What We’re Seeing: Margin Ratchets in Environmental, Social and Governance (‘ESG’) Loans
Margin ratchets are a concept that the banking and finance world are familiar with. Increasingly these are linked to ESG loans with both lender and borrower engagement. How do they work in practice, what are the benefits and what are the potential risks?
Typically margin ratchets are linked to financial covenants – more often than not leverage – they incentivise borrowers to improve their financial health over the life of a loan. That de-risks the business, and therefore the lend, and with that comes a willingness from lenders to accept a lower return.
We’re now seeing (upwards and downwards) margin ratchets form one of the key terms in Environmental, Social and Governance (‘ESG’) loan documentation, and specifically in sustainability linked loans. The reasoning is clear – it encourages businesses to perform against their ESG Key Performance Indicators (‘KPIs’). But how do they work in practice, what are the benefits to each party and what are the potential risks?
ESG margin ratchets - in practice
Typically these ratchets appear in loans to businesses which are keen, or at least willing, to improve their ESG credentials (and they therefore become ‘Sustainability Linked Loans’ or ‘SLLs’) rather than loans with an underlying ‘Green’ or ‘Social’ purpose.
As is often the case, agreeing the numbers ends up being the easy bit – it is the underlying KPIs that are heavily negotiated, along with how and by whom they are tested.
The range of KPIs is vast – we’ve seen this include measures of:
- Carbon intensity, with annual targets signed off by auditors, and more generally the use of fossil fuels by businesses;
- Levels of diversion of waste from landfill and improvements in recycling (as a percentage of total waste);
- Levels of renewable energy procurement (kilowatts as a % of total usage);
- The meeting of particular credentials in terms of infrastructure, construction methods and design in new builds;
- Meeting ESG disclosure and reporting requirements (even if not yet mandatory); and
- Female board representation.
Often a sustainability strategy incorporating a number of the items above is set at the outset, to be measured and reported against during the term.
Lenders will be keen for these KPIs to be tested regularly, and ideally by a third party with specific expertise in this field to ensure results are accurate and objective. One difficulty faced by parties at the moment is that such experts are few and far between – meaning there is either a significant cost in management time and/or a significant cost in payments to a third party monitor.
Of course, we all know there are huge benefits to us all in operating in a more sustainable manner, and concentrating resources on green and social causes. But in business those benefits can be difficult to quantify – so what’s keeping the market motivated?
The benefits of margin ratchets to borrowers seem clear – if they perform well, they save money. In addition, we’re now seeing some lenders allow borrowers to advertise the fact they have qualified for this type of loan, which can be a real asset for marketing purposes.
This is firmly on the agenda of every lender we have exposure to (albeit with different levels of focus and investment). Each has their own internal and external targets and those will become more closely scrutinised and more widely publicised over coming months and years. Providing these loans helps meet those targets, and there does seem to be a genuine desire amongst stakeholders to use their position in the market to make some positive changes: the fact that lenders are being more ambitious about ESG and innovative in how they do that has to be good for everyone.
The two key challenges that we’re seeing:
Greenwashing: given the marketing benefits, there is a risk that targets are not ambitious enough, or too generic. That might be because levels against KPIs at the outset are artificially inflated, or because the ratchet down is too easily achieved. It’s also really important that the KPIs being measured are business/ industry specific, and that often requires additional expertise. Ratchets are pointless if the KPIs and changes are not meaningful.
Cost: As outlined above, there will be a cost to borrowers in measuring these KPIs. That is likely to sit alongside an underlying cost in actually making the changes required to improve performance against them. If the margin reduction is not significant enough to outweigh the cost of performance, these types of loans simply won’t be taken up.
Lack of consistency: the various lending institutions offering ESG loans do not yet have a consistent approach to setting targets or measuring them. This can cause particular challenges when borrowers are expected to comply with the requirements of a number of lenders across a syndicate. In some cases borrowers already have ambitious and business specific ESG targets; it can be frustrating if they’re asked to change those in order to ‘fit’ a lender’s generic policy requirement.
Margin ratchets can’t be a cherry on the cake when finance is being offered. In order to be meaningful the underlying targets needed to be embedded in the business, with buy-in at board and shareholder level so that they become a key item for discussion at term sheet stage. Businesses need to recognise that there will be a cost involved in implementation and testing, but that ultimately the benefits (which may not all be obvious in the accounts) will outweigh that.
There’s a real need for all stakeholders in our market to upskill their staff, so that drafting, monitoring and reporting on these KPIs becomes easier, and therefore cheaper. That will also ensure that the targets can become more bespoke and business appropriate. That should naturally happen over time as demand increases.
There are various drafting initiatives ongoing which should help provide some commonly accepted standards, drafting and levels of ambition, but ultimately the detail will be different on every deal depending on the business and industry – it has to be in order to have any real impact and avoid greenwashing.
To hear more about what we have been doing in this space, both internally and for our clients, see below:
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