We were very pleased to have the opportunity to speak with
Lloyds Bank’s Greg Sidlow (Relationship Director, Funds
Finance), Varun Sarda (Managing Director, Sustainability & ESG
Finance) and Rebecca Tozer (Associate Director, Sustainability
& ESG Finance) to discuss the increasingly prevalent nature of
ESG concepts seen in the Fund Finance market.
Fund Finance Friday: Greg, Varun, Rebecca
– thank you very much for taking the time to contribute to
FFF and for providing your thoughts on the ever-evolving
ESG constructs in fund financing. It was fantastic to work with you
both on your recent deal with Cinven, which incorporated a variety of
bespoke ESG KPIs across the fund manager’s
platform.
Greg: Thanks for having us.
FFF: Greg, if we could start
with you. Could you give us some insight from the banker’s
perspective on the role of ESG within the fund finance
market?
Greg: ESG has long been on the agenda for LPs and GPs, with many
sponsors being signatories to the UN Principles for Responsible
Investment. ESG forms a key part of LPs’ diligence process, and
we only expect this to continue to grow in prominence going
forward.
GPs have also built out dedicated ESG teams to help integrate
ESG due diligence and management of risk and opportunity throughout
the investment cycle. ESG monitoring and reporting have been built
out accordingly, with the creation of the ESG Data Convergence
Project in September 2021 being a notable industry development.
In line with the wider loan market, the fund finance industry
has witnessed significant growth in ESG/sustainability-linked loan
(SLL) financings over recent years. The ESG activities undertaken
by many sponsors often serve as a helpful foundation for creating
the key performance indicators (KPIs) and sustainability
performance targets (SPTs), which typically analyse the performance
of the underlying investments rather than the sponsor
themselves.
We have also seen this translate into GPs incorporating ESG
aspects into the leverage financing they arrange for their
underlying portfolio companies. While we have not seen the
inclusion of such ESG features threaten liquidity for fund
financings, it has served to increase lenders’ appetites in
certain cases given the focus on ESG lending from many
institutions.
Structuring an SLL requires specific diligence and close
dialogue between ESG teams within sponsors and banks arranging the
financing to ensure the facility is set in line with the LMA
Sustainability Linked Loan principles.
FFF: We have worked on a number of ESG fund
financing deals and found that you have one of the largest
dedicated teams working on ESG and sustainable finance, including
SLLs. Varun, Rebecca, could you tell us a bit more about
that?
Varun and Rebecca: We strive to create a more sustainable and
inclusive future for people and businesses, shaping finance as a
force for good. One of the areas where we can make the biggest
impact is by ensuring our clients have access to the best ESG
knowledge, skills and experience required to help build a more
sustainable and inclusive economy. Our team, Sustainability &
ESG Finance, has just passed its first anniversary, as a now 20
person-strong team. This team supports our corporate and
institutional clients with sustainability and their associated ESG
financings. We bring deep technical expertise across ESG
consultancy, Net Zero and climate strategy, ESG ratings,
sustainable finance law and sustainable finance. Our Sustainability
& ESG Finance team operates on a sector-aligned model so that
we can bring dedicated industry insights into our discussions and
lenders on some of the specific nuances, challenges, and market
understanding of the fund finance industry and wider private
markets ecosystem.
FFF: Do you adopt a different
approach on addressing ESG principles when dealing with private
funds compared to companies?
Varun and Rebecca: The LMA SLL Principles (and their regional
equivalent) are the core principles to abide by when drawing up an
SLL. The Principles help protect the integrity and applicability of
the SLL product and provide a helpful framework for lenders to
follow around areas such as the selection of ESG KPIs, the
calibration of SPTs and the role of Sustainability Coordinator. In
order to claim compliance with the LMA principles, private funds
are required to adhere to all the core requirements of the
principles. As Coordinator, we analyse the composition of a
fund’s portfolio and evaluate the influence the fund manager
has on performance against KPIs. There may be a variance in asset
class or sector (and thus ESG materiality) for different funds, and
some funds span many sectors. Drawing on our team’s experience
and knowledge, we carefully review each proposition, working in
conjunction with the client to encourage a KPI and SPT selection
that incorporates the most material ESG risks and opportunities to
the fund. A further distinction with private funds is that some
funds are blind pools at execution of the facility, so we don’t
have historic portfolio data to analyse to determine the stretch of
the targets. In these cases, we tend to analyse prior funds and
portfolio construction of the manager, and set targets related to
the timings of acquisitions rather than take a portfolio coverage
approach, for example.
FFF: What are the benefits of
ESG loans to a lender?
Varun and Rebecca: There are a number of reasons why lenders are
increasingly attracted to SLLs as a product. Firstly, it could be
because there is a growing demand for sustainable financing in
their client base. As of December 2021, ESG financing totaled close
to $1.2 trillion, up from nearly $500bn at the same time the prior
year. Of this, a sizeable portion were
sustainability-linked and green loans. Secondly, many lenders have
signed up to the Net Zero Banking Alliance (NZBA) and the Glasgow
Financial Alliance for Net Zero (GFANZ), which involves them
committing to reduce their financed emissions in line with Net Zero
and accelerate the decarbonisation of the economy. We therefore
need to engage our clients on ESG and SLLs and act as an enabler
for this, helping to build strong relationships between the lenders
and various departments on the client side. Thirdly, banks are
increasingly looking to grow their own ESG-aligned portfolio,
announcing sustainable finance lending commitments and preparing
for regulatory-driven green lending capital requirements that may
follow. Finally, ESG increasingly features in lender-client
discussions and tends to encourage greater transparency, which is
deemed to be a particular benefit in the private funds market.
FFF: Is it possible to ascribe a monetary value to
this?
Varun and Rebecca: The most common ESG pricing structure we see
in SLLs is the two-way ESG margin adjustment ratchet, which as the
name suggests toggles the overall margin paid up (i.e.,
the borrower pays an ESG margin premium) or down (i.e.,
the borrower receives an ESG margin discount) depending on how the
borrower performs against the selected KPIs and associated targets.
The ESG margin adjustment is not huge and usually only a small
fraction of the overall margin. Given the two-way ratchet, the ESG
structure is viewed as neutral to both the borrower and lender at
the point of signing the loan agreement (with only future
performance against KPIs determining whether an ESG margin premium
or discount is applied). Hence, lenders do not view this as a
chance to increase monetary value from loans; rather, they view the
ESG margin adjustment there to incentivise positive borrower
performance against KPIs. Given the public commitments lenders have
made (e.g., NZBA), it is critical that lenders support
borrowers’ transition to a more sustainable future in a fair
manner.
FFF: Similarly, what do
you see as the key benefits for private funds and their
investors?
Varun and Rebecca: ESG loans offer funds the opportunity to
showcase their ESG ambitions to the market by tying their
sustainability strategy into their financing. Setting KPIs and SPTs
can help the fund’s key stakeholders, such as investors and
banks, to understand the fund’s non-financial impact but can
also improve its workforce appeal, with evidence suggesting that
younger potential employees are commonly influenced by ESG when
choosing where to work. Moreover, setting annual targets and
encouraging monitoring and reporting of verified KPIs aptly
positions funds for upcoming reporting that will be mandatory for
many under CSRD and recommended under SFDR. While the pricing
benefit isn’t huge and isn’t usually the main draw for
funds, it can represent a significant driver of positive change,
especially on larger drawn facilities. Furthermore, investors
encourage GPs to embed ESG across all their procedures, including
fund finance, and to integrate ESG into all stages of the
investment process, taking advantage of the opportunities as well
as mitigating the ESG risks, to create long-term value. Investors
are increasingly enquiring into funds’ ESG performance,
understanding that credit risk will soon incorporate ESG
evaluation, meaning that it may become harder to access liquidity
without a consideration to ESG. On a related but separate point, it
should also be noted that, slowly but surely, access to bank
capital is evolving, with liquidity starting to concentrate around
sectors and borrowers that are focused on sustainability, with
KPI-linked SLLs being the primary way of demonstrating
sustainability commitments (which, in turn, helps lenders achieve
their own sustainability commitments in terms of financing lower
emissions and helping borrowers transition to a more sustainable
future).
FFF: What are the
challenges you face in negotiating ESG provisions in fund financing
transactions, both with negotiating opposite the borrower and also
negotiating with other syndicate partners?
Varun and Rebecca: Most funds understand that the benefits of
executing an SLL need to be balanced against the reputational risk
of executing a transaction perceived to be unambitious, which could
lead to a heightened risk of ‘greenwashing’ accusations.
This, together with the private nature of the market, means that
sponsors tend to be more cautious than clients in other sectors,
often opting to keep their KPIs private. With the rise of ESG, many
funds are interested in discussing ESG Finance and are surprised to
hear the level of information required from their portfolio
companies, leading to the recommendation of longer lead times for
deals so that they are done right, rather than rushed. In addition,
varying levels of interest and in-house capacity can affect
funds’ abilities to influence ESG improvement.
On the lender side, we have seen a fairly significant range in
styles and sophistication for tackling ESG Finance. Some lenders
have strongly developed teams and governance committees that
support their engagement in ESG transactions, whereas others do
not. Some deals have been done where less challenging targets were
set or less rigorous verification signed off on; these deals
coordinated by less-experienced lenders set undesired precedents,
compared with best-practice deals that we promote and relish. That
being said, we are increasingly seeing lenders push back on some
SLL approaches and, in extreme cases, declassifying SLLs internally
due to their own ESG governance. In short, lenders are no longer
all ‘term takers,’ and scrutiny around the integrity and
robustness of ESG metrics will soon be commonplace.
FFF: What considerations do you
have to ensure the relevant ESG terms and associated KPIs should be
measurable, reportable and achievable by the
borrower?
Varun and Rebecca: KPIs are typically tailored to a
borrower’s overall sustainability strategy. The key to market
credibility is ensuring that the KPIs are relevant, meaningful and
stretching. Agreed KPIs should ideally align with sector priorities
and be mapped to reputable external assessment bodies
(e.g., SBTI), as well as aligning with the LMA principles.
In order to be measurable and reportable, the fund needs to ensure
that its portfolio companies are reporting against the same KPIs,
in the same units and measurements – standardisation of
measurement and reporting across a fund is crucial. This will also
aid independent assurance and verification.
FFF: Looking at the
current macro socioeconomic and geopolitical climate, there have
been a number of significant events that have caused some concern
in the lending market generally. In particular, we’re thinking
of the invasion of Ukraine, the development of sanctions policy,
high inflation and the threat of a recession. How have these events
shaped your view in how you address ESG
constructs?
Varun and Rebecca: These macro events are, of course, relevant
from an ESG perspective but – given the breadth of the topic
− we are primarily interested in how these events are
manifesting themselves into material ESG risks and opportunities
for underlying borrowers. For example, human rights, labour
mobility and supply chain resilience are becoming key areas of
focus in our assessment. Furthermore, there is growing awareness
within the banking community that ESG risks are no longer
intangible long-term risks; rather, as shown by recent climate and
geopolitical issues, these ESG risks can crystalise quickly
(including through regulation and rapidly changing stakeholder
views), affecting the financial stability of companies and sectors.
We are integrating assessment of ESG risks into our credit approval
process which looks to scan horizon ESG risks that may impact the
credit risk profile of borrowers (via what we call ‘ESG credit
risk factors’).
FFF: Similarly, how have allegations of greenwashing or general criticism
influenced your shaping of ESG constructs and/or
dealing with the borrowers’ ESG officers?
Varun and Rebecca: As mentioned before, lenders are increasingly
becoming more sophisticated in their approach and challenging the
ambitiousness of SPTs, with increased scrutiny and governance on
their side to protect against greenwashing allegations. We
typically engage in comprehensive discussions with a borrower’s
ESG officers to dissect the LMA principles, relevant sector
materiality maps and industry guidance (that is publicly
available), so that they understand what is expected of them when
entering into an ESG financing. While we aim to work closely with
funds, we won’t shy away from declining the sustainability
aspects of a transaction if we don’t believe in their
robustness.
FFF: Given that ESG is certainly becoming more
‘mainstream’ (indeed, there is rarely a deal we see which
does not involve a conversation around whether ESG concepts can be
included and many historic deals we have put in place are being
amended to include ESG constructs), are you starting to see an
alignment/more standardised ESG terms and KPI
metrics?
Varun and Rebecca: We are, thankfully! Some of the facilities
executed in the years before the publication of the LMA SLL
principles would not stand the rigour and scrutiny in today’s
market. As the market evolves, we are seeing strengthening
criteria, stretch of targets and rigour of verification, which
protects all participants in the financing. While documentation and
terms still vary, it is standardising across the market, with funds
tending to choose similar KPIs that facilitate benchmarking and
peer comparison.
FFF: Looking forward, do
you think that the pressure to deliver investor returns in a
challenging economic environment could result in ESG terms and KPIs
loosening? Further to this, does the discussion around ESG
regulations impact your view on how ESG in fund finance will
develop?
Varun and Rebecca: We don’t think ESG terms and KPIs will
loosen; if anything, they will strengthen. While many investors are
understandably focused on returns, many are increasingly enquiring
about ESG and understand that, in order to preserve the value of
their investments in the longer-term, ESG improvement is required.
ESG regulation will promote increased transparency, monitoring and
reporting. Regulatory requirements will activate funds that are
currently resisting ESG, driving the slow-movers up the curve,
increasing overall ESG performance and verification in fund
finance.
FFF: There’s been a
lot of talk about the use of ESG ratings for public companies and
possibly at fund level. Do you think these could ultimately replace
the use of KPIs as a way of measuring ESG performance in the future
– particularly in the context of sustainability-linked
loans?
Varun and Rebecca: ESG ratings have been used for some time as
KPIs, either alone (covering the whole spectrum of E, S and G) or
as part of a KPI suite. Ratings are a great way to quantify and
evaluate ESG performance in a single measure, facilitating the
setting of targets and benchmarking. This could potentially be a
game changer in helping to evaluate portfolio company and
fund-level performance; however, it requires significant up-front
time and investment. Rating agency methodologies can differ
greatly, and some will be better suited to some private funds than
others. We have recently launched an ESG Ratings team to support
clients in this regard. Beyond linking to any specific SLL
borrowings via a KPI, we find that ESG Ratings are increasingly
being used by stakeholders in their overall assessment of companies
and funds – impacting both the debt and equity story.
Suboptimal ESG Ratings can impact access to capital, and at the
very least pose challenging questions when fund raising. We are
actively working with clients to provide insights on ESG ratings
and the fragmented rating agency landscape with a view to
optimising ratings.
FFF: Finally, if you had a (solar or wind powered)
magic lamp, what three changes would you like to see to ESG
financing generally?
Varun and Rebecca: Increased ambition, transparency and quality
of verification.
Greg Sidlow is one of the Relationship
Directors in the Sponsors & Structured Finance Group at Lloyds,
managing a scale portfolio which is principally comprised of large
& mid-cap European primary private equity sponsors.
Greg has led some of the largest capital call and
Sustainability-Linked Loan financings in the European market, both
in terms of absolute quantum and the scale of syndicates involved.
Greg has also successfully originated, structured and executed
continuation fund financing, GP co-invest and NAV facilities as
well as Fund level and Management Company FX solutions.
Greg has a deep sector knowledge of private markets, having
worked within Fund Finance for over 12 years and been in his
current role since 2014.
Varun Sarda leads the ESG Advisory team in
Sustainability & ESG Finance at Lloyds and has a particular
focus around the Financial Services and Financial Sponsors sectors.
He has over 15 years’ experience across roles in sustainable
financing, ESG ratings, sustainability and climate change
consulting, in-house sustainability governance and implementation
and the NGO sector.
Prior to joining Lloyds, Varun led NatWest’s ESG
Advisory business in Corporate & Institutional Coverage. Before
that, Varun led NatWest Group’s foray into integrated reporting
and engagement with institutional investors on sustainability. He
also led the Group’s approach and response to various ESG
ratings, benchmarks and performance measurement.
Varun has also previously worked in environment and social
risk management, covering sectors such as Oil & Gas and Power
Generation, and he worked at two leading ESG ratings agencies
(Innovest Strategic Value Advisors and EIRIS), both of which are
now majority owned by MSCI and Moody’s, respectively.
Varun is a regular public speaker on sustainability in
finance and ESG stewardship. He has a Master’s from the London
School of Economics (LSE) and a Bachelor’s degree from Imperial
College London.
Rebecca Tozer joined Lloyds in 2018 and has
worked across credit and coverage functions of the Commercial Bank
in London and in Paris. She has worked in the Sustainability &
ESG Finance team since it was set up in June 2021. Rebecca is the
ESG Industry Lead for Financial Sponsors, delivering ESG
origination and market insights to her client base. She supports
the end-to-end experience from initial introductions to ESG,
through the development of sustainability strategies, and on to
sustainability-linked financings and frameworks.
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