Integrating ESG into Fund Finance
By Gemma Lawrence-Pardew, Head of Sustainability, LMA
ESG factors are becoming increasingly prominent in fund finance transactions as fund managers and their lenders come under growing pressure to demonstrate how they are tackling the climate emergency and other ESG issues.
In this article, we consider the key drivers behind the uptake of sustainability-linked loans in fund finance transactions, the challenges and the future landscape. These are explored in more detail in our new joint publication, “A Guide to the Application of the SLLP1 in Fund Finance”2 (the Guide).
A Recipe for Success
It is no surprise that funds are looking to incorporate sustainability credentials into their investment processes given the current climate of stricter regulatory reporting requirements, increasing stakeholder awareness, and the growing understanding that ESG is inherently connected to higher returns.
Lenders are similarly eager to lead the charge in promoting the transition through their financial products, for example by boosting the quantity of loans to finance green or social projects directly (through use of proceeds loans), and/or enhancing a borrower's sustainability profile (through sustainability-linked loans).
These parallel forces have created an environment in which innovative finance structures have flourished at the intersection of ESG and fund finance.
“When you combine the lenders and the funds industry's ESG motivations, you have a recipe that works”
Chiva Lai, Senior Director, APLMA.
Guardrails Against Greenwashing
Innovation, however, is typically followed by a period of consolidation. As such, we expect fund finance structures to coalesce around established market standards and best practices, including the Green, Social and Sustainability-Linked Loan Principles3 (the Principles).
“The Principles create vital safeguards preserving the integrity of the sustainable loan market and are increasingly acknowledged for creating guardrails against greenwashing. As sustainability-linked features take increasing prevalence in fund finance transactions, it is important that the core components of the SLLP be adhered to and this is the focus of the Guide produced.”
Tess Virmani, Head of Policy, LSTA.
Addressing the Challenges
The Guide seeks to address the most prominent challenges faced in applying the SLLP to fund finance facilities. These include:
(a) the difficulty of setting key performance indicators due to a fund’s limited physical operations, uncertainty of investment pipeline or a lack of consistent metrics across a fund’s underlying investments;
(b) limited historical ESG data on borrowers, the fund or sponsor, as applicable, and the underlying investments; and
(c) shorter tenors relative to other types of financings.
Furthermore, jurisdictional anomalies, varying sophistication of funds and (potentially) cost-prohibitive external reviews all add to the complexity of these structures.
However, none of these challenges are insurmountable.
“This is a dynamic and innovative market, where multiple strategies have been adopted to progress increasing adoption of sustainability-linked loan provisions into fund finance transactions. These strategies are by no means exhaustive and we expect to see further adaptation take place moving forward as drivers to adopt ESG continue to surge ahead.”
Deborah Low, Partner at Haynes Boone.
As this market develops, it is important to acknowledge that, while there is no one-size-fits-all solution, the SLLP provide a framework to help to ensure the credibility of sustainable fund financing structures.
Moving Forward
The Guide focuses solely on the application of the SLLP and does not drill down into the use of proceeds instruments, i.e. green and/or social loans. Use of proceeds instruments are better suited to net asset value facilities, where the fund has a mature portfolio to borrow against, and which can be used to finance an acquisition.
Moving forward, it is for the Associations to consider whether a second publication, addressing application of use of proceeds structures, is required, and we invite market feedback on this point.
1. Sustainability-Linked Loan Principles, February 2023
3. The Principles, and supporting Guidance, can be found at https://www.lma.eu.com/sustainable-lending/resources