A Year in Review

Sustainability-Linked Leveraged Loans in 2023

Azzurra Camillieri, Bart Capeci & Elisabeth Campbell

In this article, we examine the trends seen in European sustainability-linked leveraged loans (SLLLs) in 2023 reviewed by Reorg.

In short:

SLLL volumes increased in 2023 to €10.6 billion, but issuance halved to 24% from 53% in 2022;
2023 SLLLs offered a modest 7.5 bps cumulative upward and downward adjustment to the margin compared with 10 bps in 2022;
SLLLs in 2023 enhanced transparency through more reporting and external verification requirements; and
Environmental and social concerns dominated in 2023 SLLLs.

Market Overview

Despite turbulent market conditions, political unrest and increased regulatory requirements, 2023 saw European SLLL volumes1 increase 17% year-over-year to €10.6 billion, representing more than double the volume of 2023 sustainability-linked bonds.

The return of investor confidence in 2023 in European leveraged loans2 did not extend to SLLL issuance. While volume increase is to be celebrated, 2023 SLLL issuance3 – as a proportion of broadly syndicated leveraged loan issuance – halved to 24% from 53% in 2022. We note that three loans that came to market with sustainability-linked provisions in 2023 had those mechanics removed during syndication. With maturity extensions and refinancing needs acting as key drivers for primary market issuance in 2023, it is possible that borrowers preferred to focus on tackling these priorities rather than ESG issues, as setting up SLLLs can be time consuming.

Sector Dominance

The material, industrials and consumer (staples, discretionary) sectors have consistently dominated the European SLLL market since 2021, and 2023 was no exception. In addition to these prevailing sectors, SLLLs continue to spread their wings and 2023 saw increased issuance in healthcare, communications services, real estate and information technology.

Pricing Adjustments

In line with the European market standard, all 2023 SLLLs applied annual margin increases upon a failure to meet the agreed sustainability performance targets or the specified ESG ratings and annual margin decreases upon successfully meeting such targets or ratings.

Similar to what was recorded in 2021 and 2022, the vast majority of 2023 SLLLs apply the ESG margin ratchet to all facilities within the SFA.

A significant minority (20%) applied the ESG margin ratchet solely to the term loan facility, in contrast to 2021 and 2022.

In 2023, the range of the cumulative adjustment to the sustainability-linked margin is slightly tighter compared with the previous years, ranging from +/-5 bps to +/-15 bps.

2023 SLLLs offered less appealing rewards than the ones offered in 2022 SLLLs, with 40% of 2023 SLLLs offering a modest +/-7.5 bps adjustment, compared with 47% of 2022 SLLLs which offered a +/-10 bps adjustment.

Cumulative Margin Adjustments	2021	2022	2023
2 bps	3%	0%	-
2.5 bps	0%	7%	-
5 bps	11%	0%	25%
7.5 bps	47%	13%	40%
10 bps	32%	47%	25%
12.5 bps	3%	0%	-
15 bps	8%	7%	10%

KPIs

As it was the case in 2022, environmental KPIs feature in almost all 2023 SLLLs (93%). Social KPIs remain consistent with 2022 levels, featuring in 33% of 2023 SLLLs, but governance KPIs dropped to 20% of 2023 SLLLs.

2023 welcomed the inclusion of new KPIs in a handful of SLLLs, including KPIs focused on air quality (13%) and social concerns such as health and safety in the workplace (20%) and working conditions (7%). This is a positive sign, showing that from an “E” and “S” perspective, not only climate change and diversity issues matter.

From a numbers perspective, largely consistent with the trend seen in 2022 and 2021, 44% of 2023 SLLLs featured three KPIs.

Disclosure, Reporting and External Verification

Positively in 2023, SLLLs have enhanced transparency through more rigorous disclosure, reporting and external verification requirements.

The number of borrowers providing sustainability reports, either from an independent third party (5%) or the company (65%) has significantly increased to 70% in 2023 compared with 47% in 2022. This is a positive development in terms of transparency as these reports are intended to provide lenders with more fulsome information, including the methodology on how calculations have been made when asserting performance and any adjustments to the KPIs/SPTs.

Another positive development toward ESG transparency is that the number of SLLLs that require an external verification with respect to the borrower’s determination of SPTs increased to 70% in 2023 from 60% in 2022 and 2021.

Sleeping Sustainability-Linked Leveraged Loans

Since 2021, we have seen senior facility agreements where the parties wanted to offer an SLLL, but couldn’t agree on the KPIs/SPTs at the time of loan origination. So instead they agreed to postpone their setting to a later time. These SLLLs are known as “sleeping SLLLs.”

As illustrated below, sleeping SLLLs in the European leveraged market have continued to grow since 2021, representing 35% of 2023 SLLLs.

Sleeping SLLLs could possibly have a positive impact on the ESG space. They could encourage more borrowers to opt for sustainability-linked financing where it would be difficult to complete all the necessary related work at the time the deal launches. They could also provide flexibility within the sustainability-financing instrument to allow parties to conduct further due diligence in establishing the SPTs/KPIs that should apply.

Care should be taken to ensure that when set in the future, the KPIs/SPTs are meaningful and ambitious (for example, they should not be set at a level that the borrower already knows it will achieve based on data available to it after loan origination) and the loan is not prematurely labeled as an SLLL.

Further guardrails relating to inclusion of sleeping mechanics in an SLLL are set out in the LMA’s Best Practice Guide to Sustainability-Linked Leveraged Loans published in collaboration with the European Leveraged Finance Association in October 2023.

Looking Ahead: 2024 Outlook

Despite the return of investor confidence in 2023 for European leveraged loans generally, this did not really extend to sustainability-linked instruments as issuance of SLLLs decreased as a proportion of broadly syndicated leveraged loan issuance. However, sentiments for SLLLs in 2024 remain confident given their volume increase in 2023.

In addition, following the inclusion of additional KPIs (for example, air quality, health and safety in the workplace and working conditions) by borrowers in 2023, we hope to see more social and governance KPIs added to the list of those covered by sustainability-linked instruments in 2024, despite the perceived difficulties in measuring the actual impact of social and governance KPIs.

Disclosure and reporting is definitely one area where all market participants have been heavily involved and where improvements can still be made. While we welcome the enhanced transparency through more reporting and external verification, which featured in 2023 SLLLs, we hope this trend for improvement continues throughout 2024 and beyond.

1. As a proportion of the overall European leveraged loans market as captured in Reorg’s primary market database.

2. According to Reorg’s primary market database, European term loan B issuance volume in 2023 totaled €87.8 billion compared with €29.3 billion in 2022 - https://go.reorg-research.com/reorg-emea-leveraged-loans-wrap-2023.

3. As a proportion of European leveraged loans reviewed by EMEA Covenants.