Considerations of “environmental, social and governance” (or ESG) criteria with respect to a company’s management and operations continue to take on greater importance in lenders’ and investors’ credit and investment decisions. How a borrower or a target company measures up to these ever-developing ESG standards will impact its cost of capital and value to potential investors and acquirors. While it remains difficult to predict how the perception of a company’s ESG performance (or even its rating) may impact its capital-raising efforts or its likelihood of success or failure, a number of trends seem inevitable.
- Enhanced Disclosure and Regulation. While the European Union has taken the lead in advancing ESG-related disclosure regulation, similar action is expected in the US in the near term by many market participants. Although the Securities and Exchange Commission’s focus has been largely directed at investment funds that market ESG-friendly strategies, the agency is expected to propose new rules with the goal of enhancing ESG-related disclosures by all public companies (and perhaps by extension even private companies may follow such disclosure guidelines). While questions remain regarding the nature of such disclosures – be it responses to a uniform set of questions or a general discussion of certain issues — it is certain that a new reporting regime is taking shape. To date, investors and lenders have largely had to rely on their own due diligence or voluntary disclosures by companies. This has been supplemented by a growing number of ESG rating agencies. As larger players continue to enter this market, ESG ratings will become more consistent and reliable, be more tailored to specific industries, and play a much larger role in lending and investment decisions.
Of course, with greater disclosure will come greater attention from the public. There is little doubt that traditional and private lenders will pay closer attention to a prospective borrower’s compliance with ESG standards as they continue to develop. Pressures will come from a number of angles. These include (i) public relations concerns stemming from greater attention paid to lenders doing business with ESG laggards, (ii) large institutional investors curtailing lending activities with poor performers, and (iii) concerns regarding a borrower’s ability to compete and succeed in a changing environment. Recognizing the importance of this trend, and noting that many borrowers in the leveraged loan markets are not public, the Loan Syndications & Trading Association (LSTA) published a form of ESG Diligence Questionnaire. If used as intended, the questionnaire would be completed by borrowers at the time of loan origination and be available for review by prospective lenders. It includes queries regarding ESG governance, the existence and nature of a borrower’s ESG policies, the sources of a borrower’s revenues, and other matters that may be important to lenders concerned about the ESG health of their borrowers.
- Increased Costs and Other Changes. For those borrowers that perform poorly in ESG ratings, it is reasonable to expect that the supply of prospective lenders willing to engage with such borrowers will decrease. In turn, the terms and conditions of credit available to those borrowers will become more costly. This may be evidenced in higher interest rates and fees and the tightening of negative covenants, among other things. We should also expect that lenders will insist on comprehensive reporting from their borrowers, and perhaps in-term reviews from independent third parties, showing compliance with new and enhanced covenants developed with certain ESG-related goals (reduced emissions or greater diversity, for example). Indeed, so called “sustainability-linked loans” (or SLLs) are already increasing in number. For borrowers with established sustainability programs, the LSTA has also published the Sustainability-Linked Loan Principles, intended to outline the common characteristics of such loan products. These loans, which are not limited to certain projects like other green-loans, include incentives to achieve certain ESG targets, perhaps by allowing step-downs in the pricing grid. Of course, SSLs are only available to companies that have a delineated sustainability program. Those that do not may find themselves with significantly higher cost of capital.
The rise of SSLs will surely lead to increased SG&A costs as well. Modifying operations, for example, to satisfy ESG rating criteria could be costly. Hiring employees with the expertise needed to report on ESG performance to lenders and rating agencies, and the retention of third parties to provide independent verification, will also increase borrower costs.
- Divisive mergers, spinoffs and asset sales. There has been much discussion recently regarding the so-called “Texas Two-Step” – a divisive merger procedure under Texas corporate law that allows a Texas company to shed certain assets/liabilities associated with its historical activities into a separate vehicle without having to utilize traditional “transfer” or spinoff agreements. Recently, this maneuver has been used by companies facing mass tort liabilities to shield their on-going business operations and subsequently address those liabilities in a bankruptcy of the newly created entity. While not without controversy, the Texas Two-Step has been used successfully by a number of companies to divide certain of their operations, assets and/or liabilities into newly created, independent entities. In time, we should anticipate that companies with challenging ESG issues that cannot be cured with simple corrective measures will consider divisive mergers as well as traditional spinoffs and asset sales as appealing strategies. Those operations that are the sole cause of concerns may be separated from the whole, allowing the remaining business to better succeed in a new ESG-focused paradigm.
While sustainability-linked lending is gaining traction in the financing markets, it has not infiltrated the day-to-day activities of members of the restructuring community. It may not be long before some lenders find that junior capital or a refinancing is no longer a feasible option for their troubled borrower due to its subpar ESG ratings. While the failure to meet ESG criteria in a credit facility often leads to pricing consequences rather than defaults, that will surely change over time. When that does, lenders will find themselves facing defaults stemming from events that they have not previously addressed and may need to consider unconventional remedies. For borrowers, the day may soon come when lenders seek to impose strict ESG reporting and hurdles when asked for an amendment or forbearance. In other credits, borrowers may quickly find themselves with a new cast of lenders after its original group sells into the secondary markets due to external ESG pressures to exit facilities. While the consequences of a new regime of ESG ratings may be difficult to predict, members of the restructuring community would serve themselves well by staying current on trends in the regulatory and SSL landscape.