Bud owner Anheuser-Busch InBev NV and a plastic packaging maker in Portugal are among a flood of borrowers using financial carrots and sticks to improve their performance on things such as the environment and boardroom diversity. The sticks, complain some investors, don’t leave much of a mark.
Since last summer, companies have issued nearly $240 billion of debt with special rules that reward them with lower borrowing costs—or penalize them with higher ones—depending on if they meet self-made targets for things such as cutting carbon emissions, or for getting more women on boards, according to Dealogic. That nearly doubles the total issuance of such debt over the previous three years.
Lenders have long put ratchets on loans or step-ups on bonds that cause interest rates to change depending on a company’s financial performance. But the idea of tying interest costs to nonfinancial risks, such as reducing carbon emissions, or improving governance, is relatively novel.
The surge in bonds and loans tied to environmental, social and governance performance, known in industry parlance as ESG, is meeting a huge demand from investors for such investment products.
Fund managers like them because they qualify for ESG-labeled funds that they can sell on to investors. One irony of ratchet loans, is that the investors get paid more if the companies fail to meet their objectives. This is meant to compensate investors because a borrower that misses governance targets is a riskier prospect.
For the borrower, it is also a way to get cheaper loans.
BlackRock, one of the world’s largest asset managers, recently arranged a $4.4 billion loan facility linked to racial diversity, women in leadership and sustainable assets under management in its own business that could raise or lower its financing costs by at least 0.05 percentage points—equivalent to $22 million annually if the facility were fully drawn. The normal interest rate is 0.625%, according to BlackRock’s SEC filing.
Tariq Fancy, who spent nearly two years as chief investment officer for sustainable investing at BlackRock and runs an education-focused nonprofit organization in Canada, says such penalties are too small to matter.
“A BlackRock might get a bit of egg on its face if it doesn’t hit its targets, but that’s not going to make any difference to the individual decisions made down in the business,” he said. “How is the hiring person going to know, or care, that the finance department makes marginally more or less due to their hiring decision?”
A BlackRock spokesman said the financing enhances the company’s “commitment and accountability to achieving certain sustainability goals.”
Budweiser beer owner
is among the top-10 ESG-linked borrowers, with a loan of $10 billion issued in February, according to Dealogic.
The first junk bond with an ESG-linked step-up was this year’s €650 million deal, equivalent to $784.2 million, from coal-heavy Greek electricity group Public Power Corp. It faces 0.5 percentage point in extra interest if it fails to cut carbon dioxide emissions by 40% by 2022 versus 2019 levels—or €3.25 million annually.
Since last summer, around $15 billion of loans that have ESG linked financing costs have gone toward private-equity deals, according to 9fin, a research firm. These are the first such leveraged loans sold to investors through specialist investment vehicles known as collateralized loan obligations.
The penalties and benefits attached can be as little as 0.025 percentage point of annual interest for each target. That compares with typical savings of 0.25 percentage point for reducing debt-to-earnings multiples by the equivalent of one-quarter of annual earnings, according to 9fin.
“It’s the reputational risk that comes from missing your target that is much worse” than the interest penalty, said Fraser Lundie, head of credit at fund manager Federated Hermes.
He wants to buy ESG-linked debt and encourage companies to pursue challenging targets, but not when it offers a worse return than plain debt from the same firm.
“A company might have one bond that is sustainability-linked, but the whole company is explicitly tied to that sustainability target,” Mr. Lundie added.
He also wants to see more standardization in the size of ratchets, how regularly companies are assessed against targets and measurement by independent parties.
Carlyle is one of the private-equity firms that has been most eager to add ESG targets to the financing of its portfolio companies. In February, it also arranged a $4.1 billion credit line that its own buyout funds can use in which interest costs are linked to board diversity among their portfolio companies. It wouldn’t disclose the size of the ratchets.
“The fact that you have an economic consequence to a target you’ve set raises the profile of that target, everyone knows it’s there,” said Sam Lukaitis, a director in Carlyle’s European financing group. “I think the economic impact of these will grow over time.”
Carlyle-backed Portuguese plastics packaging group Logoplaste last summer became the first company to add ESG-linked interest costs to a junk-rated loan sold to investors. It has targets linked to emissions and use of recycled plastic, each worth 0.05 percentage points.
The company already had reasonable green credentials for a plastics business through an accident of history. Its founder Marcel de Botton, had run Portugal’s largest plastics company before a socialist revolution in the mid-1970s ultimately led to him losing control of the business.
When starting again, he aimed to avoid rules on employee ownership by keeping his businesses small: That sparked the idea of smaller scale packaging production on the same site of its clients’ factories, which meant less emissions from transporting goods.
Later, he saw that as an environmental virtue and separately set up a plastics recycling business.
Logoplaste’s chief executive, said having publicly-declared ESG targets attached to financing were mostly about increased scrutiny and accountability. But the financial incentive is also important. “It is putting your money where your mouth is,” he said. “I believe it’s going to become part of the license to operate.”
Still, some investors don’t like being asked to pay for changes they believe companies should be making anyway.
“If you want to reduce your own carbon footprint, you’re not going to ask your mortgage provider to give you a discount for doing it,” said Jonathan Butler, London-based co-head of global high-yield at PGIM, the fund management arm of U.S. insurer Prudential Financial. “This is effectively just a backdoor way of private equity reducing their margins [on borrowing costs].”
Write to Paul J. Davies at [email protected]
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