SUSTAINABILITY

Debt finance

The rise of sustainability as a strategic issue is having two main impacts in the world of corporate borrowing.

The first is on the demand for capital: corporates transitioning their businesses, and new ventures forming with the express intention of addressing the world’s sustainability problems, need capital, and lots of it.  In response, borrowers may need more debt and can increasingly look to source this through finance that is in some way ‘green’.

The second impact is on lenders. Mainstream banks are coming under pressure to transition their own financing activities to make their loan portfolios more sustainable. As a result, just as with established equity investors, financial institutions are increasingly focusing on non-financial characteristics alongside financial considerations. This is manifesting itself in an increasingly commonplace model of sustainable lending, linking loan terms to a borrower’s performance in relation to pre-determined Key Performance Indicators (KPIs). These may relate to, for example, energy efficiency or reduction in greenhouse gas emissions, diversity and inclusion targets or corporate governance transparency.  Typically the margin for the loan will decrease where those KPIs are satisfied and increase if they are not. Sustainability-linked pricing is also now routinely included in working capital facilities and is becoming more prevalent in event-driven financings, both in the investment grade and cross-over or leveraged markets.

The regulatory environment relating to corporate debt is developing rapidly in parallel: this year sees the FCA publish feedback on ESG integration in UK capital markets, the EU Green Bond Standard take further shape, and the EU green taxonomy help provide a common language and a clearer definition of what is ‘sustainable’, with the UK’s taxonomy and Sustainability Disclosure Requirements to follow in the short term.  Together, these developments are expected to limit room for potential bond greenwashing and harmonise expectations over the meaning of sustainable lending in the debt markets. Borrowers therefore increasingly have to consider non-financial considerations and present a positive carbon transition trajectory if they are to avoid rising costs of capital and tightening liquidity.

"These developments are expected to limit room for potential bond greenwashing and harmonise expectations over the meaning of sustainable lending in the debt markets."

Public equity markets

Public equity markets have been comparatively slower to adapt. There is no accepted model for a “sustainable IPO” or a “green rights issue” in the way that there is for a sustainable loan or green bond. There is also no received wisdom over the types of non-financial KPIs or reporting metrics that issuers are expected to include in equity prospectuses or investor presentations.

This lag in adaptation is partly structural. Equity capital has always had far fewer strings attached than debt capital, where a borrower may be forced to run its business in a particular way through KPIs and covenants (or suffer drastic consequences such as potential coupon adjustment, drawstops, repayment demands and security enforcement).

The power of equity investors comes instead from the ability to use engagement to put pressure on boards to change course or vote a certain way at shareholder meetings. Many of these levers, such as requisitioning shareholder meetings, voting against directors’ reappointment or ultimately selling down are, however, quite extreme and typically used where engagement and influence fail to deliver results.

Added to this, debt finance is typically provided by a collection of banks and other financial institutions.  These are subject to intense regulatory scrutiny and where market norms, once developed, spread quickly amongst the lending community. This is demonstrated powerfully by the emergence of various sustainability-related lending principles, such as the ICMA Green Bond Principles, the LMA Sustainability Linked Loan Principles and the LMA Social Loan Principles.

In equity markets, despite the not insignificant take-up of the 2020 UK Stewardship Code and the arrival of multi-manager engagement platforms like Climate Action 100+, institutional shareholders tend to act more independently when selecting, managing and documenting their investments. Market norms in executing and managing those investments, particularly in public equity, are therefore perhaps a little slower to develop and harder to decipher.

Nevertheless, there are initial signs of sustainability having an impact on how public equity (both primary, through an IPO, and secondary, through placings, open offers and rights issues) is raised and for what purpose. For example:

• IPOs and other market debuts: a number of companies coming to the public equity markets for the first time are seeking to present sustainability as a key plank of their core strategy and investment proposition. For example, Made.com Group plc, which successfully completed its IPO in 2021, selected sustainability as one of its four key “strategic pillars”. Made.com has an extensive, board-approved, sustainability and responsible sourcing strategy, sustainability KPIs, a dedicated sustainability team which focuses on developing, implementing and tracking progress of the sustainability strategy, and a sustainability council made up of employees from different areas of the business which applies the sustainability strategy in real-life situations throughout the company.
• Secondary equity raises: Water company Severn Trent raised £250 million in 2021 by way of an institutional placing¹ specifically to fund six new green projects endorsed by the watchdog Ofwat, building on their pledge to spend £1.2 billion on plans to help further sustainability and assist customers and communities across the Midlands.²

As sustainability takes on a more prominent role for investors, issuers and regulators alike, so it becomes subject to increased scrutiny. This scrutiny has the potential to impact a number of processes in the public equity markets. For example sustainability related statements in prospectuses will need to be subject to more robust verification, review and testing. So too with public disclosures more broadly, including those in annual reports and trading statements; assurance and verification processes will therefore have some catching up to do.

But implementing new processes may be challenging. The disclosures in question are often forward-looking and aspirational with some tied to distant future dates without a reliable means of assessing whether the goal, target or ambition in question is in fact realistic or not when judged according to the relevant issuer’s financial position, strategy and market standing. Indeed there is an opportunity for the development of both market and legal frameworks to provide assurance tailored to these new forms of disclosure, just as there is now a commonly used approach for competent person’s reports for mineral companies.

In the context of a prospectus in particular (with its associated personal liability for directors) boards, in-house legal teams and professional advisers will need to start applying the same level of rigour to sustainability-related statements as is applied to key financial-related sections such as the no significant change statement, working capital statement, synergy forecasts and profit forecasts.

There are also some signs of structural change from regulators and issuers which might aid in catching-up with debt markets. For example, the London Stock Exchange’s Green Economy Mark allows investors to identify “an investible universe of ‘green economy’ equities, enabling a broad exposure, rather than a focus on one area”³. It identifies London-listed companies and funds that generate 50% to 100% of their revenues from products and services that contribute to the global green economy. Approaches such as this could help open up a market in green-labelled equities similar to green bonds, and provide a complement to ESG ratings by giving additional insight into the issuer.

For the public equity markets, the simple point is this: if capital is searching for somewhere to go that has good ESG credentials, issuers who are able to provide those credentials will benefit through higher demand for equity. It may be that enhanced disclosure requirements and ESG-focused investment funds will accelerate this by helping companies that are genuinely aligned with sustainability to emerge more clearly. Corporates will want to be responsive to developments in public equity in order to maintain attractiveness.

Private equity markets

Trends are much harder to discern in the private equity markets but, in general, private companies face much less scrutiny than their public, listed counterparts. Indeed there is some evidence of sustainability-led disposals by listed companies generally which have resulted in target businesses, particularly in oil and gas, being owned by private equity firms and private operators, with some recent commentary⁴suggesting that this trend is increasing.

Predicting the future relationship between private markets and sustainability is difficult. Today private markets do in some sectors provide a ready-made home for businesses which have fallen foul of the sustainability agenda (and there are flows of private capital to suggest private investors are taking advantage of this), but that will change over time. More private investors, particularly private equity firms, will adjust their investment objectives to cater for an increasing number of more sustainability-conscious investors and to seek financial returns from the energy transition and other structural changes affected by the desire to be more sustainable.

This is evidenced by the number of new funds being created to invest in ‘green’, or otherwise sustainable, businesses: in Q3 2021, for example, flows into ESG funds totalled $54.7bn, beating the total record for 2020⁵. But this transition will take some time, and considerably longer than in the public equity markets, because the levels of scrutiny, particularly from the media and shareholders, and the absence of other stakeholders like proxy associations, means that the impetus for change is notably less strong. That said, new reporting obligations such as those under the Sustainable Finance Disclosure Regulation, will drive change. There are already plenty of signs of private equity sponsors, particularly those which are listed or otherwise have the scale to face more significant scrutiny from investors, the media and others, shifting their activity towards investing in more “ESG-appropriate” assets and businesses. Blackstone being a notable example⁶.

"In Q3 2021, flows into ESG funds totalled $54.7bn, beating the total record for 2020."

Sustainability also has the potential to impact a range of other areas of corporate decision making, like capital return policies, share buybacks, dividend policies and capital expenditure.

In many of these areas, there is a tension between on the one hand the “E” and “S” drivers (which emphasise the importance of stakeholder protection) and, on the other hand, the objective at the heart of capital return strategies such as dividends and buybacks (which emphasise returning value to shareholders). Some businesses, like BNP Paribas, BIC, Campari and Enel⁷ have tried to square this circle through so-called “ESG buybacks” that allocate part of the outperformance⁸ of the buyback to funding an ESG project.

More broadly, decisions by corporates to do things like invest in new technology, pivot asset portfolios so that they are more appropriate for the energy transition, change manufacturing processes or alter supply chains all have a financial impact. It will be interesting to see to what extent shareholder expectations around leverage ratios, levels of capital expenditure and dividend policies change to allow for this upheaval.