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ESG Focus: The Next Big Thing – Part 8

ESG Focus | Nov 17 2021

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: The Next Big Thing – Part 8

Sustainability-linked loans are transforming the leveraged-loan market as corporations and investors eye ESG-driven M&A and dividend recapitalisations, and seek to mitigate ESG risks in standard transactions.

-M&A and joint-ventures on the menu
-Financial-services sector ripe for ESG-driven M&A
-Innovation in leverage-loan market
-ESG due diligence the new must-have

By Sarah Mills

Sustainability-linked loans (SLL) are about to change the leveraged loan market.

The world is flush with cash post-covid given bad debts performed better than feared; and corporations are assessing the potential for leveraged SLLs to fund mergers and acquisitions and capital-management initiatives.

Observers believe SLLs offer huge opportunities for the smartest and most sophisticated companies, given they allow corporations to tailor loans to their industry, business and strategy.

Those that do this well will enjoy windfalls through improved interest margins and strategic leverage. Leveraged SLLs can ratchet those returns up again.

Sustainability is also dovetailing with the digital revolution to form the fourth-industrial revolution.

Given the digital market is already ripe for M&A, regardless of sustainability, and given much of the digital innovation is likely to support sustainability; it is considered another prime market for SLL funding.

The mandatory verification of SLL performance against some ESG targets that were enshrined in the global SLL principles last May will, for the first time, give investors an insight into the previously private, relationship-driven syndicated loan market.

With greater transparency and accountability will come more deals: ESG-driven mergers & acquisitions; institutional loans, and private equity (we cover the latter two in coming articles).

Big end of town cashed up and ready to blow

The big end of town is gearing up for a leveraged SLL splurge. 

Banks, institutions and private-equity are cashed up after the trillion-dollar covid printing spree and intend to invest much of those funds into green, circular, and fourth-industrial revolution initiatives.

PWC expects investors will hone their sights on companies ranging from those with heavy balance sheets to those prioritising scaleable and technology-driven targets.

On the flip side, corporations are girding their loins for one of the biggest transitions in history and will be jockeying for position in the M&A market.

As the transition gains pace, M&A is expected to thrive as players seek to redefine portfolios and companies divest non-core businesses, or businesses which may affect their sustainability credentials.

Some corporations will be seeking to offload less-aligned assets to meet new strategic imperatives, and some to just simplify ESG reporting to gain investor favour. 

Others will be on the acquisition path, seeking assets that align with their ESG and fourth-industrial-revolution strategies, or to extract accretive ESG value where possible. 

There is already movement at the station. PWC reports the number of deals involving private equity rose to 36% in the first half of 2021, compared with the long-term average of 25%.

It is likely that some M&A is also being brought forward to pre-empt the higher standards of a transition environment.

Financial services sector ripe for ESG-driven M&A

PWC expects the financial service industry may be one of the first cabs off the M&A ranks.

“ESG criteria continue to redefine risk management and value creation in the FS (Financial Services) industry,” says PWC on its website. 

“FS deals around sustainability reflect the desire to acquire ESG assets and know-how. 

“Alongside this, clear ESG reporting and credentials will only become more important in M&A transactions as regulations tighten across jurisdictions and investors seek out ESG-compliant opportunities.

PWC says wealth management is leading the financial services sector transformation. 

“We expect ESG to ripple through the deals side of the industry in the coming months as risk weightings may increase on non-ESG compliant products and the insurance sector continues with its own sustainable transformation,” says PWC.

PWC’s Christopher Sure, Global Services Deals Leader for PWC Germany, says private equity’s willingness to participate in the growth phase is pushing multiples and purchase prices higher.

As a result, he expects many financial-services corporations will likely accelerate their transformation disposal activities.

Innovation and leveraged loan growth for M&A

It will be interesting to see how corporations use the leveraged SLL market to drive value.

Linklaters says the European leveraged loan market is starting to embrace ESG issues.

In Europe, companies are already using leveraged ESG finance for direct lender/unitranche deals; fund finance; real estate fund and infrastructure finance; mergers and acquisitions and dividend recapitalisations.

In terms of M&A, observers expect that strong alignment between strategy and sustainability will play a part not only in the success of a company, but in its merger-and-acquisition plans.

Advanced companies on the sustainability front may be able to extract sustainability value from laggard targets, making acquisitions more accretive.  

Such purchases could theoretically earn a company margin step-down from the lender in instances of outperformance on sustainability accretion, yielding further windfalls.

While it is possible that a large company with poor sustainability credentials could extract value by bringing in-house sustainability knowledge from smaller competitors; it is less likely given the complexity, politics and standard practice of M&A integration. 

Smaller companies with strong sustainability credentials are likely to command higher prices; which in turn could act as a moat.

On the flipside, they could attract hostile attention as big laggards remove threats and snap up some positive ESG inputs.

In terms of process, most companies are likely to embark on a transformation process first in order to extract value from M&A; suggesting a role for SLLs in change management, which we discuss in a separate article.

In order to access SLLs for M&A, ideally both the lender (in particular) and the target would need to offer clear reporting to provide greater assurance of meeting loan covenants. 

Here come the deals

To date, most SLLs have been struck with investment-grade companies, primarily through revolving credit facilities (RCFs), notes Bloomberg.

But this year, ESG leveraged loans staged a rise.

More than a quarter of European leveraged term loans now have a SLL pricing mechanism including ESG language, says S&P Global Market Intelligence’s LCD.

Bain Capital and Cinven entered an agreement to buy Lonza Ingredients for a total of 4.2bn Swiss francs.

Lonza Ingredients is a global provider of specialty chemicals for microbial control solutions that eliminate or control harmful and unwanted micro-organisms, that are used in disinfectants, preservatives, sanitisers, personal care products, coatings and industrial uses.

Lonza Ingredients secured a US$1.13bn term SLL to help finance its buy-out.

In terms of SLL contract provisions, White & Case tells “It’s still quite ad-hoc as to whether ESG provisions are included in leveraged loans and so it is dealt with on a deal-by-deal basis.”

This is likely to change as the adjustments process and SLLs are increasingly streamlined.

Vehicle glass repair and replacement company Belron used a SLL as part of a dividend recapitalisation.

Dividend recapitalisation is a form of leveraged recapitalisation that involves the issuing of new debt by a private company that is later used to pay a special dividend to shareholders, reducing the company’s equity financing in relation to debt financing. 

It is newly incurred debt, not company earnings, and common shareholders are less likely to benefit from such arrangements.

Dividend recapitalisations can be used to exit an investment, recover an initial investment without losing a stake in a company, and eliminates the necessity to use profits to distribute dividends, particularly in a low-interest rate environment. 

Belron negotiated a US$1.62bn term B loan and a EUR840m TLB with step-ups and step-down margins. (7.5bps down for meeting recyclable glass and decarbonisation KPIs; and a -10bps penalty for failing.)

Conducting ESG due diligence for M&A and JVs

ESG due diligence is shaping up as a critical element in the M&A and joint-venture process.

Covington reports that a global survey of private-equity general partners shows 54% gained a reduced bid price after conducting ESG due diligence and 32% had an increased price.

Covington cites an instance in which a Chinese buyer shaved -$10m off the asking price for a European manufacturer of tableware after uncovering environmental liability, weak working conditions and board processes, as well as the potential for labour disputes.

Helsinki University says the main benefits of ESG due diligence include risk mitigation; positioning for future ESG-related opportunities; impacts on valuation; and higher long-term returns.

Covington’s Sustainability Toolkit outlines the key ESG due-diligence considerations for those embarking on M&A and joint-venture transactions.

Participants need to identify, quantify and evaluate ESG risks posed by a transaction (according to industry and through the supply chain, including cultural values and the social repercussions of the post-merger integration strategies that may affect synergies); then determine risk mitigation measures or adjust the pricing to reflect the impact of the risk.

They also need to gain an understanding of the target’s ESG risk-management objectives and operations; and it is a good idea to compare the target’s voluntary reports with its SEC filings.

When it comes to joint ventures, Covington says arrangements work best when partners have similar sustainability policies and standards; and those with a majority stake in a project usually shoulder the greatest risk.

Martin Vezer from Sustainalytics’s Thematic Research Team writes in Research Gate that M&As can carry a range of ESG risks, including losses associated with withdrawn or terminated transactions, credit rating downgrades, valuation volatility and various financial and legal consequences; and concludes that ESG compatibility can be a contributing factor to the success of M&A deals.

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