In March 2024, a group of associations in the fund finance industry announced the release of the latest addition to the Sustainable Lending Library, A Guide to the Application of 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, the Guide offers practical advice on applying the Sustainability-Linked Loan Principles (SLLP) in fund finance transactions. It outlines potential challenges and considerations that may arise and discusses how the SLLP can be effectively used in the fund finance market while aligning with the overarching goals of the SLLP.

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

By addressing each core component of the SLLP individually, the Guide directly tackles any potential conflicts between these components and the structural aspects of fund financing. The Guide also provides a non-exhaustive list of potential key performance indicators (KPIs).

Contextualizing Green Loans, Social Loans and SLL

As we discussed in our May 2020 Blakes Bulletin: New Guidance Documents on Green Loans and Sustainability Linked Loans, a key distinction between SLLs and green or social loans lies in the use of loan proceeds. Although structuring a fund finance transaction as a green or social loan may be feasible if the proceeds are solely allocated to green or social investments, many borrowers may find the restrictions on fund usage too limiting. Additionally, investment funds may face challenges in meeting the stringent criteria of green or social loans if they lack control over the management or operations of the investments. Despite this, green or social loans may be attractive for funds dedicated to environmentally or socially impactful sectors.

As we discuss below, SLLs are appealing due to their sustainability and flexibility in structure, making them suitable for borrowers across various sectors, including those traditionally deemed challenging to transition towards sustainability. Additionally, SLLs necessitate borrowers to report their performance against predetermined KPIs to the lender group, which is particularly appealing in a landscape where lenders prioritize ESG reporting.

SLLs in Fund Finance: Practical Challenges

Practical hurdles have emerged in implementing the SLLP within fund finance transactions for several reasons. The Guide addresses nine of these challenges, with the understanding that the list is not exhaustive.

  1. Borrowers are often newly formed, with limited historical data or no pre-existing sustainability strategy at the fund or portfolio company level. This lack of data makes it difficult to assess sustainability performance targets (SPTs) in the context of the borrower's business.
  2. Identifying relevant KPIs for internal fund operations can be challenging due to limited physical office space and staffing. In such cases, sustainability or ESG strategies may be implemented by the fund's sponsor instead. Consolidating these strategies into an SLL at the sponsor level may be more efficient than offering multiple SLLs to individual funds.
  3. With the growing emphasis on ESG factors in investment strategies, borrowers in fund finance transactions formulate investment-level KPIs to secure funds, recognizing the impact of ESG factors on investment decisions. However, uncertainty about the fund's investment pipeline makes it challenging to predetermine relevant KPIs and ambitious SPTs consistently applicable across investments. Lenders may need to conduct deeper reviews of investment selection and administration processes than standard diligence.
  4. As ESG gains traction among funds, some are just beginning to formulate policies, facing divergent investor priorities. If proposed SLL requirements exceed investor expectations, particularly regarding third-party verification, or deter investments supported by investors, neither party may see an SLL as an efficient resource allocation.
  5. The variety and scale of investments present challenges for third-party verification, as it can be costly and difficult to gather sufficient data and find appropriate verifiers. Additionally, differing standards among portfolio companies add complexity. The high verification costs could deter borrowers.
  6. For investments where the fund lacks control over portfolio companies, ensuring data collection or compliance with the SPTs may be challenging. It may not be appropriate to request the borrower to take specific actions in lieu of the portfolio company if it's responsible. Likewise, if the fund controls most or all portfolio companies, diversifying KPIs across companies is essential.
  7. For funds dedicated solely to advancing ESG objectives, if a suitable KPI or SPT beyond "business as usual" cannot be determined according to the SLLP, they may not qualify for an SLL. In such cases, a green loan or social loan may be more appropriate.
  8. Given the short tenure of many fund finance facilities (one to three years), SLLs typically adjust pricing after the initial year. This shorter timeframe may make it difficult to gather and utilize sufficient data to justify implementing a sustainability feature, potentially reducing its value for the borrower.
  9. Market conventions and regulations for applying sustainability principles to investment funds evolve and vary by jurisdiction. Lenders and borrowers should stay up to date on current requirements when negotiating KPIs and SPTs, ensuring they surpass regulatory standards.

Key Performance Indicators (KPIs)

The Guide outlines that in fund finance transactions, lenders and borrowers vary in their approaches to incorporating sustainability-linked provisions into credit facilities. However, a key aspect remains consistent: selecting KPIs and adjusting pricing must align with ambitious sustainability objectives relevant to the borrower's core business or investment strategy, surpassing standard requirements. Borrowers may choose KPIs based on internal operations or fund investments. Collaboration between borrower and lender is crucial to clearly define KPIs and suitable SPTs. A KPI tied to the fund's investments may be calculated as a percentage of investments meeting specified criteria, incentivizing increased compliance over time and potentially extending to individual portfolio company operations or impacting metrics for the entire fund, like reducing financed emissions. Gradual phasing of KPIs or eligibility criteria for included investments may be needed, such as holding an investment for a minimum period before counting it towards compliance.

Calibration of SPTs

Market participants should carefully review the SLLP for guidance on setting SPTs. Regardless of differing approaches to KPI implementation in fund finance transactions, SPTs should be suitably ambitious and reflect SLLP recommendations, including material improvement beyond business as usual, benchmarking against external references, alignment with the borrower's sustainability strategy, external guidance and adherence to a predetermined timeline. Additionally, benchmarking against historical performance and comparable peers within the industry is recommended. This may involve referencing the historical performance of previous investment funds raised by the same sponsor entity or similarly situated investment funds to assess if the borrower's goals sufficiently improve upon prior practices.

We will continue to keep you updated on the development of SLLs in fund finance in both international and domestic lending markets.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.