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Investors split on pricing implications of ESG structures, wary of 'greenium'

Investors in the European leveraged finance market are divided over whether a pricing advantage for borrowers placing high-yield bonds with structures linked to environmental, social and governance-related criteria is justified, according to a new buyside survey carried out by the European Leveraged Finance Association, or ELFA.

ESG-linked structures have allowed borrowers to reduce their cost of capital in many cases, and of the investors questioned by ELFA, 51% believe that such an advantage, or "premium," is acceptable on sustainability-linked bonds, providing the structure and targets of the notes are robust and credible, while 55% believe this premium or advantage on green/social/sustainable bonds is justifiable.

While sustainability-linked bonds are a relatively new product in Europe — with the first non-investment-grade transaction with a coupon step-up linked to ESG-related key performance indicators, or KPIs, emerging only in March this year — investors are wary of issuers looking to jump on the bandwagon to get a pricing advantage, also dubbed a "greenium" by some in the market, while not fully embracing the tenets of ESG across their business.

"Even if issuers don't hit their KPI, they're still enjoying the benefit of the greenium on the sustainability-linked bond," said Sabrina Fox, CEO at ELFA. "If there's a benefit straight out of the gate — and especially if they never have to test their KPI if that date falls after the call period — then it can feel disingenuous to investors. It can seem as if issuers are only bringing these deals to get the greenium, not because they're actually strongly committed to sustainability, as they should be."

Indeed, although half of investors may be happy for issuers to enjoy a pricing advantage on sustainability-linked loans, according ELFA's survey, they are keen for coupon step-ups to be more punitive should borrowers miss their ESG-linked KPIs. "The step-ups have been too low," said one investor, replying to the survey. "Sustainability-linked bonds are being used by 'polluting' companies to reduce the cost of funding and attract investment, [and] they need to be more impactful to cover for the fact that they screen badly on coal, emissions, etc."

While most of the sustainability-linked bonds completed to date in the European market have included a "standard" coupon step-up of 25 basis points if KPIs are not hit, 75% of investors surveyed do not believe this is high enough. ELFA found that 39% of investors thought a step-up of between 25 bps-50 bps was appropriate, while 30% answered that it should be larger than 50 bps, or equivalent to 20%-50% of the final coupon.

The survey also revealed investor concern over when ESG-related KPIs are tested, with worries emerging that some companies may be able to reap the benefit of interest savings while still avoiding meeting, or even testing, targets by issuing bonds that are callable before the KPI test date. Roughly half of investors said that issuers should face a cost of 50% plus the coupon step-up for calling the bond, if the non-call period ends before the KPI is tested. Another 36% said that a call price of either 75% or 100% of the coupon should be payable.

Call for clarity
In the leveraged loan market, ELFA's report highlights investors' demands for transparency in the processes of setting, monitoring and testing ESG-linked KPIs. Almost all the buysiders participating in the survey (96%) said that all relevant KPI information should be determined and disclosed before investors commit to a deal, with almost 90% saying that the terms of an ESG-related margin ratchet should not be flexed in response to a high level of demand.

Meanwhile, 32% of respondents said they think investors should have the opportunity to provide input on KPIs before committing to a transaction, with almost 37% answering that "investors should, at a minimum, be involved by way of a call with the borrower’s head of ESG/sustainability coordinator." In contrast, 32% believe that this is the job of the arranger or sustainability coordinator on the deal. Roughly 70% of investors surveyed, though, say a third party should be involved in setting up KPIs linked to margin-ratchets. This is to assuage concerns across the market regarding 'greenwashing,' whereby borrowers inflate their green credentials for their own advantage, and to ensure that issuers are engaging with ESG topics in the most robust way possible.

"There has been a dearth of sufficiently ambitious and credible targets, and investors want to have more engagement with issuers to ensure that they can assess whether the targets are material," said ELFA's Fox. "They need to articulate that they need something beyond 'business as usual.'"

Investors are clearly keen that companies incorporating ESG-linked margin ratchets into leveraged facilities are as transparent as possible about their ongoing performance. Some 87% of respondents to ELFA's survey said that a third party should audit the KPIs annually, while 82% said that the margin step-up should kick in if a borrower does not provide an ESG/sustainability report or third-party confirmation.

ELFA surveyed 170 investors, with 90% of respondents noting that they owned bonds or loans incorporating ESG provisions. Its subsequent report, "The Emergence of ESG Provisions in Leveraged Finance Transactions," was published today, July 7.