In Q3 2023, lenders closed USD71 billion (NZD115 billion) in global sustainable loan financings (according
to data published by Refinitiv LPC), with sustainable loan structures making up about 11.5% of the total global issuances for that quarter. While this is down globally on previous quarters, sustainable finance is now a permanent feature of loan markets, and often forms part of conversations borrowers are having with their lenders.
What is sustainable finance?
There are two main categories of sustainable finance available to borrowers. Green loans (sometimes referred to as “use of proceeds loans”) are loans made available exclusively to finance or refinance, in whole or in part, new, and or, existing eligible “green projects”. Sustainability-linked loans are loans where the pricing varies depending on whether the borrower achieves predetermined sustainability performance objectives. In other words, the borrower is incentivised to improve its sustainability performance by receiving more favourable pricing than it would if it doesn’t achieve those performance objectives. Sustainability-linked loans can be used for any purpose. They are not limited to being used for green projects and are therefore generally available to a wider segment of the market. Failing to meet the sustainability objectives will not result in an event of default.
How can sustainable finance be used in M&A?
It is possible to use either a sustainability-linked loan or a green loan to fund an acquisition. A green loan can be used to fund eligible green projects by the target. Alternatively, a sustainability-linked loan can be used where the sponsor has sufficient information about the target to agree performance targets with its lenders.
In practice, given the usual tight timelines surrounding an acquisition, and level of due diligence required to set meaningful and ambitious targets, it is much more common for the acquisition to be funded through a traditional debt structure and converted to sustainable finance down the track.
Advantages of using sustainable finance
Sustainable finance structures can provide additional access to capital as well as pricing benefits. However, over and above these benefits, a commitment to sustainability is becoming important for businesses who want to maintain a positive reputation within the public eye and is also becoming more of a key focus for stakeholders and investors. By using a green loan or a sustainability-linked loan, a borrower can demonstrate a commitment to improving its business’s sustainability performance and be held accountable while also obtaining the favourable economic benefits mentioned above.
Challenges with sustainable finance
Green loans tend to be the domain of certain sectors that are predisposed to having green projects to finance. Examples of these are energy, buildings and transport. A green loan cannot be used where green projects cannot be identified.
As mentioned, sustainability-linked loans can be used for any purpose, including working capital. However, determining an appropriate set of Key Performance Indicators (or KPIs) and Sustainability Performance Targets (or SPTs) takes time, money, and access to information. This can prove challenging in the context of an acquisition. To appropriately calculate benchmarks for KPIs, in-depth due diligence on a target company is needed, a process that is labour intensive, time consuming and in some cases difficult to access. It is important that appropriate benchmarks are set as if they are too conservative the change may not be meaningful, and a company can be at risk of being accused of green-washing.
The costs associated with entering into, and satisfying the ongoing requirements of a sustainability-linked loan, can be disadvantageous in a smaller market such as New Zealand. When entering into a transaction, there are two main contributors to heightened cost. There is the direct cost of extra due diligence and the indirect cost of a prolonged transaction due to both the negotiation of an appropriate sustainability-linked loan framework with the lender and the time needed to complete the extra due diligence. Small savings on margins may be outweighed these costs.
Common New Zealand approach
Given the difficulties highlighted, it has been more common in New Zealand to complete the acquisition and then, where appropriate, consider refinancing to a sustainability-linked loan down the track. This diminishes a lot of the time pressure on the borrower to fully understand the ESG (environmental, social and governance) position of the target, and once an acquisition is completed, the borrower has far easier access to management and information to more accurately assess the risk attached to entering into a sustainability-linked loan.
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