Already this month, French private hospital operator Elsan doubled its potential discount to 15 basis points. As is common in such deals, there’s an equivalent premium if Elsan misses targets. Its three key performance indicators, or KPIs, are patient satisfaction, reduction of waste per stay and employees’ work-life balance.
CVC Capital Partners holds a minority stake in Elsan and also recently opted for debt with ESG-linked pricing for its buyout of Stark Group AS. The sponsor chose ratchets based on metrics portfolio companies had identified as areas for improvement, and any savings would be reinvested into environmental impact-reduction efforts, a person familiar with the private equity giant’s operations said.
“At five or even 10 basis points, investors won’t think too hard about the overall return for strong credits,” said Edward Martin, a managing director in Bank of America’s leveraged finance team. “But given how spreads are compressing, if we start broaching those ratchet levels, it will cause some real discussion around pricing regardless of the credit quality,”
Granted, fund managers can choose to walk away. But low interest rates are driving the demand for the yield offered by leveraged loans, so any manager who rejects a deal in protest against weak ESG targets can be swiftly replaced.
Deals for Kloeckner Pentaplast, Elsan, Euro Ethnic Foods SA and Flender GmbH—all with ESG-driven pricing features—were snapped up by investors and later traded higher, Bloomberg data show.
Seeking Transparency
Another pet peeve of investors is how borrowers monitor and report their progress. Only two sub-investment-grade borrowers counted so far by Bloomberg have used a ratings firm. For bespoke targets, some investors—though not all—want a third-party to sign off.
“Margin ratchets on loans need to be externally audited,” says PGIM’s Butler, arguing that companies should not be allowed to self-certify.
The biggest frustration for investors in trying to judge how well a company fits with broad ESG themes is the lack of information firms provide. That’s something loan pricing targets could help with.
“Even if KPIs are close to being hit from the start, management now know it is something they need to disclose and analysts will ask about on a more regular basis,” says Capital Four’s Skodeberg.
That kind of transparency is the focus of investor bodies like the European Leveraged Finance Association, and will help managers see how well borrowers align with broad targets such as the United Nations Sustainable Development Goals.
“How the market develops and matures—on both the issuer and investor side—will regulate how broadly these ratchet regimes are adopted,” said Murad Khaled, a managing director in leveraged capital markets at Bank of America. “Investors can’t be seen to be waving through deals that don’t have a claim to something tangible and measurable.”
This article was provided by Bloomberg News.