In recent years, we've seen an increasing number of loan agreements that incorporate environmental, social and governance (ESG) metrics, driven by among other things the focus on (1) climate change mitigation, (2) diversity, equity and inclusion and (3) good governance.
Incorporating ESG metrics into loan agreements has been one way for borrowers to credibly signal to lenders and other external stakeholders that they are committed to responsible business practices. For lenders, a borrower's commitment to achieving particular ESG metrics may be viewed as a risk mitigant. In addition, some lenders look to originate or participate in sustainability-linked loans (SLLs) as part of their investment mandate. As discussed below, SLLs often have better pricing terms for borrowers. Even in today's difficult credit markets, we are seeing demand for ESG-linked loans.
On their surface, SLLs look like normal loans, with a lender (or a group of lenders) providing one or more loans and an agreement that the proceeds are to be used for stated purposes. Where they differ is in their pricing: SLLs offer incentive pricing tied to the company's ability to meet certain ESG-based performance targets, commonly referred to as key performance indicators (KPIs). KPIs are selected by the company and its lenders (often with the help of outside consultants) and can be quite varied, and in some cases bespoke. The price of the company's loan is modestly adjusted on a periodic basis according to whether the company has met the agreed upon KPIs.
Thus far, most of the SLL issuances have come out of Europe. However, although still a niche product, a number of lenders are offering SLL products in the United States and we are seeing growing interest in this product, especially by larger corporations. As credit markets rebound, we expect to see an increase in SLLs, including in the U.S. Even in tough credit markets, they may be attractive to lenders as an indicator of credit quality.
However, increasing lender sophistication and the flight to quality has resulted in greater scrutiny of whether KPIs are meaningful and, if so, achievable. Also, lenders are taking a holistic view, as part of their credit analysis looking beyond the specific ESG KPIs, at the borrower's management of ESG-related risks and opportunities more broadly. On the borrower side, there is increasing sensitivity as to how SLLs my be perceived by anti-ESG constituencies. That is starting to factor into consideration of both KPIs and messaging.
The SLL market continues to evolve, and we expect that will be the case for the foreseeable future. Over time we expect that new bells and whistles will be developed to incentivize borrower performance. We also expect to see metrics tied to a growing range of topics, such as biodiversity and other facets of natural capital and human rights. With the SLL market still evolving, Ropes & Gray is keeping a close eye on recent and evolving trends, as well as helping to shape the market.
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