Sustainably-linked loans: navigating new Loan Market Association guidance for fund finance facilities

As the financial sector stands at the crossroads of economic growth and sustainability, the Loan Market Association's (LMA) will hope that its March 2024 guide on sustainability-linked loan principles (SLLPs) for fund finance facilities (Guide) emerges as a critical compass for fund finance. 

The Guide is a useful tool for fund finance practitioners who want to understand and apply the SLLPs in a consistent and robust manner, offering practical guidance on the application of the SLLPs in fund finance transactions by identifying challenges and considerations that may arise and discussing how the SLLPs may be best utilised in a manner consistent with their overarching goals. The Guide demonstrates the growing interest and demand for sustainable finance products in the fund finance industry, and the potential for sustainability-linked loans (SLLs) to play a significant role in advancing environmental, social and governance (ESG) policies and goals.

Understanding sustainability-linked loans

SLLs incentivise borrowers to improve their ESG performance by linking the loan terms to pre-defined sustainability targets. SLLs differ from other types of sustainable finance products, such as green loans or social loans, which require the use of proceeds for specific projects or investments with a positive environmental or social impact. SLLs do not have such use of proceeds restrictions, but instead focus on the borrower's overall sustainability performance or achievement of a specific goal, measured by key performance indicators (KPIs) and sustainability performance targets (SPTs).

Challenges in applying SLLPs to fund finance transactions

SLLs are increasingly popular among investment funds that want to align their borrowing strategy with their ESG objectives and demonstrate their commitment to responsible investing. However, it is recognised that applying the SLLPs to fund finance transactions can pose some practical challenges that include:

• difficulty in setting material KPIs due to the limited internal operations of a fund, uncertainty of investment pipeline, and/or a lack of consistent metrics across a fund’s underlying investments;
• limited historical ESG data on borrowers, the fund or, as the case may be, the sponsor and the underlying investments; and 
• for certain fund finance products, shorter tenors relative to other types of financings. 

Practical guidance

The Guide suggests some possible approaches to overcome these difficulties, and considers how the SLLPs can be best utilised in the fund finance market in a manner consistent with the overarching goals of the SLLPs, including: 

• KPIs: 
  • basing KPIs on known or identifiable criteria relating to the fund's investments or internal operations;
  • using external benchmarks or references (for example, the Science Based Targets Initiative, International Capital Market Association or the International Sustainability Standards Board) to help identify relevant and material KPIs for the specified industry or investment strategy;
  • gradual phasing in of KPIs, or incorporation of eligibility concepts to define investments that will be included in the calculation of SPTs, as the fund continues to acquire investments, or the borrower requires the ability to hold an investment for a minimum period of time to reasonably effect change; and
  • in respect of relatively short tenored fund finance transactions with extension options, expanding the SPTs out to the latest possible contemplated maturity, or providing for the re-evaluation of SPTs once the facility has completed its initial term, being mindful that lenders should not contemplate a reduction in requirements absent compelling market or transaction specific circumstances.
• Calibration of SPTs: 
  • ensuring that SPTs are suitably ambitious and reflect the recommendations included in the SLLPs; and
  • benchmarking SPTs on historical performance and comparable peers within the relevant industry.
• Reporting and verification: 
  • requiring borrowers to provide reporting to the lenders as to monitoring of the SPTs at least annually and include independent and external verification of each SPT for each KPI for any relevant period to assess performance;
  • ensuring that, where available, historical reporting is provided to the lender during initial negotiations and structuring of the transaction; and
  • reference by lenders to the reporting that funds are providing to their investors, to the extent such reporting would otherwise meet the criteria set forth in SLLP.

You can read more about SLLs and the LMA SLLPs in our previous blogpost,  Sustainable drafting for sustainability-linked loans?, Rachel Richardson, Andrew Perkins, Adam Caines, Jamie Macpherson (macfarlanes.com).