Our key views:
- The US lags behind the EU in sustainability-linked loan issuance and maturity.
- The market is still immature overall, and a pedagogical approach is still very much needed.
- The EU integrates more SLLs into the credit structure, making them mainstream among banks and private credit.
- Even though federal banks have paused further increases in interest rates, now is the time for US fund managers to integrate SLLs into the credit structure and have financial incentives for sustainable change.
Sustainability-linked loan (“SLL”) issuance has grown significantly across the global market since its introduction in 2017. In particular, the European, American, and Asian markets have seen this issuance increase, rising from €11bn in 2017 to €877bn in 2022 (Banco Bilbao Vizcaya Argentaria, 2023). Although Europe got off to an early start over the Americas and Asia, the latter regions are rapidly closing the gap. A market rebound is expected in 2023 after a recovery from a 2022 dip in global loan issuance, in accordance with last year’s rise in interest rate increases among central banks (Economist Intelligence Unit, 2023). Additionally, with the Securities and Exchange Commission (“SEC”) drafting proposed legislation regarding environmental, social, and governance (“ESG”) on the public market, the private sector may look to follow suit for reputational purposes (Ernst & Young LLP, 2022). As stated by Marieke Boudeling, lead of our ESG US advisory team, "Now is the perfect time for US fund managers to start considering integrating SLLs into their sustainability approach, especially if they are considering fundraising in Europe."
The popularity of SLLs among borrowers has surged in recent years, resulting from a number of factors. Among these is the margin reduction, which reduces loan interest if the borrower can achieve their sustainable performance targets (“SPT”), helping the borrower save money in the long term (Norton Rose Fulbright, 2023). With recent hikes in interest rates, we expect the margin reduction to make SLLs more attractive in the market. SLLs have no specific use for proceeds, allowing access to a wide range of borrowers (Cadwalader, 2023; Norton Rose Fulbright, 2023). As long as a company is willing to adopt a sustainability strategy, there is potential for an SLL. Additionally, with SLLs come reputational benefits and a signal to stakeholders that the borrower is committed to their sustainability goals (Norton Rose Fulbright, 2023). As with borrowers, SLLs have gained popularity among lenders, which are promoting SLLs as they strive to hit net-zero commitments and align with regulations (Norton Rose Fulbright, 2023; Principles for the Responsible Investment, 2022). These factors will continue to drive the increase in SLLs over the coming years.
The first SLL agreement was signed in Europe in 2017, and since then, the European market has continued to act as a market leader in SLLs (S&P Global, 2021). In 2022, roughly 50% of leveraged loans in the EU had sustainability-linked clauses, an increase from 44% in 2021, despite a drop in leveraged loan issuance between the years (Reorg, 2023; White & Case, 2023). Additionally, 52% of SLLs issued globally in 2022 were in Europe (International Monetary Fund, 2023). In total, €374bn in SLLs were issued across EMEA in 2022 (Banco Bilbao Vizcaya Argentaria, 2023). The Green New Deal, which includes the Sustainable Finance Disclosure Regulation (“SFDR”), Corporate Sustainability Reporting Directive (“CSRD”), and EU Taxonomy, has acted as a driver for SLL issuance in Europe by encouraging sustainable investment via the regulation of fund disclosures (Norton Rose Fulbright, 2022). Issuance has slowed recently in Europe, as SLLs often arise from refinanced loans. Many of these loans were refinanced throughout the pandemic and will not need refinancing until 2024-2025 (Bloomberg, 2023). The drop in issuance among European lenders is expected to continue in the near future, giving the US and other markets an opportunity to catch up.
The United States has historically been hesitant when it comes to SLLs. The margin rachets of SLLs can seem counterintuitive to US LPs, which have a heavy focus on fiduciary duty. However, improvements in sustainability profiles help reduce the risk profile of investments, aligning with the LPs’ fiduciary duties. Despite this hesitancy, in recent years, the US market has begun to bridge the gap with the EU (White & Case, 2023). Although regulation of ESG in the American private market lags behind European regulations, SLL issuance has experienced significant growth in the US, due in part to the capital flexibility that comes with SLLs (Cadwalader, 2023). Additionally, upcoming SEC regulations aimed at regulating ESG disclosures in the public market may affect SLL issuance in private credit as LPs look to improve their reputation among investors (Ernst & Young LLP, 2022). Despite a significant drop in leveraged loan issuance in 2022, SLL issuance remained steadfast ($205.8bn) indicating a high resilience to drops in the market. As such, it is likely that SLL issuance will increase in 2024 due to the anticipated reduction in interest rate increases by central banks, an improved economy, and a weaker dollar (Economist Intelligence Unit, 2023).
The increase in SLL issuance rates in both the EU and the United States since their inception in 2017, in addition to altered economic conditions, such as higher interest rate climates in most geographies, lays the groundwork for a further increase in issuance in 2024 and beyond. Additionally, the effects of additional market regulation from the SEC on SLLs are yet to be determined, but it may support SLL issuance in the private market. US fund managers are advised to explore or further integrate SLLs as an instrument for driving ESG performance in their strategies.
As we expect the issuance of SLLs among private credit players to increase significantly over the coming years. We are here to guide you, through the intricacies of SLLs. For further information, please contact our team.
