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Ready, Set, Disclose? ESG Lending and The Middle Market
By Jeffrey Dunlop, Chris Swartout and Salma Taleb
The European Union’s recent passage of its Sustainability Financial Disclosure Regulation marks yet another milestone in the progression of environmental, social and governance matters. This article will review this regulation and related ESG disclosure requirements, together with other notable ESG developments, and discuss their impact on middle-market lenders.
In March 10, 2021, the “Level 1” disclosure requirements under Regulation (EU) 2019/2088 of the European Parliament and of the Council of November 27, 2019 on sustainability-related disclosures in the financial services sector (the “Sustainability Financial Disclosure Regulation” or “SFDR”) became effective. As a result, certain participants in the financial markets of the European Union (“EU”) are now required to make mandatory disclosures in respect of environment, social and governance (“ESG”) matters. These regulations, which generally require disclosure to end investors on the integration of sustainability risks, consideration of adverse sustainability impact and the promotion of ESG and other sustainability considerations in the decision-making process, reflect the latest milestone in the progression of ESG’s impact on financial institutions and investors. In this article, we will review the SFDR disclosure requirements as well as certain other related U.S. and non-U.S. regulatory requirements and similar developments, and explore theimpact of these matters on middle-market lenders in the U.S.
What is ESG?
First, a brief primer on ESG. In general, ESG refers to certain nonfinancial factors increasingly used to evaluate activities of companies and risks faced by investors in those companies as they relate to environmental, social and governance matters. Environmental factors relate to the conservation of the natural world, both as a company uses its own space or production facilities (such as energy efficiency and waste management), and its environmental footprint (such as greenhouse gas emission). Social factors relate to a company’s approach to matters such as diversity, gender equality, human rights, data privacy and labor standards. Governance factors relate to a company’s board composition, audit and legal compliance (such as anti-bribery and anti-corruption policies, whistleblower protections, political contribution policies and intercompany information exchange). A number of ESG frameworks and principles have been established in attempts to assess and address these factors. For example, the Equator Principles, originally formulated in 2003, set forth a voluntary risk-management framework now adopted by 116 financial institutions in 37 countries for determining, assessing and managing environmental and social risk in projects. Another example is the GRI Standard for Sustainability, which originally launched in 2000 and seeks to create a global common language for reporting on sustainability standards. However, use of these frameworks and principles by companies and investors to drive ESG investment, in practice, is a relatively recent development.
According to Bloomberg Intelligence, the value of ESG-related financial assets globally may reach as high as $53 trillion by 2025 and represent more than a third of total projected assets under management. This reflects an increase from approximately $15.0 trillion in 2014 and $22.8 trillion in 2016.In the lending world, issuances of “green bonds” (requiring that proceeds are utilized for “green” or other sustainability purposes) and “sustainability linked bonds” (which allow for a general use of proceeds, but tie other economic aspects of the issuance to ESG factors) have risen dramatically in recent years. Global green bond issuance was approximately $269.5 billion in 2020 and a report by the Climate Bonds Initiative predicts that number may climb to $450 billion for 2021. Sustainability-linked bonds are a more recent extension and are, likewise, predicted to increase. As one example, in September 2020, Novartis AG issued €1.85 billion of sustainability-linked bonds. In that issuance, Novartis AG set targets for increasing patient access to certain pharmaceutical treatments around the world, the results of which may have a 25-basis-point effect on the coupon rate of the bond. Private credit markets have followed a similar pattern in terms of tying economic benefits to sustainability and other ESG metrics. Global property managers such as KIMCO Realty Corporation, VENTAS Realty, LP and Alexandria Real Estate Equities, Inc., among others, have all recently entered into billion-dollar credit facilities, whereby pricing adjustments ranging from 1.0 to 6.5 basis points are driven by energy efficiency ratings (e.g. LEED) and other similar environmental sustainability metrics. These are just a few examples. A detailed review of these facilities is beyond the scope of this article, but a pattern of increased focus on opportunities for ESG investment in the credit markets is clearly emerging. It should come as no surprise, then, that regulatory bodies are engaging more on ESG matters as well.
The SFDR and Other ESG Regulatory Developments
The EU is the largest market in the world in terms of sustainable investment value. Accordingly, it is through this lens that the SFDR was enacted to “increase transparency of sustainability-related disclosures and to increase comparability of disclosures for end investors.” The SFDR is comprised of two levels of mandatory disclosure. Level 1, which covers the disclosure requirements effective as of March 10, 2021, initially followed a “comply or explain” basis. This means that covered, or in-scope, financial advisors and asset managers must either make the necessary disclosures or explain why sustainability risks are not relevant and, as a result, why such disclosures are not required. Effective as of June 30, 2021, the “explain” option was no longer available to entities with more than 500 employees. Moreover, in-scope entities are likely to have considered reputational pressures and potential uncertainty as to how an “explain” option may be perceived from an investment risk management perspective. The likely result is that most in-scope entities probably sought to “comply” with the Level 1 disclosure schedules voluntarily at the outset. In-scope entities under the SDFR are broadly defined to capture a wide range of financial market participants and financial products, including credit unions, investment firms, insurance intermediaries, asset managers and financial advisors; the SDFR is applicable to all firms outside of the EU that market funds in the EU.
Generally speaking, Level 1 requires in-scope entities to (a) disclose, via publication on their website, approaches to the integration of sustainability risks and consideration of adverse sustainability impact in their decision-making processes and (b) include, in precontractual disclosures, descriptions of how sustainability risks are integrated into their investment decisions or advice, together with the results of internal assessment of likely impact of sustainability risks on returns of any relevant financial products. More specifically, Level 1 disclosures require demonstration of adequate due diligence prior to making any investment with discussion of relevant policies and how they integrate applicable risks into such policies. The SFDR specifically highlights the need to review the potential adverse impact of investment decision, and the return of an investment, on sustainability factors in relation to climate and other environment-related impact and social and employee factors including human rights, anti-corruption, and anti-bribery matters. Such disclosure reporting is based on the “principle of proportionality” such that the review is required to take into account the nature and scale of activities relative to the types of financial products or investment made available. In addition, with respect to financial products with a specific sustainability focus, Level 1 requires pre-contractual disclosures of how such products promote environmental or social characteristics, or have a sustainable investment as their objective. Level 2 disclosures, which are projected to become effective in January 2022, will require the above to be disclosed periodically (as opposed to only on a pre-contractual basis under Level 1) and be subject to further detail in final guidelines and regulatory technical standards that were published in final draft form on February 2, 2021 and remain subject to EU endorsement following final review.
While the direct impact of the SDFR and disclosure requirements on in-scope entities is clear, the indirect impact may be no less impactful. Many investors, whether formally subject to the SDFR or otherwise, may require information from companies necessary to assess ESG and sustainability risk in anticipation of potential coverage by the SDFR, or such investors may just view ESG information gathering and analysis as a prudent extension of general underwriting and due diligence in light of the rapid increase of investment in this area. Though the SDFR is the first comprehensive regulatory framework to address ESG disclosure requirements, the EU is by no means the only regulatory body interested in this field.
Japan implemented a significant development in the world of ESG when, in 2015, its nationalized Government Pension Investment Fund (“GPIF”) signed the United Nations’ Principles for Responsible Investment and issued its own investment principles incorporating a number of sustainability factors. As a result, GPIF, which is the largest pension fund in the world with over $1.5 trillion of assets under management, grew its ESG investment in Japan by over 300% from 2015 to 2018. The 2015 initiative by GPIF followed the Japanese market’s adoption of the Stewardship Code as a principles-based approach to investing in 2013. The Stewardship Code, as revised in 2020, seeks to promote sustainable growth and returns through shareholder engagement and, among other principles, instructs institutional investors in the Japanese markets to consider medium and long-term sustainability factors in investment strategies and disclose, in their stewardship policies, how sustainability issues are utilized in decision-making. So, unlike the SDFR’s mandatory disclosure requirements, Japan’s Stewardship Code seeks similar ESG investment engagement through a core set of principles. As another example of Japan’s leadership on ESG matters, it implemented the “womenomics” initiative in 2013 that aims to make the workplace more fair for women through focusing on increasing women in the workforce and female board representation.
Financial regulators in the U.S. show signs of moving in a similar direction. Following the U.S. rejoining the Paris Agreement on Climate Change in February 2021, which has been a major force behind all ESG-related regulations worldwide, the U.S. Securities and Exchange Commission (“SEC”) announced the creation of a new Climate and ESG Task force in March of 2021. This task force’s initial focus will be to identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules. In addition, the task force will analyze disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies. It is not difficult to forecast that these SEC efforts and initiatives may be the underpinnings for future U.S. regulatory changes in ESG and related disclosure requirements similar to those required under the SDFR.
Impact on Lenders in the Middle Market
There is no doubt that ESG frameworks, initiatives and related disclosures will continue to influence the credit and other investment markets. But, more specifically, how are ESG matters likely to impact middle-market lenders in the U.S.? Many U.S. lenders who transact in the middle market are already subject to the SFDR disclosure requirements, either directly or indirectly through affiliates and other corporate relationships. Such lenders are already seeking information and analysis from their borrowers in order to comply with the SFDR requirements. Middle-market lenders not subject to the SFDR, or not likely to be subject to any similar SEC requirements, to the extent they develop in the future, are still likely to face direct and indirect ESG impact in a couple of ways.
In the near term, the most noticeable impact on middle-market lenders will be expanded ESG information gathering. Many lenders are now requiring ESG and related diligence as part of their initial underwriting. Those who have not yet started gathering this information should consider beginning the practice. What drives each lender to begin or expand such inquiries will vary by circumstance. It may be driven by disclosure requirements, investment directives, general due diligence, risk assessment or simply as a best practice to keep up with the market. But, in any event, the expansion will almost certainly continue. To that end, the Loan Syndications and Trading Association (“LSTA”) published a model ESG diligence questionnaire in February 2020  that was updated in May of 2021. The questionnaire is designed to be completed by the borrower during initial due diligence and seeks to standardize the collection of ESG information by loan market participants. The LSTA model provides a good framework to outline the criteria and related information necessary for lenders to understand the ESG risks a company faces, and the way in which these risks are being addressed.
In the longer term, it is possible to envision the type of sustainability-linked credit transactions currently prevalent in the large bond and private credit markets, which align potential economic benefits with achievement of ESG and other sustainability metrics, trickling down to the middle market. However, this is likely some time off for a variety of reasons. The time and expense necessary to monitor compliance with these metrics, which will often include third-party audits or reviews, is significant. Many large, multinational companies are already monitoring these metrics and in many cases obtaining third-party ESG audits for other reasons, such as regulatory requirements or good corporate citizenry. For middle-market borrowers who are not already monitoring ESG metrics, the expense will make economic sense only if the interest adjustments or other cost-savings are sizeable enough to provide a meaningful incentive. To date, publicly available data suggests the market for these adjustments is typically in the range of a few basis points, though in some cases perhaps as much as 25 basis points. For a middle-market borrower with a $100 million credit facility (to say nothing of the borrower with a $10 million loan) the cost of investing in and monitoring a robust ESG-compliance program will likely still outweigh the potential savings from a sustainability-linked loan facility. But the focus on ESG initiatives is not only driven by economics. If governmental and regulatory requirements, shareholder and stakeholder interest and general societal pressure continue to emphasize ESG factors in investment decision-making, one can imagine middle-market sustainability-linked lending products on the horizon.
We conclude with one final data point: in July 2020 Refinitiv introduced a sustainable finance league table to track leading credit and other investment companies operating in ESG-related transactions. Lenders should expect their competitors to be taking ESG seriously. If nothing else, middle-market lenders should take efforts to understand ESG risks and initiatives relative to the borrowers they serve, and look for opportunities to differentiate themselves (among borrowers and fund investors) in this developing market.
 ESG assets may hit $53 trillion by 2025, a third of global AUM, Bloomberg Professional Services (Feb. 23, 2021), https://www.bloomberg.com/professional/blog/esg-assets-may-hit-53-trillion-by-2025-a-third-of-global-aum/.
 Final Report on draft Regulatory Technical Standards, European Securities and Markets Authority (Feb. 2, 2021)
 Integration and Engagement Key to ESG Investing in Japan, Institutional Investor (Jan. 6, 2021)
 ESG Diligence Questionnaire; LSTA (Feb. 3, 2020) https://www.lsta.org/content/esg-diligence-questionnaire.
About the authors:
Jeffrey Dunlop is a principal in the Commercial Finance Group of Goldberg Kohn Ltd. His practice focuses on the representation of banks and other commercial lenders in structuring, negotiating and documenting a variety of commercial finance transactions. His experience includes secured asset-based and cash-flow loans, leveraged buy-outs, mezzanine financings, second lien financings and unitranche loan transactions. In addition, Dunlop has extensive experience in cross-border lending transactions involving North and South America, Europe and Asia.
Chris Swartout is a principal in the Commercial Finance Group of Goldberg Kohn. His practice focuses on the representation of banks and non-bank financial institutions in structuring, negotiating, and documenting a broad range of commercial finance transactions, including acquisition and working capital financings, recapitalizations, refinancingsand other complex financial transactions. His experience includes secured asset-based and cash-flow loan transactions, first-lien/second-lien, split-lien and unitranche structures, and mezzanine and hybrid lending products. He frequently represents lenders in international financings involving multiple jurisdictions and has dealt with borrowers in numerous industries, including manufacturing, technology, software, business services, healthcare and agriculture business.
Salma Taleb is an associate in the Chicago office of Mayer Brown LLP and a member of the Banking & Finance practice. She focuses her practice on receivables and supply chain financing. Prior to joining Mayer Brown LLP, Taleb worked as a commercial finance lawyer where she represented banks and financial institutions in asset-based and cash-flow finance transactions.