Fund financing and ESG: from the impact niche to the mainstream

The importance of flexible fund financing has grown in the European private equity market in recent years. This was further accelerated in 2020, with many players seeking subscription credit facilities or NAV-based loans to ensure liquidity at fund level as the coronavirus crisis hit the market.

In parallel, the greater integration of ESG into day-to-day investment activity and portfolio management has started to influence the fund financing landscape.

Combining fund facilities with interest-linked ESG goals seems a logical step forward from setting ESG targets at the outset of an investment, or taking out an ESG-linked credit facility on acquiring or refinancing a portfolio company. ESG-linked facilities at fund level generally require sponsors to set measurable ESG key performance indicators for their portfolio companies and at GP level, with interest margin repayment penalties incurred if they fail to meet these targets, providing an incentive to commit to ESG.

Impact investors have been early adopters, even for debut funds. Nordea Asset Management-backed Trill Impact took an ESG-linked fund-level revolving credit facility for its debut fund in 2020; the vehicle held a EUR 900m final close in September 2020. Fellow impact investor Bluewater Private Equity announced an ESG-linked NAV facility for its debut fund in May 2021, arranged by Investec, as reported.

Such facilities are not solely the domain of impact or sustainability investors, however. PE players including Waterland and CapMan have announced ESG-linked loans for their funds this year. Carlyle joined the ranks of GPs that have arranged such facilities for their European strategies earlier in September 2021, announcing a EUR 2.3bn facility for its European funds, with targets focused on diversity at board level, as well as greenhouse gas reporting and governance outcomes.

Such facilities are not wholly new to Carlyle, however; the GP took a USD 4.1bn ESG-linked credit line for its US strategies in 2020, while its AlpInvest division took an ESG-linked facility for AlpInvest Co-Investment Fund VIII (ACF VIII) in May 2021.

Swift proliferation
Various surveys have shown the increasing importance of ESG to GPs and LPs alike. For example, Investec's latest GP Trends survey revealed that 62% of the GPs who responded have rejected an investment on ESG grounds, versus 55% in the survey conducted the previous year. The concern is even more present for larger funds, with 82% of funds larger than GBP 1bn saying that they have avoided investments due to ESG factors, versus 56% of those under GBP 1bn.

In June 2020, prior to the recent raft of facilities announced in the European market, EQT announced that it had taken out what was then the largest ever ESG-linked subscription credit facility to date in the PE market; the GP took a EUR 2.3bn facility with a EUR 5bn upper limit for its PE business line.

James Yu, a partner who manages the financing activities within the EQT Partners Equity and Mid-Market teams at EQT, says that such loans have been becoming increasingly important. "I've been amazed at how swiftly this has proliferated in the past 18 months," he notes, adding that such facilities are becoming ingrained on the debt side of the market, too. "We are starting to see an ecosystem where bond investors and banks are now starting to focus on ESG, seeing how they can incorporate these targets into their loans. They can give an issuer targets that are meaningful and challenging, providing a benefit on rates if they achieve these targets or penalising them if they don't. It can affect your chances of getting a loan, or sometimes it is even a condition to participate."

While margin repayment reductions or increases are certainly a motivating target for the ecosystem, lenders will want to ensure that GPs missing their targets does not equate to greater revenue for themselves, creating a perverse disincentive to back ESG. "You have to think carefully about the potential or perception of a negative motivation," says Matt Hansford, head of origination and NAV financing in Investec's fund solutions division. "One way to solve this is that the money incurred does not go to the lenders: you can ringfence it for certain ESG-related projects or charities. So the fund still pays the full margin for the facility, but it's not funnelled to the lenders – it goes into ESG in itself, at ground level. It creates a circular effect and fills the gap in some way that was created by missing those targets."

Risk and returns
EQT's Yu acknowledges that sticking to ESG goals set in a financing facility is by no means easy, but can reap rewards. "There is a cost element of paying for ESG advisers, as well as the opportunity cost of management's time and hiring people within their own firms to work on this," he says. "But we think this makes our companies more valuable. If a buyer is planning to make an investment and is looking at two companies, we think people will pay more for the sustainable one. The initial benefits are harder to quantify, but we believe it is positive for returns, which will be well in excess of the costs."

Investors are starting to view a focus on ESG as a benefit; it's not quite a condition, but it is heading in that direction" – James Yu, EQT

The benefits extend beyond the positive impact on a single deal or vehicle financed with ESG-linked facilities. GPs that are seen as the vanguard of these trends can hope to tap into growing LP awareness for ESG, providing a fundraising incentive in an increasingly competitive market. "Investors are starting to view a focus on ESG as a benefit; it's not quite a condition, but it is heading in that direction," says EQT's Yu. "In the past, LPs would just want to make sure you were not doing anything bad, and it was about a negative checklist. Now it's more a question of whether what you are doing is good, it's about what actions are being taken in real time. The bar has been raised."

PE houses have certainly not been shy in publicising the successful setup of ESG-linked facilities, when the detail of traditional leveraged finance packages (let alone fund financing facilities) have traditionally not been a common fixture in press releases.

Hansford is convinced that demonstrating how ESG at fund level can be linked to returns will also benefit lenders. "As more GPs show over time that achieving ESG goals means that portfolio companies and their teams are more engaged, enthusiastic and empowered, and can therefore create better returns as a result, it becomes more about credit quality than margins. The question is how you approach the risk – if the risk is lowered, then you can approach the financing differently."

Hansford further clarifies the risk and credit quality position for lenders: "At the moment, the ESG element is not linked to the credit quality of the financing. So we are not looking at the ability for the investment to be 'better' or 'worse', or higher or lower risk, due to the achievements in ESG. But once you can quantify that, there is another set of lenses you can take this through. LPs will think about this as well. The question for them is what the risk is in the equity: how robust is it, what are the chances of it performing poorly versus going up in value and becoming more saleable?"

In any case, and while returns are still at the heart of the PE model and in LPs' motivation for backing the asset class, there are signs that investors are starting to move away from a purely binary approach. Notably, a survey by placement agent Capstone Partners published in July 2021 revealed that 27% of the global LPs surveyed were willing to trade lower performance for excellent ESG credentials.

Reporting back
However, good ESG and sustainability intentions need to translate to solid and comparable reporting of progress. The issue of setting appropriate and measurable KPIs in a comparable format can prove as tricky in the negotiations of fund financing facilities as it is for evaluating investments or assessing a portfolio's ESG performance.

"There are concerns in the market about setting KPIs and their potential impact," says Yu. "Market participants, including lenders, need to work out if the KPIs are meaningful and if the targets are challenging, without being so unrealistic that the management teams end up taking the penalty interest. There could be some teething issues in real time as the market tries to find more universal standards and looking at how to do this in an orderly way, but there is a real desire from borrowers and lenders to do this."

The development of internal and external reporting structures is likely to be a significant factor in the development of ESG-linked fund financing facilities. One aspect holding GPs back from taking on such facilities, in spite of their perceived advantages, could simply be that they are keen to get their house in order before committing, says Investec's Hansford: "GPs want to put their name to something that is impactful, measurable and deliverable, so it's a question of whether GPs are ready for this on that specific generation of fund. I think it will be adopted widely in a number of years, but the question for GPs is whether it is the right time. We have spoken to many who are still working on their ESG framework. You do have to report in a clear, transparent way, so if you have not got the processes set up or not tested them thoroughly, it does not make sense to take one of these facilities."

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