If last year was any indication, 2022 could be another banner year for the enduring syndicated loan market. According to financial data provider Refinitiv, new issuance of sustainability-linked loans (“SLLs”) reached $717 billion in 2021, an increase of more than 300% year-over-year from 2020. As the appetite for sustainability-related credit facilities grows, lenders must also be prepared to meet the changing needs of borrowers in this market. Traditionally, SLLs have been more aligned with the environmental component of a borrower’s Environmental, Social and Governance (ESG) strategy; However, as borrowers give more space to non-environmental objectives in their ESG strategies, SLLs are now increasingly incorporating social objectives, either stand-alone or in addition to environmental (and/or governance) objectives. ).

For the uninitiated, sustainability-linked loans are a type of lending instrument designed to incentivize borrowers to achieve certain predetermined environmental and/or social sustainability goals. A distinguishing feature of an SLL is that a particular economic outcome, usually a reduction (or increase) in the price of the loan, depends on the borrower meeting (or failing) sustainability performance targets ( SPT) that match certain predetermined criteria. key performance indicators (KPIs). Unlike green loans, SLLs do not require loan proceeds to be used for a green or sustainability-related project, and can be used to fund any general business purpose.

Borrowers’ growing interest in the social aspects of ESG comes as diversity and inclusion (D&I) initiatives gain acceptance and workers increasingly return to the office, making health and employee safety a renewed corporate priority. Partially reflecting this trend, in April 2021, private equity firm Blackrock amended its $4.4 billion revolving credit facility, introducing a sustainability-linked pricing mechanism that references three distinct KPIs, including two (Black, African American, Hispanic and Latino Employment Rate and Female Leadership Rate) are socially oriented. In the months that followed, we also saw more and more borrowers, including the following, integrating one or more social KPIs into their SLLs:

• The Southern Company (miscellaneous supplier expenses);
• American Campus Communities Operating Partnership LP (diversity employment rate, diversity director rate);
• HP Inc. (percentage of black and African Americans among US-based executives);
• Autodesk, Inc. (women in technical positions); and
• Enerplus (Average frequency rate of occupational accidents with lost time over 3 years).

Choose KPIs
When incorporating socially oriented KPIs into an SLL, lenders and borrowers will typically establish KPIs tailored to the borrower. This approach provides lenders and borrowers with increased flexibility to ensure that loan sustainability provisions are closely aligned with the Sustainability Linked Lending Principles (SLLP).¹ The key performance indicators that most adhere to the SLLP will be both critical to the borrower’s business, relevant to the sustainability challenges facing the borrower’s sector, and capable of being benchmarked.

Importantly, loan KPIs should also be linked in some way to the ESG strategy of the borrower or its parent company. A review of an organization’s ESG materiality assessment can provide a basis for lenders to assess which sustainability topics (whether environmental, social or governance-focused) are most material to an organization’s business. borrower and its stakeholders. Lenders should be wary of establishing key performance indicators that have not been previously documented by the borrower or otherwise established as an internal business priority. An SLL containing KPIs with no demonstrable link to a borrower’s business or policies can raise issues of so-called “sustainability washout”, which poses a reputational risk for all parties to the ready.

Alternatively, lenders and borrowers can also choose to adopt a KPI that references a sustainability rating issued by an independent ESG rating agency, such as MSCI, Sustainalytics or VE (formerly known as Vigeo Eiris). Using their own internal methodologies, ESG rating agencies will calculate a borrower’s sustainability performance against that of the borrower’s industry peers. Using such a rating agency can also have the benefit of lending an added aura of credibility to a company’s ESG reporting, as ESG rating agencies will normalize scores within a given sector, providing a additional context to investors.

SPT Calibration
In accordance with the SLLP, borrowers must have a meaningful input into the development of the SPTs, which must remain ambitious throughout the life of the loan. SPTs, including for social KPIs, can be based on one or more benchmarking approaches, including an assessment of the borrower’s own performance over a period of time, a comparison of a borrower’s performance compared to that of its peers, or by reference to others, science-based indicators, including targets that may already be set at the national, regional or international level. SPTs should not be set at lower levels, or on a slower trajectory, than any related targets that may have already been set by the borrower in internal strategies or elsewhere.

Typically, SPTs will be structured to target improvement in a borrower’s own performance along the relevant metrics. To ensure that these SPTs remain ambitious, lenders and borrowers may choose to incorporate a rolling baseline. Using this methodology, each year the borrower’s performance from the previous year is fed into the SPT and will require some degree of improvement over this previous year’s benchmark to achieve the SPT.

Verification
In line with the May 2021 version of the SLLP, lenders and borrowers are now required to obtain verification from an independent, external reviewer of a borrower’s performance against all SPTs. This review should take place at least once a year and is frequently performed by the borrower’s financial auditor, but any qualified external reviewer with the required experience, such as an external consultant or ESG rating agency, can perform the exam. Reviewer verification is typically issued in the form of an independent audit or statement of assurance that is provided when the borrower reports on its performance, often in its financial statements or ESG reporting documents.

Outlook
As the SLL market continues to mature, more changes to market norms are likely to await borrowers and lenders. As borrowers continue to refine their ESG strategies to incorporate more social and governance issues, they are likely to seek to leverage reputational benefits by including more key performance indicators related to these issues in their packages. SLL. Moreover, with the increasing number of SLL issues, “sustainable washing” will remain a constant concern in the market. The May 2021 revisions to the SLLP established the verification requirement, in part, to avoid “durability washout” and preserve the integrity of the SLL product. In light of these risks, lenders and borrowers would be well advised to build additional flexibility into their loan documents, particularly around rights to modify and adjust sustainability goals and related requirements. reporting and auditing.