The ESG performance will be measured quarterly, with the average performance of the portfolio companies judged by reference to three KPIs.

By Paul Davies, Dominic Newcomb, Farah O’Brien and Michael Green

On 11 June 2020, private equity firm EQT announced that it has entered into an environmental, social, and governance–linked fund-level subscription credit facility (SCF) with an upper limit of around €5 billion[1]. The SCF, which is currently at €2.3 billion, is believed to represent the largest ESG-linked facility seen to date on the global fund financing markets, and is further evidence of the increasing interest in ESG among private equity firms.

SCFs are loan facilities made by banks or credit institutions to private equity funds in order to provide a short-to-medium-term substitute for limited partner capital. Also referred to as bridge facilities, they are becoming an increasingly popular way for funds to raise capital.

The EQT SCF is considered ESG-linked by virtue of the connection between the ESG performance of the portfolio companies that the fund invests in and the interest rate payable on the SCF. The ESG performance will be measured quarterly, and audited annually, with the average performance of the portfolio companies judged by reference to three key performance indicators (KPIs). The results will then impact the interest rate payable by the fund to the SCF lenders, with the rate having the ability to rise or fall from its baseline level.

The three KPIs that the SCF will have reference to are:

• The portfolio company board’s gender equality
• The portfolio company’s efforts in transitioning towards renewable energy
• The portfolio company’s sustainable governance platform.

As has become increasingly common in sustainability/ESG-linked financing, the KPIs are explicitly tied to a number of the UN Sustainable Development Goals (SDGs).

The EQT SCF represents another example of the growing popularity of sustainability/ESG-linked financing. According to the most recent data from Bloomberg, the sustainability/ESG-linked loan market grew from US$5 billion in 2017 to over US$62 billion in the first nine months of 2019 alone. Part of the reason for the popularity of these instruments has been their flexibility, with achievement (and therefore the possibility of lower interest rates) based on business-wide KPIs, allowing the proceeds to be spent for general corporate purposes (and not earmarked for specific ESG-focused projects). However, despite the rapid growth of the sustainability/ESG-linked loan market more broadly (and increasing attention on the bond market equivalent), linking fund-level SCFs to ESG performance is a relatively novel concept, which few firms have, up until now, looked to utilise.

EQT, which has a firm-wide Responsible Investment and Ownership policy, and has been a signatory of the UN Principles for Responsible Investment (UN PRI) since 2010, has developed its ESG infrastructure at both the portfolio company and firm level over a significant period of time. However, it is far from alone among private equity firms in placing increased focus on ESG in recent months and years, with firms reacting to the increased public attention on ESG issues, in addition to new laws and regulations such as the EU’s Green Deal.

Given that the sustainability/ESG-linked finance market is, at this point, still at a nascent stage with respect to fund-level financing such as SCFs, it will be interesting to note whether these type of facilities become more popular with private equity firms as part of their future financing strategies. As a number of firms are making public commitments, signing up to standards such as the UN PRI, and reacting to new ESG-related regulation, it seems possible that many firms will identify these circumstances as an opportunity to achieve better rates of financing. If a firm’s portfolio will need to demonstrate strong ESG performance anyway, it may find leveraging that performance to reduce the cost of borrowing beneficial.

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

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

[1] The details of the EQT SCF have been obtained from publicly available sources.