To aid potential investors, ELFA has called for a coordinated approach to ESG disclosure and analysis amongst leveraged finance borrowers.

By Paul A. Davies and Michael D. Green

Environmental, social, and governance (ESG) issues are playing an increasing role in the global leveraged finance market. As a result, borrowers who wish to access this market should consider paying closer attention to their ESG performance. The European Leveraged Finance Association (ELFA) has called for a coordinated approach to ESG disclosure among companies that wish to access leveraged loans, with the aim to help potential investors analyse ESG issues in a more consistent and uniform manner.

This blog post will explore the reasons why ESG factors are becoming such a crucial aspect of the leveraged finance sector and the response of ELFA to this development.

The Growth of ESG

The importance of ESG factors in mainstream investment decisions has grown rapidly in recent years. The market has already seen the significant impact of ESG issues on M&A, particularly in the private equity sector – for example, the number of signatories who have committed to the UN’s Principles for Responsible Investment at the end of 2018 included more than 2,000 asset owners (accounting for almost US$90 trillion of assets under management).

This uptick in considering ESG matters as part of portfolio management is partly a response to demand from clients, but it also reflects a broader acknowledgement that consideration of ESG factors, alongside traditional metrics such as financial performance, can enhance investor outcomes — a subject Latham & Watkins covered in this September 2018 blog post.

ESG in the Leveraged Finance Industry

Investor demand for disclosure of ESG factors within the leveraged finance industry has been slower to grow than it has within investment grade lending. ELFA attributes this phenomenon to the fact that investment grade corporates have a considerable advantage when it comes to ESG disclosure. ELFA suggests that this advantage is the result of the prevalence of MSCI-rated entities, as there is considerable overlap between ESG-rated investment grade issuers and the large-cap listed companies on which MSCI predominantly focusses its efforts.

Conversely, leveraged finance is often home to smaller-cap and/or privately owned companies that MSCI has not ESG-rated. Many of these companies have been slower to disclose ESG metrics, as the pressure within the industry to make such disclosures has not built at the same rate as for larger corporates. This status quo is coming to an end, however, as lenders begin to recognize the impact that ESG can have on financial performance.

ELFA Response

In response to ESG’s increased role in the leveraged finance industry, ELFA has called for a coordinated approach to ESG disclosure and analysis amongst leveraged finance borrowers, and is seeking investors’ views on this issue in a new survey. ELFA’s concern is that, at present, investors that are demonstrating an interest in ESG performance are gathering that information from different sources — and the availability (and quality) of that information can vary greatly from borrower to borrower. Additionally, investors are asking different ESG questions, which means borrowers are exerting more time and resources to find answers to queries they previously may not have considered.

ELFA plans to use its survey to gather details of the type of ESG information that investors are seeking, in order to relay those details to borrowers. This standardisation aims to allow borrowers to efficiently report on the factors that lenders want further details on, and also give lenders the opportunity to effectively compare underlying ESG performance metrics across different companies. To the extent that effective metrics can be compiled for ESG factors, analysis of these factors can be incorporated alongside a more traditional credit analysis, improved ESG analysis should allow investors a broader and better picture of companies as a whole.

Conclusion

ESG factors and the wider performance of companies with regard to sustainability are becoming increasingly crucial to investment decisions. This is true not just for the ever-growing number of ESG or sustainability-linked funds, but also for mainstream sources of finance, as managers and banks realise the financial benefit of investing in companies with strong ESG credentials. The drive by ELFA to introduce a coordinated approach to ESG disclosure and analysis is a natural step in a market that, whilst currently containing large amounts of information, lacks consistency in its presentation and content.

Latham & Watkins will continue to monitor developments in this area.

This post was prepared with the assistance of James Bee in the London office of Latham & Watkins.