ELFA survey highlights ESG concerns in leveraged finance
Investors are worried that some leveraged issuers are “gaming” the market for ESG debt by raising cheaper deals with a green premium – or greenium – that can be called before environmental targets are even tested, according to a survey by the European Leveraged Finance Association.
High-yield bond issuers are able to save money by printing ESG-labelled deals around 10bp–25bp inside their conventional curves, irrespective of whether ESG targets are met or not, due to high investor demand for the paper, ELFA said.
Some 51% of investors said that a greenium is justified on sustainability-linked high-yield bonds provided deal structures and targets are robust and credible, but some investors are concerned that they are being used simply to refinance existing debt more cheaply.
“Most companies seem to be issuing SLBs to refinance other debt using the 'greenium' benefit,” a survey respondent said.
ELFA said in one instance a high-yield SLB had even been used to pay dividends to shareholders.
The first sustainability-linked high-yield bonds and leveraged loans were issued late last year, and ELFA’s survey of more than 170 investors highlights several issues that will require further work to resolve.
“It is important that any potential concerns among investors are tackled at this early stage to ensure the European leveraged finance market is both resilient and transparent,” said Sabrina Fox, ELFA’s CEO.
Although it is still early days for ESG-focused leveraged finance, 90% of credit investors own bonds or loans with ESG provisions, the survey said.
Some 72% of those surveyed called for external verification of ESG targets before issuance and 96% want annual reporting.
Bigger step-ups required
Eight high-yield SLBs have been printed this year, according to ELFA. The survey said 75% of investors are calling for a higher coupon step-up than the standard 25bp if issuers fail to hit ESG-based key performance indicators and/or sustainability performance targets.
Some 39% of investors said a coupon step-up of 25bp–50bp is appropriate, and 30% of investors said that it should be higher than 50bp, or equivalent to 20%–50% of the final coupon.
“Pricing needs to be more aggressive,” one respondent said.
SPT test dates are typically set from one to four years to match the shorter call structures and maturities of high-yield bonds, but the first call date precedes the first SPT test date on some deals.
Half the investors surveyed said that the cost of calling a bond before ESG tests should be 50% plus the coupon step-up, but some investors called for a more punitive 75% or 100% rate to discourage calling and refinancing or repaying deals before KPI or SPT tests.
“Unless the call price is set at a materially higher level, this undermines the SLB structure completely,” ELFA said.
SLLLs see range of approaches
Sustainability-linked leveraged loans are seeing a premium or discount to the margin ranging from plus or minus 2.5bp to plus or minus 15bp, although no standard has been established. Around a third of borrowers have already tried to apply interest savings to ESG projects, ELFA said.
The mechanics of the premium or discount often differ depending on the number of KPI targets, with different criteria for success or failure, while some individual KPIs have specific adjustments – either a premium or reduction, while others move both ways.
ELFA has found the level of ambition difficult to quantify on SLLL targets, and the timing of KPI disclosure is also an issue for investors.
“We note that some of the target levels have already been achieved in the past or have flat-lined after two years, as opposed to showing year-on-year improvement,” ELFA said.
While most targets are presented in term sheets, some borrowers have not given investors information on KPIs before commitment deadlines, and some deals even allow borrowers to set KPIs with agents after syndication.
Some 96% of leveraged loan investors said that all relevant KPI information should be determined and disclosed before they commit to a deal, and 90% said that it would not be appropriate to flex or reduce ESG KPIs if deals see strong demand.
ELFA is working with the Loan Market Association on guidance that will outline best practice for incorporating ESG metrics into SLLLs and give more detail on ESG roles, such as ratings providers and sustainability coordinators, and the timelines for syndicates to review KPIs.