New guidance on sustainability-linked lending principles in fund finance | Blake Cassels & Graydon LLP

[co-author: Grace Nguebou, Articling Student]

In March 2024, the Fund Finance Industry Association Group announced the release of the latest additions to the Sustainable Finance Library. A guide to applying the Sustainability Linked Loan Principles in Fund Finance (guide).

Published jointly with the Asia Pacific Loan Market Association, the Loan Market Association and, for the first time, the Fund Finance Association, this guide provides practical advice on applying the Sustainability Linked Loan Principles (SLLP) in fund finance transactions. Masu. It outlines potential challenges and considerations that may arise and explains how to effectively use his SLLP in the fund financial market, in line with the overarching goals of the SLLP.

In recent years, sustainable finance has gained wide acceptance. With the introduction of SLLP in March 2019, many lenders and borrowers in the fund finance sector looked to these principles for direction in integrating sustainability-linked loans (SLLs) into fund finance transactions. Despite having sophisticated strategies that incorporate environmental, social and governance (ESG) factors into investment decisions and operations, funds may face difficulties in applying SLLPs to fund financing facilities. .

By addressing each core component of SLLP separately, the guide directly addresses potential conflicts between these components and the structural aspects of financing. This guide also provides a non-exhaustive list of potential key performance indicators (KPIs).

Contextualizing green loans, social loans, and SLL

As explained in our May 2020 article, Blakes Bulletin: New guidance document on green loans and sustainability-linked loans, the main difference between SLLs and green or social loans lies in the use of the loan proceeds. Although structuring a financing transaction as a green or social loan may be feasible if the proceeds are allocated solely to green or social investments, many borrowers find the restrictions on the use of funds too restrictive. You may feel it. Furthermore, if an investment fund does not have control over the management and operation of its investments, it may have difficulty meeting the stringent standards for green and social loans. Nevertheless, green or social loans may be attractive to funds specializing in sectors with environmental or social impact.

As we discuss below, SLL’s sustainability and structural flexibility make it attractive to borrowers from a variety of sectors, including companies that have traditionally been considered difficult to transition to sustainability. suitable for Additionally, SLL requires the borrower to report his performance against pre-defined KPIs to a group of lenders, which is particularly attractive in situations where lenders prioritize her ESG reporting.

SLL in fund finance: practical challenges

Several reasons pose practical hurdles to implementing SLLPs within fund financing transactions. This guide covers nine of these challenges, with the understanding that the list is not exhaustive.

1. Borrowers are often newly established and have limited historical data or no existing sustainability strategy at the fund or portfolio company level. This lack of data makes it difficult to evaluate sustainability performance targets (SPTs) from a borrower’s business perspective.
2. Identifying KPIs related to internal fund operations can be difficult due to limited physical office space and staffing. In such cases, sustainability or ESG strategies may be implemented by the fund sponsor instead. Consolidating these strategies into one SLL at the sponsor level may be more efficient than offering multiple SLLs into separate funds.
3. With the increasing importance of ESG factors in investment strategies, borrowers in fund finance transactions are recognizing the impact of ESG factors on investment decisions and developing investment-level KPIs to secure funding. However, uncertainty regarding a fund’s investment pipeline makes it difficult to predetermine relevant KPIs or ambitious SPTs that can be applied consistently across investments. Lenders may need to conduct a deeper review of their investment selection and management processes than standard diligence.
4. As ESG gains traction among funds, some funds are just beginning to develop policies in the face of divergent investor priorities. If her proposed SLL requirements exceed an investor’s expectations, particularly with respect to third-party verification, or prevent an investor-backed investment, neither party can ensure that her SLL is an efficient resource allocation. It may not be considered as such.
5. The diversity and size of investments pose challenges to third-party verification, as collecting sufficient data and finding suitable verifiers can be costly and difficult. Additionally, different portfolio companies have different standards, which adds complexity. High verification costs can deter borrowers.
6. For investments where the Fund does not have control over its portfolio companies, it may be difficult to collect data and ensure compliance with the SPT. If the portfolio company is responsible, it may not be appropriate to ask it to take certain actions on behalf of the borrower. Similarly, if a fund manages most or all of its portfolio companies, it is essential to diversify his KPIs across companies.
7. For funds dedicated solely to advancing ESG objectives, the fund may not qualify as an SLL if appropriate KPIs or SPTs beyond “business as usual” cannot be determined in accordance with the SLLP. In such cases, green loans or social loans may be more appropriate.
8. Because many fund financing facilities have a short lifespan (1-3 years), SLLs typically adjust their prices after the first year. This short period can make it difficult to collect and utilize enough data to justify implementing sustainability features, which can reduce their value to borrowers.
9. Market practices and regulations for applying sustainability principles to investment funds are evolving and vary by jurisdiction. Lenders and borrowers should keep up to date with the latest requirements when negotiating KPIs and SPTs to ensure they exceed regulatory standards.

Key performance indicators (KPIs)

This guide outlines that lenders and borrowers have different approaches to incorporating sustainability-related clauses into credit facilities in fund financing transactions. However, important aspects remain consistent. KPI selection and pricing adjustments should go beyond standard requirements and align with ambitious sustainability goals related to the borrower’s core business or investment strategy. The borrower can choose his KPIs based on internal operations or capital investment. Collaboration between borrowers and lenders is essential to clearly define KPIs and appropriate SPTs. KPIs associated with a fund’s investments may be calculated as the percentage of investments that meet specified criteria, encourage increased compliance over time, and potentially extend to the operations of individual portfolio companies. or impact fund-wide metrics, such as reducing emissions through funding. It may be necessary to gradually phase in KPIs and eligibility criteria for eligible investments, such as holding investments for a minimum period of time before counting towards compliance.

Calibration of SPT

Market participants should carefully review the SLLP for guidance regarding SPT settings. Regardless of the different approaches to KPI implementation in fund financial transactions, SPTs are appropriately ambitious and require significant improvements beyond business as usual, benchmarking against external references, alignment with the borrower’s sustainability strategy, and external guidance. , and should reflect the recommendations of the SLLP, including adherence to prescribed timelines. . Additionally, we recommend benchmarking against past performance and comparable competitors in your industry. This includes looking at the historical performance of previous investment funds raised by the same sponsoring company or similarly located investment funds to assess whether the borrower’s objectives are a sufficient improvement from previous practices. It may include:

We will continue to provide updates on SLL’s developments in fund finance in international and domestic lending markets.