David López Velázquez

Uría Menéndez, Madrid

david.lopez.velazquez@uria.com

Lucas Delclaux Arana

Uría Menéndez, Madrid

lucas.delclaux@uria.com

Carlos Montoro Esteve

Uría Menéndez, Madrid

carlos.montoro@uria.com

Introduction

Sustainable financing has become more than a mere trend in the Spanish corporate lending market; it has started to become the market standard and will increasingly shape the agenda of market participants. Spanish financial institutions and private lenders are looking more and more to promote long-term investments in sustainable economic activities and to channel investment and financing towards activities with an environmental, social, or corporate governance (ESG) component.

The more sophisticated the financing, the more visible this trend – verging on a standard – is. The Loan Market Association has created an array of guidelines and principles to provide a framework for what should be recognised as an increasingly important area of finance: not as a completely new type of corporate lending, but as a class of leverage financing where specific sustainable principles are applied. Further evolution is still expected and, needless to say, the Spanish market is deeply influenced by the principles and market standards set in the UK corporate lending market.

This article concisely analyses the current trends in the Spanish loan market.

The current situation in Spain: increasingly common, but still a work in progress

Market participants in Spain are starting to promote sustainable financing as part of their general business strategies.[i] Sustainability-linked loans (‘SLLs’) are gaining in popularity and companies are taking due account of ESG values. These values are developing into part of the core criteria when taking investment decisions, which are becoming more and more driven by the fundamentals of sustainable economy: the reorientation of capital flows, choosing sustainable paths that help mitigate environmental and social risks, and transitioning to a long-term resource-efficient economy.

It has become increasingly common for both lenders and borrowers to involve newly created in-house ESG departments in ESG transactions. These experts now play a key role in defining sustainability performance targets and ESG-related transaction issues. In addition, sustainable financing’s increase in popularity – along with the transparency requirements that naturally go along with it – has paved the way for new market participants, such as sustainability consultants or external ESG reviewers and rating agencies (more on this below).

While the rapid growth of sustainability-linked financing demonstrates appetite in the market, there is still room for progress. The market lacks clear eligibility criteria for SLLs − indeed, some market participants have not yet grasped the difference between green loans and SLLs – while certain players still consider these issues to be mere marketing tools, and others misuse the ESG label and rush into SLL structures where the challenging nature of the targets is, at the very least, questionable. In other words, debtors are not always demonstrating meaningful ESG credentials alongside their investment opportunities – so-called ‘green washing’.

That said, there is a clear long-term intention to transition to a greener and more sustainable lending market. Hopefully, the sustainable lending fundamentals will be further developed and settled in order to establish a market standard, just as the Green Bond Principles administered by the Internal Capital Market Association have done for the green bonds.

The challenge of agreeing on the key performance indicators for SLLs

SLLs seek to incentivise sustainable business models through the borrower achieving specific performance targets. These targets should relate to ESG key performance indicators (KPIs). Setting these KPIs and targets requires time and discussion during the negotiation of the financing transaction and should be analysed on a case-by-case basis, taking into account the borrower’s business. KPIs should be challenging and tailored to the expected performance of the business: different thresholds may be agreed for each year of the loan, but none of them should be a ‘given’ for the borrower.

This area involves various different teams, including the external reviewer, who is in charge of verifying the debtor’s compliance with the KPIs and sustainability targets. Post-signing verification is also a necessary element of SLLs.[ii] On the lender side, one or more sustainability coordinators are appointed to assist the borrower in the negotiation phase.

While KPIs in SLLs are sometimes predefined, certain financing transactions in Spain leave them to be determined in the future. In these cases, lenders do not push for the financing to be classed as a SLL (so as to avoid any risk of being deemed ‘green washing’ or ‘sustainability washing’), but rather leave it to the borrower to decide in the future whether the loan should be linked to sustainability performance targets. Although there may be specific provisions in the documentation (such as the maximum price adjustment, or the appointment of the sustainability consultant or reviewer who will determine the KPIs and performance targets), it is the borrower that decides whether to link the existing financing to sustainability targets. This approach has been used in acquisition finance transactions in Spain where the borrower was unwilling to set sustainability performance goals until it had real clarity on the circumstances of the target after closing.

In any event, this is a complex matter and as yet there are no market standards in place. Setting challenging KPIs for the borrower is a difficult task.

The main incentive: better pricing

Price adjustments are the key incentive for debtors to comply with KPI targets. In SLLs, margin redetermination will depend on the borrower’s ESG performance, which is measured by its achievement of predefined and mutually agreed KPIs.

For SLLs, margin reduction can range from 1.5 to five basis points (BPS) if the KPI targets are met. This can also be combined with a step up if the KPI targets (or some of them) are missed: naturally, transaction pricing needs to be discussed on a deal-by-deal basis. For example, borrowers under Spanish SLLs could benefit from a three-bps margin reduction if all KPIs are met, from a 1.5 to two-bps reduction if some (but not all) KPIs are met or receive no margin adjustment (or even be subject to a margin-increase penalty) if no KPIs (as predefined in the loan documentation) are met. Other consequences arising from breaches of the ‘sustainability regime’ under SLLs are still being explored by market participants (more on this below).

Pricing-adjustment mechanisms are based on an essential idea within sustainable financing: KPI targets must be challenging and ambitious for the borrower. Theoretically, if the KPIs do not go beyond ‘business as usual’, representing an extra effort required by the borrower, the loan should not qualify as sustainable financing and the borrower should not be entitled to benefit from incentives for achieving material and ambitious ESG targets.

Consequences of breach: not an event of default, but worse pricing and loss of SLL status

Failure to meet KPIs results in an increase of the margin. However, there is no clear consensus on the other consequences of breaching sustainability provisions.

In general, misreporting or failure to report (ie, the failure of the borrower to deliver the annual report prepared by the consultant or to deliver the information required to prepare it) may impact the margin, but does not amount to an event of default under the loan. In other words, it does not trigger the right to accelerate the loan or to enforce the security. That said, if the debtor has provided incorrect, misleading, or inaccurate information to the external reviewer, the parties may consider this a misrepresentation that does amount to an event of default.

In addition, breach would trigger the loan losing its SSL status. This could be an important issue if any of the lenders’ internal approvals are subject to the loan being SSL compliant and could force that lender to transfer its interest in the loan. However, most banking and private lenders have not reached this point, although the indications are that in the medium term, financing opportunities might be made subject to SLL compliance, in which case loan documentation may have to consider specific KPI breaches as events of default.

Any review, adjustment, or amendment of the KPIs and sustainability targets in Spanish syndicate SLLs is generally subject to approval by a majority of the lenders, although unanimity may be considered depending on the circumstances leading to the modification or change.

Finally, although this is yet to be seen in Spanish financings, it may be beneficial for both parties (borrowers and lenders) to agree adjustment mechanisms for sustainability provisions, as occurs in specific foreign financial markets. This would guarantee for lenders that the KPIs and targets remain challenging for the borrowers. For borrowers, it would allow them to maintain flexibility over KPIs and to adjust them over time according to how the ESG market evolves, given that it is growing, developing and currently lacks market standards.