With more focus on environmental, social and governance (ESG) issues across asset classes, it is unsurprising that leverage finance has also increasingly focused on ESG. According to Reorg, 50% of the European leveraged loans in 2022 included sustainability linked features.

Borrowers and lenders have an equally heightened desire to demonstrate a commitment to ESG progression, as their own investors and limited partners are focusing more on ESG and require enhanced reporting. This ties in with the heightened international regulatory oversight outlined in this issue, which is driving companies to increase their reporting generally, and which continues to grow, as shown by the Corporate Sustainability Reporting Directive (EU) 2022/2464 (CSRD) coming in to force in January this year. As regulation increases, investors will seek more information.

There are, however, still significant challenges when using ESG as a metric for investment. In private debt, for example, lender education and diligence processes are relatively light on ESG specifics, and targeted diligence is rarely commissioned. Specific sectors may require certain environmental reports, but these aren't generally common. This gap at the diligence stage hinders the creation of more uniform reporting requirements and can be at odds with investors who require asset managers to demonstrate that they have considered certain ESG-related diligence on investments.

To date, there are no market standard provisions for loan documentation. On 23 February 2023, the Loan Market Association published its updated green, social, and sustainability linked loan principles, and accompanying guidance. These principles and guidance were developed to create high level frameworks of voluntary recommended market standards to promote consistency. Each principle sets out five components to enable market participants to understand the characteristics of sustainability linked-loans.

ESG-related provisions are intended to incentivise companies to improve the performance of certain areas of the business. These are often judged against key performance indicators (KPIs) that may be set at the time of closing or agreed post-closing.

Usually, the biggest incentive is an economic one. The introduction of an "ESG margin ratchet" is now common: when borrowers hit certain KPIs, a small reduction in the margin (around five to 15 basis points) is available. There may be a requirement to meet all metrics or, alternatively, a tiered approach, where meeting multiple targets potentially results in higher reductions.

Agreeing the actual KPIs is sometimes the hardest part of the process, with many companies relying heavily on generic metrics, usually relating to governance. The social aspect of ESG often focusses on equality and diversity and may include certification as to positions on modern slavery, human rights, and labour standards. Other criteria include actively requiring the company's employees to participate in local community projects or internal training. Some loans will allow for internal confirmation as to levels of success, whilst others will require third party verification.

Commentators argue that for the ratchet to have teeth and act as a real incentive for change, it needs to work both ways, such as a small increase in pricing coming into effect where KPIs are not met. At the same time, however, lenders are still willing to offer one-way economic incentives as a driver for companies to make substantive change.

Financial incentives are not the only option for investors keen to take a proactive approach to ESG. Some, for example, oblige borrowers to complete ESG questionnaires on an annual basis as a prerequisite of the credit approval process. Given the lack of conformity as to ESG reporting requirements and the contents of these reports, it is not surprising, however, that such provisions have not made their way into loan documents as regularly as the ratchet.

As the leverage finance market continues to develop, it seems likely that both sponsors and credit funds, together with their investors, will have a significant say in how ESG factors will feature in loan documentation in the future.

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