LMA Guide To The Application Of The Sustainability Linked Loan Principles In Fund Finance – Fund Finance

Introduction

Some of our recent updates (here and here) have covered Loan Market Association
(“LMA”) guidance in relation to sustainability .
Environmental, social and governance (“ESG”) issues
continue to be a focus for investment funds, and investors are
increasingly looking at a fund’s strategy and agenda regarding
ESG in making investment decisions.

In March 2024 the LMA published a new guide (the “Guide”) aimed at
providing practical guidance on the application of the sustainability-linked loan principles
(“SLLP”) to fund finance transactions. The Guide
identifies challenges and considerations that may arise and
discusses how the SLLP can best be utilised in the fund finance
market.

Differentiating between green loans, social loans and SLLs

Green and social loans require that the proceeds are used solely
to finance (i) green projects or investments or (ii) investments
with a specific social impact. By comparison, the proceeds of
sustainability-linked loans (“SLLs”) can be used for any
specific or general corporate purpose.

SLLs work by using commercial or economic terms to achieve
sustainability performance targets (“SPTs”). As a result,
structuring a fund finance transaction as an SLL affords the most
flexibility.

Challenges

Even where a fund has a sophisticated strategy that applies ESG
considerations to its investment decisions and/or operations,
challenges can arise.

The Guide notes that these challenges are not insurmountable and
that a lender’s individual assessment remains key in
determining whether a particular borrower qualifies for an SLL.

The nine most notable practical challenges outlined in the Guide
are:

Challenge 1: the borrower will often have been
recently formed, with limited data available.

Challenge 2: it can be difficult to identify
the requisite key performance indicators (“KPI”) where
the borrower has limited structural operations.

Challenge 3: the uncertainty and closed nature
of a fund’s planned investments make assessing a KPI or SPT
impractical, with a risk of inconsistency in application.

Challenge 4: the implications of SLL
requirements may extend beyond the requirements of investors.

Challenge 5: verification processes can be
impeded by the variety and volume of investments.

Challenge 6: where the fund does not control
the investment portfolio, it can be difficult to ensure the
provision of a sufficient level of data to enable assessment of
compliance with an SPT.

Challenge 7: where a suitable KPI or SPT cannot
be adequately identified, a green or social loan may be deemed more
appropriate than an SLL.

Challenge 8: fund finance transactions often
have a short term of one to three years, which can make gathering
sufficient information to qualify for an SLL more difficult.

Challenge 9: the application of sustainability
principles varies based on the relevant market and applicable
regulations.

Notwithstanding the presence of one or more of the above
considerations, lenders and borrowers may conclude that the
incorporation of SLL provisions is not precluded, so long as the
proposed transaction is administered in accordance with the
SLLP.

Selection of KPIs

The Guide states that, in order to maintain the integrity of the
SLL market, the selection of KPIs and the incorporation of pricing
adjustments must be tied to ambitious sustainability objectives
relevant to the borrower’s core business or investment
strategy, beyond “business as usual” or those necessary
to meet legal or regulatory requirements.

In the context of a fund finance transaction, these KPIs may be
set at borrower level, but investment level KPIs are increasingly
more prevalent in the market.

The Guide sets out some options for KPIs in the context of fund
finance transactions, including the following:

(a) calculating them as a percentage of investments with stated
goals meeting specified criteria (where a KPI is tied to a
fund’s investments) in order to incentivise an increase in
investments meeting those criteria;

(b) tying KPIs to impact metrics for the fund as a whole, or to
a defined subset of the fund’s activities, or to the operation
of portfolio companies holding the investments;

(c) gradually phasing them to define investments that will be
included in the calculation of the relevant SPTs as the borrower
continues to acquire investments or, if the borrower requires the
ability to hold an investment for a minimum period, time to
reasonably effect change; and

(d) if term extension options are contemplated for a facility,
extending the SPTs to the latest possible contemplated term, or
anticipating recasting the SPTs once the initial term has
expired.

To assist with the selection of KPIs, Appendix 1 of the Guide
provides a non-exhaustive list of examples of KPIs used in fund
finance transactions.

Calibration of SPTs

The Guide notes that SPTs must be “suitably ambitious”
and satisfy the recommendations in the SLLP, such as:

(a) generating material improvement in KPIs beyond business as
usual;

(b) being comparable to an external reference or benchmark;

(c) consistency with the borrower’s sustainability
strategy;

(d) be generated through external guidance and discussions with
an applicable sustainability coordinator; and

(e) following a pre-determined timeline.

The SLLP also recommends assessing SPTs based on
“historical performance” and “comparable peers in
the relevant industry”.

In a fund finance transaction, this may involve a review of
investment funds under the same sponsor entity to determine the
suitability of the borrower’s objectives and projected
performance.

Verification and Reporting

The Guide emphasises that the ESG strategy, industry and
investment policy of an investment fund form an important part of
the assessment of whether a loan complies with the SLLP.

As noted above, a common obstacle to this is a lack of available
information about such a fund, but each loan must still be assessed
on an individual basis.

The SLLP recommend that reports on SPTs be made to lenders on an
annual basis. For an investment level KPI, a mechanism for initial
and continuous assessment by the lender should also be
included.

The Guide suggests that all reporting mechanics and requirements
should be agreed during the negotiation of the loan.

Conclusion

Given the unique challenges faced by investment funds, the Guide
is a welcome addition to the LMA’s sustainability guidance.

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.