Amidst the still lingering COVID- 19 pandemic, historic production disruption and shortages in raw material, increasing inflation and the Ukraine war, finance activities continued to be strong in Germany – even though the overall number of transactions closed in the first half of 2022 is lower than in the second half of the record high year 2021.
On the other hand, it is a clear trend that sponsors are increasingly concerned with overpaying for assets in the context of a global revaluation of public market stocks. As a consequence, sponsors on average enhance due diligence processes to assess even more thoroughly transactions risks (e.g., the impact on continuing supply chain instabilities). But enhanced due diligence takes time resulting in transactions to take longer than they did over the last few years and there is great likelihood of such trend to continue in 2022. Overall, this may lead to a lower number of closed financing transactions, at least in certain segments.
Another trend is that sponsors, investors, corporates and likewise financiers put an increasing emphasis on broader corporate social responsibility and the contribution of investments/businesses to sustainable developments. In that context, environmental, social and governance (“ESG”) issues are on the rise in making investment decisions. What has a longer history in the public markets has now found its way in the private lending sector as well.
As there is not yet implemented a legal standard neither for addressing ESG issues nor for measuring ESG compliance despite the best efforts of a large number of participants, there is no uniform approach in the German market for sustainability linked loans. However, in the German MidCap financing space most financings concur therein that addressing ESG goes beyond the measurement of mere credit risks but to incentivize a company’s environmental and social impact. By that means, the focus of ESG linked loans is not to finance green projects only but to measure and monitor ESG compliance against sustainability key performance indicators (“KPI”). Those KPIs may either be very generic of very specialized, but they also link to the inclusion of environmental protections in credit documentation which had disappeared from many leveraged loans.
The setting of the KPI’s (as well as the number of performance indicators itself) is left for the participants to decide on a deal-by-deal basis. Within this dynamic, the Loan Market Association has developed Sustainability Linked Loan Principles to promote the integrity of the sustainability-linked loan product in general. Where possible and as a recommendation, KPI’s should be, amongst other things, (i) relevant, core and material to the borrower’s overall business, and of high strategic significance to the borrower’s current and/or future operations; (ii) measurable or quantifiable on a consistent methodological basis; and(iii) able to be benchmarked. Whilst it is clear that benchmarking and measurement are key constituents of the KPI indicators, our experience is that some indicators remain more generic in nature.
As with the setting of the KPI’s, there is not (yet) a binding framework as to the methodology of reporting compliance with the KPI’s and there is clear and obvious difficulty in making any framework binding. The market offers everything from external analysis and third party reporting (sometimes proving a formalized ESG rating score) to self-imposed verification and reporting by the relevant company’s management. The option selected is the result of negotiation and indeed often driven by the party which is pushing hardest for the inclusion of ESG-linked indicators.
The incentivizing benefit component of the ESG linked financings comes with the pricing ratchet. In practice, failure to comply with the KPI’s is generally not subject to a margin premium whereas compliance with all or some KPI’s may result in a reduction of the margin. In more recent sophisticated ESG linked financings the documentation provides for the obligation to apply the equivalent amount of the reduced margin in a predefined manner (e.g., reinvestment to improve ESG performance), though this is a minority deal feature.
Irrespective of how the German MidCap finance market will develop overall, integration of sustainability-linked (ESG based) feature is and continues to be one of the hot topics in 2022 and we do not expect it to lessen in the near future.