Unlocking ESG value

Key considerations for financing your deals sustainably

ESG considerations have become more prominent in the minds of acquirers when considering the risks and opportunities in the context of M&A transactions. Opting for sustainable financing options shows a focus on generating financial returns as well as making progress towards ESG targets. This article considers the financing options available to companies, the regulatory context, and the advantages and disadvantages of using sustainable financing for corporate transactions.

What is sustainability-linked financing?

Sustainability-linked financing is a form of financing that promotes good ESG behaviour for lenders and borrowers.

Unlike for green financings and social financings, the proceeds from sustainability-linked financings are not to be used exclusively to finance green or social projects. Instead, they are usually characterised by their introduction of agreed key performance indicators (KPIs) to measure the ESG changes a borrower is making to its business operations. The financial and/or structural characteristics of the sustainability-linked financing (usually the interest rate or a premium) can vary depending on whether the borrower achieves predefined sustainability performance targets for certain key performance indicators. The indicators depend on the business of the borrower (or buyer) and the nature of the financing, and they must be validated by an independent verification party.

There are three main types of KPIs: social, green, and industry specific. A CMS 2023 study of over 100 sustainability-linked financings issued between January 2020 and April 2023 provides more details on what would constitute each type and how prevalent each type is.

Sustainability-linked financing is a form of financing that promotes good ESG behaviour for lenders and borrowers.

How is it regulated?

The EU’s Sustainable Finance Disclosure Regulation specifies ESG disclosure obligations for financial market participants. In the UK, the FCA has no current plans to introduce regulatory standards or a code of conduct. However, it is continuing to monitor the market following an investigation between March to April 2023 to better understand its functioning. But no legal framework for regulating sustainability-linked loans currently exists. As such, the regulation of financings under that banner is left to market participants themselves. 

The Loan Market Association (LMA), together with the Loan Syndications and Trading Association (LSTA) and the Asia Pacific Loan Market Association (APLMA), issued certain principles to help draft sustainability-linked loans followed by the publication by the LMA of sustainability-linked loan riders to be used together with LMA model finance documentation. These aim to establish a consistent approach to the loan terms and documentation that lenders seek when providing sustainability-linked loans. While these are voluntary, there is interest from market participants in following and applying these principles as a market standard. 

However, both lenders and borrowers, fearing accusations of greenwashing, are still feeling their way and trying to be cautious when documenting and labelling finance transactions as sustainability-linked. 

What options are there?

There are three main types of funding that can be linked to environmental metrics: 

Sustainability-linked loan – A form of loan which includes an economic incentive for a borrower to meet certain sustainability standards. This is commonly expressed through a margin ratchet, where the margin will rise or fall depending on the levels of compliance with sustainability performance targets. 

Sustainability-linked bond – Similar to a sustainability-linked loan in the overarching principles but the underlying nature of the debt instrument is different.

Sustainability-linked derivative – This simply involves an ESG overlay in a conventional derivative instrument, measured using one or more KPIs that relate to certain ESG criteria.

Who is it relevant for?

A wide range of borrowers choose sustainable finance options, including corporates and investment funds as well as financial institutions themselves.

Larger companies are currently the primary recipients of these financings. However, some SMEs already include sustainable KPIs in their financings, and the possible future introduction of actual regulation will no doubt mean that SMEs will also look to sustainability-linked finance to raise capital for corporate transactions in the coming years. 

The downside for smaller companies is that the reporting obligations can be onerous and act as a deterrent given the minimal potential cost savings. Large companies can deploy sizeable teams to pursue sustainability strategies. SMEs may find determining KPIs more challenging, but they are increasingly supported by some banks or investors in using these types of financings.

Advantages

• Clear statement of your ESG strategy.
• Enhanced reputation.
• Access to additional sources of capital.
• Differentiation, offering a competitive advantage in corporate transactions.

Disadvantages

• Administration costs of managing ESG metrics.
• Risk of greenwashing accusations if the ESG objectives lack ambition.
• Scrutiny if performance targets are missed.

​While sustainability-linked financings offer opportunities to align your M&A financing with sustainability goals, companies must carefully consider their complexity.

While sustainability-linked financings offer opportunities to align your M&A financing with sustainability goals, companies must carefully consider their complexity. Ultimately, the decision should align with your company's strategic objectives ensuring that the chosen financing method supports both the acquisition and your own sustainability agenda.