where the KPIs are assumed to be fulfilled with an immediate margin reduction, only to be discontinued once the testing evidenced non-compliance
- The margin saving may partially have to be reinvested in ESG friendly projects
- Testing is done quarterly through a sustainability report/certificate provided by the borrower while for selected more complex topics such as GHG protocol emission standards, a third party review by an external advisor may be required which can reasonably only be done on an annual basis
- ESG ratchet mechanics and KPIs have so far been individually agreed between the borrower and the lenders. Law firms and funds are about to design their templates. The Loan Market Association has published a series of green, sustainability and ESG linked loan principles which may lead to more standardised ESG clauses in LBO financings in the future
- Environmental: minimum of 50% green energy supply for a SaaS provider to the construction industry; proportional water savings for a textiles manufacturer
- Social: patient satisfaction ratio for a healthcare company; number of annual trainings being offered by a computer programming firm
- Governance: minimum ratio of female board members for a TMT company; percentage of employees being offered a share participation scheme for a biosecurity firm
The overall KPI concept can be structured in a way to combine i) fundamental requirements with ii) specific improvements. A basic KPI could be the assignment of ESG responsibilities to a relevant board member, the compilation of annual ESG reports and the agreement of annual ESG targets. Once this fundamental requirement is fulfilled, additional KPIs kick in which can then be structured as specific target fulfilment ratios over time (see above sample KPIs).
non ESG eligible borrowers may have to pay margin premia to allow more significant discounts for those who are specifically ESG compliant
It is probably fair to say that the economic significance of ESG related ratchets, while more frequently used, has been limited so far, as the ultimate providers of funds are determined to go this way but on the other hand, are hesitant to sacrifice their returns on capital. Just from an economic perspective, the extra reporting efforts may need to be justified by a perceptible margin benefit. So going forward, non ESG eligible borrowers may have to pay margin premia to allow more significant discounts for those who are specifically ESG compliant. This trend would be supported by broadly agreed ESG methodologies, comparable to those used in public credit ratings, as well as certain documentation standards.
While this article is limited to providing an anonymised summary, Clearwater International is happy to enter more detailed bilateral discussions.