ESG-Linked Loan Interest Discounts in Vogue
(04 February 2020 – Global) Corporates are testing new loan features designed to boost their environmental, social and governance (ESG) credentials as investors' desire for yield in debt capital markets (DCM) underpins demand for risky loans funding private equity (PE) deals.
Concerns about climate change and diversity have moved up the finance priority list, reflecting growing demands from consumers for companies to show they are helping to tackle societal problems. Several European loans have been written with special ESG-linked terms recently, for example French health care group Elsan seeking ESG-linked interest discounts currently being marketed to European investors.
European plastic packaging business Klöckner Pentaplast is requesting investors take a hair cut on the interest it will pay on US$1.4 billion of loans if the group hits targets related to diversity in its management ranks and use of recycled material. The loan refinancing is the first time a company has asked for interest-rate discounts, known as ratchets, linked to ESG goals from US investors.
These kinds of changes won't reduce the credit risk of the borrower over the limited lifespan of a leveraged loan.
In both the Klöckner and Elsan deals, hitting any of the targets would cut interest costs by 0.025 percentage points. Hitting all three would cut costs by 0.075 percentage points. That isn't significant compared with the overall interest costs for Klöckner, which could be more than 4.75 percentage points above interbank interest rates, according to S&P LCD.
The deals are part of a wave of loan refinancings as borrowers look to cut interest costs and improve the terms on their loans in capital markets sloshing with excess cash. In the US, mutual funds that invest in riskier loans have seen the biggest three week total for new funds since 2017, according to Bank of America. The US and Europe have also seen a pick up in collateralized loan obligations (CLOs) in recent months.
Some lenders query whether they should accept a cut in their returns to encourage companies to pursue ESG objectives that they should be implementing anyway, especially if the targets aren't overly challenging.
"The criteria are pretty lax and there's a strong argument the companies should be implementing these initiatives anyway without a reward" commented Fair Oaks Capital Fund Manager, Tyler Wallace.
"It's good that companies are focused on ESG, but they should be having more diverse boards anyway. People have to be more holistic in their approach to ESG than looking at things like these ESG ratchets” said PGIM Co-Head of Global High-Yield, Jonathan Butler.