The Evolution Of

Sustainability-Linked
Loans In Direct
Lending

December 2023
 Introduction
The direct lending market is undergoing a issuance during 2023 due to the geo-political
shift in its approach to Environmental, Social, landscape and challenging macroeconomic
and Governance (ESG) factors and backdrop, ESG remains at the forefront of
sustainability, driven by both increased developments in the European leveraged
regulation and investor demand. In tandem loan market.
with this, lenders are exploring how they can
At Alcentra, we have taken a proactive
use their sphere of influence in the
approach in shaping the Sustainability-linked
investment space to actively contribute to
Loan (SLL) market according to best
positive change. One of the primary ways
practice and have used our expertise to help
that lenders like Alcentra are integrating ESG
borrowers and investors understand how to
into their investment universe is through
effectively structure SLLs.
sustainable finance, and the provision of
sustainability-linked loans. This whitepaper will provide an insight into
our learnings on the key features of SLLs
In 2022, 50% of European leveraged loans
and will use both market data and case
included sustainability-linked features, this
studies to explain how the SLL market has
continues the upward trajectory from 44% in
evolved.
2021. Despite the slowdown in primary

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 Sustainability-Linked Loan (SLL) Background
WHAT ARE SLLs?
SLLs are loan facilities that incentivise allowing for increased consistency and
companies’ sustainability performance by harmonisation across the market (collectively
linking the interest margin to the improvement called the “SLL Principles” or “SLLPs”). Aligning
of tailored ESG Key Performance Indicators to these principles is what separates SLLs
(“KPIs”). The loan’s coupon will either increase from ESG-linked facilities. We encourage
or decrease, by a pre-determined amount, borrowers to structure SLL facilities rather than
based on whether or not the company is able ESG-linked provisions as they are regarded as
to achieve a particular set of Sustainability more robust and credible by market
Performance Targets (“SPTs”) for each KPI. participants.
ESG-LINKED SLL
The adjustment to the margin is known as the
Margin benefit for meeting KPI
margin ratchet. The Loan Market Association Annual Reporting
(“LMA”) has launched a set of guiding Material KPIs chosen
principles which provide a framework on how Externally verified
Data calibration / Benchmarks
to structure an SLL according to ‘best practice’, Two- way ratchet

A GROWTH STORY
SLLs have gained considerable interest from the debt market.
borrowers and investors since their 2017 SLLs are now reaching mid-sized corporates,
market debut. and we are seeing deals being structured for
Cumulative global sustainable lending totaled companies with earnings of £100m or less.
$308bn at the end of September 2023, this The growing significance of sustainability and
represents a 1.5x increase compared Q1, with ESG is shared across all sectors in Europe,
SLL currently accounting for 86% of total where we have witnessed smaller corporates
sustainable lending volumes. creating and defining their sustainability
One of the factors contributing to the growing strategies in order to gain access to the
proportion of SLLs is the fact that these sustainable finance market and investment
facilities are now spreading to other areas of opportunities.

EVOLUTION OF THE SLL MARKET

MARKET INCEPTION MARKET BECOMES ESTABLISHED
Debut of SLLs in sustainable finance Loans enable borrowers
market. Market is largely undefined to credibly signal their ESG
and undeveloped commitments to external stakeholders
resulting in sustained growth in the
market

2019 2023

2017 2021
SHIFT IN PLAYERS
LAUNCH OF SLLPs Sustainable finance expands into
The LMA publish the SLL Principles, the direct lending and mid-market
bringing structure and space, driven by investor demand,
standardisation to the market reputational benefits for corporates
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and regulatory requirements 1
 Transaction Timeline

SLEEPING SLL TIMELINE

We understand that the leverage loan deal In order to overcome this, we can support
process can be constrained by time pressure, clients by structuring ‘Sleeping SLLs’, which are
making it difficult to agree KPIs from the outset. usually activated 6-12 months after completion.

INSERT “SLEEPING SLL” ESTABLISH SPTs “SWITCHING ON”

LANGUAGE INTO DOCS Calibrate targets to span the The SLL mechanism has
The majority of loans will start term of the loan. SPTs should been “switched on”
as ‘sleeping SLLs’. This means be benchmarked to industry through the amendment
the transaction has completed standards, historic or peer to the documentation
and the draft SLL language has performance and should be meaning the transaction
been inserted into the Facility stretching (go beyond the can now be marketed as
Agreement but, usually because regulatory requirements / an SLL and the borrowers
of time constraints, KPIs and “business as usual” trajectory). loan repayments will be
SPTs have not been finalised. subject to the margin
adjustments.

Sleeping Establish Amend

Select KPIs Switch On
SLL SPTs Docs

SELECT KPIs AMEND DOCUMENTATION

Identify the material ESG Once full diligence of the
challenges impacting the proposed KPIs and SPTs has
business and the sector. been completed and the loan
Determine appropriate KPIs adheres to the SLLPs, the Facility
which are deemed ambitious Agreement is amended to
and stretching. document the full details of the
KPI suite. 4
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 Our Learnings On SLLs
SELECTING KPIs AND CALIBRATING TARGETS
We believe the simplest way to ensure the they would ultimately benefit from cost
credibility of an SLL is to pick strong KPIs. savings to their utilities in the longer term.
When structuring SLLs, we encourage our
Once the KPIs have been selected, we will then
borrowers to select KPIs that are relevant, core
support borrowers or sponsors in calibrating
and material to their overall business. Not only
annual targets for each KPI. From our previous
will this enable the borrower to align
experience in structuring SLLs, we believe
themselves to the principles set out by the
targets are most robust when they are
LMA, we believe that performing against KPIs
assigned for each year of the loan, go beyond
with high strategic significance will also result
‘business as usual’, and are aligned to a
in more tangible benefits for the company.
benchmark, such as historic company data, an
For example, if a water-intensive firm, such as external benchmark or peer performance.
a data centre, which consumes a significant
When thinking about KPIs and targets, we
amount of water to cool the servers, were to
encourage all parties to reflect whether they
set a KPI which aimed to increase their
are:
proportion of recovered/recycled water,

Material Stretching Quantifiable Timebound

MARKET INSIGHTS – SELECTING KPIs AND CALIBRATING TARGETS

Market data suggests that borrowers and lenders typically set their margin adjustments based on
achieving between one to three KPIs, with three KPIs being the most common. The graph below
shows the frequency of KPI themes and highlights the prevalence of emissions-based KPIs over
2022. More recent data suggests that social KPIs are becoming increasingly popular in European
leverage loan structures.

300
250
KPI Frequency

200
150
100
50
0

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3
 Our Learnings On SLLs
THE IMPORTANCE OF DATA
We believe that one of the most crucial data to provide a base-line for future GHG or
elements of setting robust KPIs and targets diversity KPIs.
comes from ensuring that they are backed by Through our own ESG questionnaire and
data. Through our experience we have seen engagement with portfolio companies, we
that strong KPIs are most often measurable have seen a significant year-on-year
and quantitative rather than process-driven or improvement in the number of companies
qualitative. As a precursor to this, the best way disclosing quantitative ESG data, particularly
that companies can prepare for structuring carbon emissions. This highlights the value
data-driven KPIs is through understanding that data brings for borrowers and its ability to
their current base-line metrics and building out drive financing opportunities, enhance
their current disclosures. For example, a decision-making, and foster long-term value
company can start the process of calculating creation.
its emissions data or their gender pay-gap

MARKET INSIGHTS – IMPROVEMENTS IN ESG DATA DISCLOSURE

2022
2022 Questionnaire
Gender pay 34% 2023 Questionnaire
2023
gap 52%

Waste 16%
generated 24%

Renewable 15%
energy % 45%

Energy 35%
consumed 71%

17%
Scope 3
51%

21%
Scope 2
63%

19%
Scope 1
64%

0% 10% 20% 30% 40% 50% 60% 70% 80%

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4
 Our Learnings On SLLs
LOAN CHARACTERISTICS offering a discount on the margin if the
borrower meets the relevant targets or
The primary method of incentivising
companies to improve their sustainable
performance within an SLL structure is imposing a premium on the margin when
through a margin discount or penalty which is targets are missed. Two-way ratchets are
applied if they meet / do not meet their KPI considered more robust and better aligned
targets. with the SLL Principles as they offer no ‘free-
The ratchet is an area that has seen option’ for not meeting the targets.
considerable development since the Whilst we understand there is no strict
negotiation of the first SLLs. Early SLLs standardisation when it comes to negotiating
typically featured a one-way pricing the margin structure, we are seeing a fair
adjustment that resulted in a discount upon degree of convergence in the market around
meeting the targets, nowadays, pricing the range and nature of the margin ratchet,
adjustments tend to be two -way; either which we have detailed below.

MARKET INSIGHTS – LOAN CHARACTERISTICS

The majority of ESG margin ratchet step- Two-way ESG margin ratchets continue to be
downs and step-ups among 2022 SLLs were most common in 2023, with 77% of European
set within the range of 7.5 basis points to 10 SLLs having both step-up and step-down
basis points, with 10 basis points being the mechanisms .
most common. The tighter distribution of
We view this as a positive market
margin adjustments and the convergence
development as we expect that the investor
around 10 basis points, compared with 2021,
community will push back on the limited
suggests that the market is moving towards a
application of one-way ratchets in order to
standardised ESG margin ratchet within SLL
maximise the impact and credibility of SLL
structures.
provisions.

DISTRIBUTION OF MARGIN ADJUSTMENT

2021 2022

Step-up and step-down adjustment of 2 bps 3% 0%

Step-up and step-down adjustment of 5 bps 11% 0%

Step-up and step-down adjustment of 7.5 bps 47% 24%

Step-up and step-down adjustment of 10 bps 32% 63%

Step-up and step-down adjustment of 12.5 bps 3% 0%

Step-up and step-down adjustment of 15 bps 4% 1% 7

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 Our Learnings On SLLs

REPORTING AND VERIFICATION

A key component of an SLL is the need for borrowers to have their performance verified
borrowers to report on whether they have by an external party, aligning to best-in -class
been successful in meeting the targets set for market practice.
the year. From our experience, we have seen We see the requirements for third party
that reporting often takes the form of a verification of SPTs and the requirement to
compliance certificate submitted on an annual deliver sustainability reports as a positive
basis. In sponsor-backed deals structured as market development. However, we understand
SLLs, sponsors may suggest that hurdles remain in obtaining external
management reporting is the most verification and in ESG data standardisation,
appropriate way to measure ESG performance and we will therefore work closely with our
against KPIs. In order to enhance the integrity borrowers to support them in aligning with the
of the SLL market, we encourage our SLL principles, as far as possible.

MARKET INSIGHTS – METHODS OF REPORTING IN

REPORTING AND VERIFICATION 2022

Sustainability reports were delivered on

around a third of SLLs, with compliance
certificates delivered on two-thirds. Both
forms of reporting are intended to provide
lenders with a more fulsome set of
information (e.g., how calculations have been 66%
made; adjustments made to the KPIs/SPTs).
Positive market movements have been seen 34%
in the use of external verifiers to provide
statements of assurance as to the borrower’s
performance on SPTs, which featured in 58% Compliance Certificate Sustainability Report
of 2022 SLLs.

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6
 Best Practice Case Study

OVERVIEW
Company X, a professional service company, The company assigned increasing, annual
secured a sustainability-linked loan, maturing targets to each KPI, which spanned the term
in 2025, to finance the next phase of growth of the loan. The targets were benchmarked
and to advance their sustainable strategy. against peer performance and historic data,
Three material, stretching KPIs which were with an agreed two-way margin ratchet of 10
linked to the margin of the loan were agreed. bps. The company provided an annual
The KPIs were based around reducing carbon sustainability compliance certificate which
emissions from air travel, increasing the confirmed their performance and, in line with
diversity of the new partners intake, and best practice, an external auditor provided
increasing staff involvement in volunteering limited assurance on the accuracy of the data.
programmes.

STRUCTURING STRENGTHS

1. Robust KPIs and Targets 2. Two-way ratchet 3. Verified performance

KPIs adressed the most Two-way ratchet ensures Performance was verified
important environmental, the credibility of the SLL, no by a third party with
and social challenges faced ‘free option’ for not meeting appropriate credentials,
by the borrower. targets, bringing the SLL in protecting the integrity of
line with the investment the SLL.
Targets were benchmarked
grade and syndicated
and were aligned to the The verification enabled
market.
length of the loan. data integrity and reliability
10bps margin adjustment and was mutually beneficial
Targets stretched the aligns to current direct to both us as the lender, the
company to go beyond a lending market standard. sponsor and the company.
‘business as usual’
trajectory and exceeded all
regulatory requirements.

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7
Glossary

COMPLIANCE CERTIFICATE SLEEPING SUSTAINABILITY LINKED LOAN

A borrower may have its sustainability linked In the event that timing issues prevent the
loan or associated sustainability linked loan structuring of an SLL but some relevant ESG
framework certified against an external information is made available, market
sustainability assessment standard. An participants may opt for a sleeping SLL
assessment standard defines criteria, and structure. These are loans which “switch” on
alignment with such criteria is tested by the SLL label after signing once full diligence
qualified third parties/certifiers. of the proposed KPIs and SPTs is completed
and provided that the loan adheres to the
GREENWASHING SLLP and related guidance at the time it is
activated.
Greenwashing refers to the practice of
gaining an unfair competitive advantage by
marketing a financial product as SUSTAINABILITY LINKED LOAN (SLL)
environmentally friendly, when in fact it does
not meet basic environmental standards. In Sustainability linked loans are any types of
the context of green loans, greenwashing is a loan instruments and/or contingent facilities
term that has been used to describe which incentivise the borrower’s achievement
situations where a borrower or project is held of ambitious, predetermined sustainability
out to have green credentials but where these performance objectives. The borrower’s
claims are, in fact, misleading, inaccurate or sustainability performance is measured
inflated. using SPTs (as defined below). Sustainability
linked loans are commonly aligned in the
market with the Sustainability Linked Loan
KEY PERFORMANCE INDICATORS (KPIs) Principles (defined below).

A measurable value that demonstrates how

effectively a company is achieving key SUSTAINABILITY LINKED LOAN PRINCIPLES
business objectives. They are critical (key) (SLLP)
indicators of progress toward an intended
result. KPIs provide a focus for strategic and The SLLP are intended for broad use by the
operational improvement, create an market, providing a framework within which
analytical basis for decision making, and help the flexibility of the sustainability linked loan
focus attention on what matters most. Select product can be maintained. The SLLP provide
KPIs are often used in the context of a high-level framework, enabling all market
sustainability linked loans to measure participants to clearly understand the
improvements in the borrower’s characteristics of a sustainability linked loan.
sustainability profile. The SLLP will be reviewed on a regular basis
in light of the development and growth of
sustainability linked loans.
MARGIN RATCHET

The margin ratchet is a mechanism whereby SUSTAINABILITY PERFORMANCE TARGETS

the initial margin is reduced or increased (SPTs)
when the company meets / does not meet
their pre-determined sustainability SPTs include KPIs, external ratings and/or
performance targets. A one-way ratchet will equivalent metrics which measure
simply decrease the margin if the target is improvements in the borrower’s
met, with no penalty if the target if not met. A sustainability profile.
two-way ratchet will both increase and
decreased according to performance.
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 Why work with Alcentra?

Expertise Choice

Our dedicated ESG and Investment Through the development and provision
teams combine deep experience in of sustainability-related products, we
structuring sustainable finance products provide our clients with a wide range of
across many sectors with expertise and choices when it comes to structuring
awareness to help clients make the right their loans, which can be tailored to
decisions for their firms and the align to the sustainable strategies of our
environment. borrowers.

Insight

We understand the challenges facing

our borrowers as markets and
regulators respond to climate change.
Our insights are curated to provide
you with the updates that matter most
to your business.

SOURCES

2022 European Sustainability-Linked Loans Wrap: Sustainability-Linked Loans Continue to Gain Prominence in 2022 but Margin Adjustments Remain
Modest (reorg.com)

ELFA-Best-Practice-Guide-to-Sustainability-Linked-Leveraged-Loans-1.pdf (elfainvestors.com)

Sustainability Linked Loan Principles (SLLP) – LSTA

Overview - SASB
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Disclosures

DISCLOSURES This is not a financial promotion. This paper is proprietary and not to be reproduced or
redistributed in whole or in part without the prior written consent of Alcentra. All views, opinions and
estimates in this paper constitute the best judgment of Alcentra as of the date hereof, but are subject to
change without notice, and do not necessarily represent the views of Alcentra. The information in this
paper may contain projections or other forward-looking statements regarding future events, targets or
expectations regarding the strategies described herein (including those introduced by the terms “may,”
“target,” “expect,” “believe,” “will,” “should” or similar terms). There is no assurance that such events or
targets will be achieved and may be significantly different from that shown here. The information in this
paper including statements concerning financial market trends, is based on current market conditions,
which will fluctuate and may be superseded by subsequent market events or for other reasons.

Certain information contained herein is based on outside sources believed to be reliable, but its
accuracy is not guaranteed.

The information in this paper is only as current as the date indicated and may be superseded by
subsequent market events or for other reasons. Nothing contained herein constitutes investment, legal,
tax or other advice nor is it to be relied on in making an investment or other decision. Investors should
independently investigate any investment strategy or manager, and consult with qualified investment,
legal, and tax professionals before making an investment.

FOR FINANCIAL USE ONLY / NOT FOR DISTRIBUTION TO THE PUBLIC BENEFIT STREET PARTNERS | ALCENTRA 12
 Alcentra Direct Lending Team Members

Joanna Layton Alex Walker Howard Sharp Vai Patel

Managing Director Managing Director Managing Director Head of ESG

BSP / Alcentra BSP / Alcentra BSP / Alcentra

London New York Boston
160 Queen Victoria Street 9 West 57th Street 399 Bolyston Street
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