Junk-rated companies owned by private equity firms are tapping ESG narratives to cut borrowing costs. Debt investors worry about being played.

To lop a sliver off its interest rates, German packaging company Kloeckner Pentaplast GmbH, owned by SVPGlobal, promised to use more recycled material and add more women in senior roles. French hospital operator Elsan SAS, also private-equity owned, pledged to improve customer satisfaction and cut waste, while PAI Partners-owned Euro Ethnic Foods SA said it would increase the number of electric forklift trucks used in its stores.

The number of sub-investment-grade European firms whose interest rates are tied to how well they do on their sustainability goals has more than doubled since the start of the year. For their part, yield-hungry debt investors are willing to give up some return for borrowers making environmental, social and governance improvements, even as they cast a wary eye on companies that may be setting cosmetic or low-balled goals.

“We see a bit of greenwashing,” said Jonathan Butler, head of European leveraged finance at PGIM Ltd. “Companies are trying to price their debt at tighter levels by doing something they needed to do anyway...Companies are exploiting the ESG angle to reduce the cost of their debt.”

The finance industry is under pressure from governments, regulators and investors to factor in broad ESG-related concerns including climate change and workplace gender and racial imbalances. That has meant fund managers now have to factor in more than just profit maximization in their investment thesis.

Meaningful Change
Butler, like other managers, worries that pricing linked by a so-called margin-ratchet to ESG targets is a “convenient” way for companies to cut funding costs without necessarily addressing sustainability values in a meaningful way.

Take Kloeckner Pentaplast, for example. The German plastic packaging maker’s ESG targets are not “particularly ambitious,” George Curtis, an analyst, says in a blog for TwentyFour Asset Management.

Kloeckner Pentaplast is promising to increase the share of women in senior roles by two percentage points to 27%, the proportion of recycled material in its packaging by four points to 26% and to cut its emissions. The company can trim 7.5 basis points off its interest margin—currently 475 basis points—if it meets the three goals.

The targets set out for Kloeckner Pentaplast reflect the commitment to integrating ESG factors as drivers of value creation, a spokesman for the company’s private-equity owner SVPGlobal said. If the goals are achieved, the company will be well positioned relative to its peers, he said, adding that most others in the industry are in single digits for the percentage of recycled material content.

Double Discount
For loan funds, being demonstrably planet-friendly has become an important marketing tool, but giving away interest income could become problematic if targets are deemed to be too easy.

“If you give companies easy milestones they’re just getting a cheaper margin on the loan,” said Torben Skodeberg, co-founder of Capital Four Management. “We will then try to price that into the initial margin, otherwise it becomes unfair to our investors.”

And while discounts available to junk-rated companies are much smaller than in the investment-grade market, lenders fear they may get steeper as the trend takes hold and borrowers push for more.

 

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.