Putting fund finance on a sustainable footing

Europe's private equity fund finance market is embracing sustainable finance techniques developed for labelled debt. SMBC Group's Natalya Tueva, Eleni Askianaki and Indira Masullo explain

Environmental Finance: What is fund finance, and how much appetite is there for the asset class among institutional investors?

Natalya Tueva: Fund finance takes various forms but is typically either subscription finance or net asset value (NAV) finance. Both are debt financing to support private equity funds with liquidity management, timing of cashflows, investment activity and speed of deal execution. The most common type of fund finance is subscription finance, which is secured over the uncalled capital commitments of the investors (limited partners, or LPs). This provides funds with valuable operational flexibility.

Conversely, NAV finance looks to the underlying assets of the fund, rather than investors, for security and repayment. NAV finance has become increasingly common as an additional form of flexible fund-level finance, partly driven by the reduced level of initial public offering and exit activity in the private equity market.

Eleni Askianaki: Fund finance has become increasingly attractive as it provides flexibility, access to liquidity and reduces operational burdens for fund general partners (GPs). Subscription finance has been the mainstay of the fund finance market for many decades and makes up the bulk of market, with NAV finance seeing significant growth over recent years and becoming a well-established product. Although it's difficult to get precise figures due to the private nature of most of the transactions, broadly accepted estimates put the global market size at around $1 trillion.

On the demand side, subscription finance is dominated by banks, given the typical revolving nature of the facilities, whilst NAV finance can attract a variety of investors, including banks and non-bank lenders such as insurance companies and pension funds.

EF: What is driving the incorporation of ESG considerations into fund finance?

NT: In financial markets generally, there is an increased awareness of risk and opportunity around ESG, increased demand among key stakeholders for improved ESG performance, specific ESG mandates from certain investors, and the rise of both voluntary and mandatory regulatory ESG disclosure requirements. The fund finance market, particularly in EMEA, is not immune to these drivers.

EA: Specifically, within fund finance, the incorporation of ESG features via sustainable finance labelled issuance demonstrates an alignment of interests between fund managers and lenders which, in turn, drives the growing momentum of ESG debt. There is also a growing number of sustainability-themed and impact-focused funds, which present good opportunities to use sustainable finance structures, including both sustainability-linked and sustainable use-of-proceeds fund finance. Fund managers are keen to demonstrate that ESG is high on their agenda and that they are investing responsibly. Simultaneously, lenders seek to demonstrate alignment of their ESG strategies and where they lend, which has driven most financial institutions to set sustainable finance commitments, which typically include fund finance flows.

EF: What are the mechanisms for applying sustainable finance approaches to fund finance?

EA: As with the wider labelled sustainable finance market, there are two main mechanisms: use-of-proceeds instruments, which must be directed to specific, identified eligible opportunities; and sustainability-linked instruments, which incentivise or penalise the borrower based on the specific aspects of its ESG performance, either at the sponsor level, fund level or, more usually, at the portfolio company level. At SMBC Group, as Sustainability Coordinator, we have structured fund finance deals in sustainability-linked as well as green use-of-proceeds formats.

NT: In terms of these mechanisms, the existing suite of market principles and guidance documents developed by the Loan Market Association (LMA), the International Capital Markets Association (ICMA) and the Loan Syndications and Trading Association (LSTA) can be applied to fund finance structures.

For example, in March of this year, several of these organisations published a guide to the application of the Sustainability-Linked Loan (SLL) Principles to fund finance, which SMBC Group contributed to.

SMBC Group recently acted as a joint Sustainability Coordinator for Basalt Infrastructure Partners' inaugural sustainability-linked subscription finance line, dated November 2023, which was structured in line with the LMA SLL Principles. The alignment was confirmed in a positive second party opinion. Basalt is a dedicated infrastructure investment firm with a transatlantic focus on mid-market infrastructure. Its ESG strategy aims at promoting sustainability considerations across four key ESG pillars: climate resilience, protecting the environment, valuing human capital and good governance.

EF: What are the key considerations for structuring sustainable fund financings?

NT: Understanding the overarching objective of the GP or fund helps determine the direction of travel when it comes to the right sustainable finance structure. For example, funds classified as Article 9 under the EU's Sustainable Finance Disclosure Regulation or impact funds will be subject to ESG reporting obligations. These could be leveraged to support either a use-of-proceeds or a sustainability-linked structure, or potentially both.

An Article 9 fund would focus on investments that meet key criteria, such as contribution to a social or environmental objective, adherence to the do no significant harm principle, or observance of good governance principles by investee companies. While some impact funds tend to be less rigorously defined, they make investments in companies which generate a positive impact on society and/or the environment.

It is important to consider regulatory requirements. If the sustainable finance structure enables the investments to go beyond business as usual in terms of ESG performance and regulatory requirements, a sustainability-linked structure might be applicable.

On the other hand, it's also important to consider investment constraints and very carefully evaluate if the structure's sustainability elements have the potential to unnecessarily constrain any of the fund's investment objectives.

EF: What are the challenges in applying the SLL Principles or the Green Loan Principles to fund financings?

Indira Masullo: Starting with SLLs, which represent the bulk of ESG-labelled loans in the market, there are a number of considerations for KPI definitions and target setting. As the borrower in fund finance is typically an investment fund, it may not necessarily have the majority control required to influence change at the portfolio company level. Furthermore, private equity funds typically have limited visibility (at the point the fund is established) on what the fund's future investment portfolio may look like. Considering that KPIs must be material to the underlying economic activity, this can make the process of defining the sustainability KPIs more challenging in fund finance compared with other types of lending.

Some solutions include setting KPIs that focus on portfolio companies' ESG performance, while also considering the ESG profile at the fund level. Another approach is the inclusion of control factors and minimum holding periods for portfolio companies in the definition of the KPI – so portfolio companies might only fall under the scope of the KPI if the GP has majority ownership, as an example, and/or once they have been in the portfolio for a certain period.

Another consideration is to ensure that the targets are set at the right level and are ambitious, which again can be challenging given that borrowers are often recently established funds with no data on ESG past performance. However, it is possible to use analysis of the performance of peer funds, or of the GP's previous funds.

Furthermore, fund finance facilities (i.e. subscription facilities) are typically of short tenor, which raises questions in terms of sustainability target improvements that are ambitious and impactful and can be achieved in a short time frame. Here, lenders and borrowers should focus on what is material and ambitious in the mid- to long-term and ensure that the legal documentation includes the relevant mechanics in the event of an extension.

For green use-of-proceeds fund finance, the GP's limited visibility of the fund's pipeline of investments complicates the process of defining green project categories that are eligible for the green loan proceeds, which are required to be fully defined at signing of the loan agreement. However, an ESG-focused fund typically relies on specific ESG investment criteria, with periodic reporting provided to LPs and lenders, which could form the basis for a green loan structuring.

EF: How should borrowers and investors seek to manage risks around greenwashing?

EA: This is a very prominent topic of conversation, given the increased level of scrutiny by regulators over ESG claims and allegations of greenwashing.

There are a few things that borrowers and lenders can consider to manage greenwashing risks. First, when it comes to sustainable finance labels, the aim should be a robust and ambitious financing structure that is in alignment with the relevant applicable principles and guidance documents.

Also, depending on the type of fund, its targeted investments,and the sustainability strategy, it is sometimes worth considering obtaining a third-party opinion on the financing, to independently validate its ESG elements.

Regarding documentation, there are a few relevant provisions and measures to address. For example, consider including a means of reopening the sustainability elements of the structure if it is no longer deemed appropriate or fit for purpose. Incorporation of a declassification clause – which we see as a growing trend – allows borrowers and lenders to remove the sustainable finance label from the facility if it's no longer deemed appropriate or if important ESG provisions have been breached and cannot be remedied. It is also important to ensure that appropriate periodic reporting is agreed to adequately monitor the ESG performance and to give time to act, if needed.

Inclusion of so called 'sleeping' SLL provisions in the facility documentation has attracted some level of criticism, and thus should be considered carefully. A sleeping SLL is essentially a conventional loan agreement that contains provisions to convert the facility to a SLL after the closing date. Companies taking that approach should not market or refer to the facility as sustainable finance. They should also ensure that any conversion into a sustainable finance structure should take place within a short timeframe. In June this year, SMBC Group contributed to the latest edition of the LMA's quarterly sustainable finance publication – Horizons. The thought-leadership article, coauthored with global law firm Ashurst, discusses the concept of sleeping sustainability-linked loans, their potential suitability under certain conditions, and critical considerations for maintaining the integrity of financial instruments that integrate ESG outcomes.

Ultimately, if a borrower is not ready to put sustainable fund finance in place, then they should not do so just to tick a box. A borrower can demonstrate that it takes sustainable finance seriously, and potentially avoid greenwashing claims, by only proceeding when it is ready.

EF: How do you see the sustainable fund finance market maturing? How might its potential be unlocked?

EA: The sustainable fund finance market has started to develop over the last few years, so there is definitely room for growth.

As the market further matures, we expect to see more sophistication, and we believe that this is a natural evolution of sustainable finance in general. Some of the trends that have been helping to unlock sustainable finance markets' potential include:

• increased number of impact funds (both credit and equity);
• lenders setting more focused ESG KPIs and targets, including for sustainable finance transactions;
• increased level of attention to ESG issues by LPs, GPs and investors;
• investors and lenders seeking to participate in sustainable finance deals as a way to meet their own investment mandates;
• sustainability seen as a tool to protect and create value;
• recent and upcoming regulatory changes and increased level of regulatory scrutiny around greenwashing and ESGmisconduct.

There is an important role for GPs to play in promoting sustainability within their investments.

IM: There is a broader consensus emerging around how borrowers and lenders should approach materiality when structuring sustainable finance products. This can only help the growth of the sustainable finance market, as structuring a sustainable finance product is about what is meaningful and impactful.

At the same time, we see signs of innovation. Green eligibility criteria for loans are being implemented to allow capital to flow to the broader range of green technologies that will be necessary to decarbonise the economy. We're going beyond the typical wind and solar projects to more complex green projects, including those that require an assessment of their lifecycle greenhouse gas emissions. Separately, issuers are considering KPIs that go beyond their direct control, such as corporates' sustainable supply chains and, in the case of financial institutions, the reduction of their Scope 3 financed emissions, which are the most material part of their carbon footprints.

Natalya Tueva is an executive director and head of SMBC Group's Sustainable Finance, Loan Capital Markets EMEA team, and Eleni Askianaki and Indira Masullo are both directors, in the same team, all based in London.

For more information, see: www.smbcgroup.com/emea

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