In line with the global trend of increasing importance of sustainability-linked loans, the Loan Market Association (LMA) and the European Leveraged Finance Association jointly published on 5 October 2023 the updated Best Practice Guide to Sustainability-Linked Leveraged Loans (the “Updated Guide”), which contains updates to the original Best Practice Guide to Sustainability-Linked Leveraged Loans published in June 2021 (the “Original Guide”).
The Updated Guide seeks to provide practical guidance as to the application of the Sustainability-Linked Loan Principles (SLLP) as revised on 23 February 2023 to leveraged loans (SLLLs), setting out what borrowers, finance parties and their respective advisers should consider when integrating sustainability factors into leveraged loan facility agreements. Leveraged loans are uniquely positioned to incorporate sustainability-linked loan (SLL) characteristics because of (i) the close relationship between lenders and borrowers due to the on-going due diligence process in leveraged finance transactions, (ii) information reporting is not constrained by securities law and (iii) investors and lenders are accustomed to performing “deep dives” into the borrower’s business.
Nevertheless, precisely because of the unique nature of leveraged finance where the availability of details required to structure an SLL (including the selection of key performance indicators (KPIs) and sustainability performance targets (SPTs)) depend heavily on the underlying due diligence material and statistics available for a particular borrower at any point in time, questionable KPIs and SPTs may be presented or even agreed upon before the parties are aware of the full picture.
Further, due to the tight time constraints in leveraged finance transactions, parties may in certain situations rush to agree on opaque KPIs and SPTs that may be either too easily achievable or overly optimistic to be meaningful when there is a lack of data to support the chosen KPIs and SPTs. As such, particular guidance is required in the leveraged finance arena when incorporating sustainability factors.
The main amendments to the Original Guide are to update the provisions to align them with market developments to promote transparency, reduce “greenwashing” and reflect the updates in the SLLP. The most important and timely updates to the Original Guide are the updates on the selection and communication of KPIs and the calibration of SPTs.
In addition to the introductory section, the Updated Guide addresses several areas: (i) Terminology, (ii) Roles, (iii) Selection and Disclosure of KPIs, (iv) Calibration of SPTs, (v) Reporting & Verification and (vi) Documentation.
The Update Guide continues to refer to the Glossary of Terms published by the LMA. It is notable that since the Original Guide’s publication in June 2021, additional terms and clarification of existing terms have been incorporated into the latest Glossary of Terms published by the LMA. The Glossary of Terms includes terms commonly used in sustainability lending products and assists in navigating the numerous acronyms used by market participants.
The Updated Guide sheds light on the types of roles typically found in an SLL transaction to promote the transparency and integrity of the financial product. While the roles of the sustainability coordinator and external reviewer remain to be important since the publication of the Original Guide, these roles have been elaborated in more detail in the Updated Guide. Further, a new role of the Second Party Opinion (SPO) provider has been included.
The Updated Guide explains that while the role of the sustainability coordinator is typically fulfilled at the pre-signing stage, they may be involved at post-signing stage if not all of the KPIs/SPTs are agreed at the pre-signing stage or if the loan is to be converted into an SLLL post-origination. In relation to the external reviewer’s role, it is clarified to be of importance at the post-issuance/post-signing stage, where they are responsible for reviewing the borrower’s performance level against each SPT for each KPI at each observation date.
The SPO provider is a new role incorporated in the Updated Guide. The SPO provider is an independent reviewer who opines on the alignment of the proposed sustainability-linked structure with the SLLP, in particular regarding the materiality of the KPIs selected and the ambition of the related SPTs at the pre-issuance/pre-signing stage.
III. Selection and Disclosure of KPIs
In line with the SLLP, the Updated Guide explains that KPIs selected must be material, and notes that the notion of materiality is multi-faceted and can be understood from (1) an economic or a strategic planning exposure or (2) a sustainability standpoint.
The Updated Guide also highlights that in relation to leveraged loans, the timing of the selection and disclosure of KPIs to the lenders may require flexibility. Flexibility should be permitted during the underwriting phase where, for instance, the financing relates to an acquisition bid and the outcome is uncertain. The Updated Guide suggests that in such situation, the best practice is to make reference to the SLL provisions in the underwriting term sheet, and include actual KPI and/or SPT selection and calibration in the long form documentation. The Updated Guide elucidates that KPIs and SPTs must be agreed and built into the final documentation.
IV. Calibration of SPTs
The Updated Guide confirms that it is no longer the case that SPTs “should” be ambitious, but instead they “must” be ambitious. Further, tracking the language in the SLLP, it also states that the SPTs must be “beyond ‘regulatory required targets’ and ‘must be relevant, core and material to the borrower’s overall business, and of high strategic significance to the borrower’s current and/or future operations; measurable or quantifiable on a consistent methodological basis; and able to be benchmarked, i.e. as much as possible using an external reference or definitions to facilitate the assessment of the SPT’s level of ambition’”.
The Updated Guide discourages parties from rushing into structuring an SLLL and makes clear that where a borrower is not ready to set SPTs before or concurrently with origination of the loan, the loan should not be communicated or referred to an SLLL. However, as cited in the SLLP, the Updated Guide points out that in exceptional circumstances, where the borrower already has a clear sustainability strategy in place, the parties may agree to include the mechanics of an SLL within the SLLL documentation, with these mechanics to be activated when the SPTs are agreed post-origination, typically with a 12-month deadline.
V. Report & Verification
In relation to reporting and verifying SPTs and as elaborated in the SLLP, the best practice is for borrowers to provide lenders at least once per annum with: (1) up-to-date information on their SPTs and (2) a sustainability confirmation statement with verification report attached. This promotes transparency and communicates the borrower’s sustainability position on a regular basis to the lenders.
Further, the Updated Guide clarifies that borrowers must obtain independent and external verification of their performance level against each SPT for each KPI at any date/period relevant for assessing the SPT performance leading to a potential adjustment of the SLL economic characteristics, after the last SPT trigger event of the loan has been reached.
The Updated Guide explains that in May 2023, the LMA published model provisions for SLLs (the “Model Provisions”), which provide a draft of sustainability-linked loan provisions for inserting into SLL documentation. Furthermore, in September 2022, the APLMA published a Term Sheet (with Sustainability-Linked Loan Appendix) and in February 2023, the LSTA published Drafting Guidance for Sustainability-Linked Loans. These provide market participants with template wordings as a starting point for their use in SLL documentation.
Shortly after the publication of the Updated Guide, the LMA also published sustainability-linked loan term sheet provisions to accompany the Model Provisions on 12 October 2023. The sustainability-linked loan term sheet provisions are contained in Part 8 of the Term Sheet for Leveraged Acquisition Finance Transactions. The sustainability-linked loan term sheet provisions provide a holistic framework for market participants to set out the sustainability-related terms they wish to incorporate into their SLL facility agreements and reflect the key terms in the Model Provisions.
The increasing importance of ESG in commercial transactions and the demand for ESG-compliant investment opportunities has led to updates to existing guidelines in all areas of the sustainable finance landscape and the leveraged finance market is no exception, as seen with the publication of the Updated Guide. The Updated Guide aligns the Original Guide with the SLLP and provides a key guidance for market participants in the leveraged finance market.