A new amendment from packaging firm Logoplaste Consultores Técnicos SA has created the first institutional term loan with interest payments directly linked to environmental, social and governance, or ESG, factors.

The Carlyle Group–backed firm has received approval from its full syndicate to tweak the pricing structure on its existing €570 million financing package so that the margin ratchets according to how much CO₂ the firm is able to save.

For those investors involved in the transaction, this "ESG pricing ratchet" may represent the future of sustainable lending. "As a debt investor, it's always scary to take on something nobody's done before with no track record of how it will go," said one senior lender. "This is a situation where finance and sustainability come intrinsically together, and it's a win-win for everybody."

Others agreed that this deal structure is likely to be replicated: "You’ll see more deals like this — this is the first, but it's not the only one," said one investor. “They won't all be identical and won't use the same metric, but will represent an acceptance by the market that this can become part of transactions.”

Portugal-based Logoplaste is a rigid plastics packaging producer, which operates on an on-site operational model that sees most of its facilities located within its customers' own premises or nearby. This not only saves on transportation costs, but also means the firm reduces its CO₂ emissions. In 2019, the firm estimated that its model saved more than 12,000 tonnes of CO₂ compared to the market norms, which is equivalent to the emissions of roughly 6,900 transatlantic flights, or the amount consumed by 557,000 trees every year. The firm aims to increase this CO₂ saving in 2020.

“Logoplaste has a unique model that is very advantageous for CO₂ savings,” said one investor involved in the deal. “Its products are all recyclable, and it's an important message to get out to the market that plastic packaging can be an environmentally friendly product.”

Key performance indicator
It is this CO₂-saving key performance indicator, or KPI, that Logoplaste asked its lenders to incorporate into the current senior facilities agreement on its term loans, including a ratchet mechanism to adjust its debt spreads based on the annual evolution of this ESG criteria.

The existing €370 million single-B rated term loan due October 2023 comprises three tranches sized at €205 million, $95.5 million and £67.3 million. In 2017 all three tranches were repriced, with the margins on the euro, dollar, and sterling pieces tweaked to E+400, L+425, and L+500, respectively. Before this amendment was announced, the euro-denominated tranche was trading at 94/96 in the secondary market, although the tranche was not very liquid due to the size.

“This is a very solid, stable issuer, which has always been very sound financially,” said one investor. “The impact from the COVID-19 crisis has not been very big, and it's always been a good company for us.”

All three parts of the TLB, a €50 million capex facility, and a €150 million revolving credit facility will now carry the ESG-linked pricing ratchet after the issuer received the required consent.

“This is a concept we have tested once before with banks but we were curious to understand how the 'single B' institutional loan investor base would react,” said Sam Lukaitis, a director in the global capital markets team of sponsor The Carlyle Group. “In the end, we were delighted to receive unanimous support across all tranches, including from a diverse group of CLOs, managed accounts, private debt, and global multi-strategy funds holding the term loan B.”

Structural questions
Some investors questioned whether the KPI would trigger a margin ratchet if the company underperformed and volumes dropped off, which would leave the firm with higher leverage and larger risk, but a lower cost of debt due to lower CO₂ emissions. However, the ESG KPI is structured so that it measures how much CO₂ is saved by the firm's operations compared to the traditional off-site packaging market norm, which sees the rigid plastics being transported to and from its customers' production facilities.

“For this company, sustainability is aligned with economic performance, but this isn't the only way to think about sustainability-linked financing,” Lukaitis said. “This is just one metric — albeit a very impactful one from an environmental standpoint — where we've found real confluence of economic and sustainability objectives. A concept like this isn't going to be relevant or applicable to every portfolio company, but I think it is very interesting to get debt investors focusing on the principle.”

Further supply expected
However, elsewhere investors who had participated in the deal suggested they anticipate seeing more term loans with ESG-linked pricing ratchets in the future.

“It's natural that the impetus will be to do more of these deals going forward,” said one investor. “Issuers need to be able to show the right measurable ESG criteria, but in the non-investment-grade world of credits, reliable, consistent data is still a challenge. If we can agree a set of metrics though — and CO₂ emissions won't work for every credit — this could be the future.”

Others agree that incorporating ESG criteria into pricing structures is likely to become more prevalent in the upcoming market.

“There are debates going on around the edges, but I think everybody agrees on the importance of ESG,” said one senior investor. “You'd hope that everyone agrees that this direction is a positive one. As a debt investor, we don't own a company so we can't dictate policy or direction. But we are asking to engage with firms, and I think it's OK to financially incentivize people around this issue. In the end it all comes down to dollars and cents with us — if a firm is better with emissions now, then it's going to save on capex down the line when companies look to reduce CO₂.”

Balancing act
For investors, the balance between the importance of ESG criteria and their own returns has been highlighted by this transaction.

“We need a deal like this to make sense on a blended basis — we have to find that equilibrium between the return we're getting and the sustainability factor,” said one investor in the deal. “If the economic downside had been bigger then that would have been different. And of course the margin goes up if they miss their target, so it does seem a sensible thing to do.”

Elsewhere, investors noted that environmental sustainability and economic returns can go hand in hand.

“The financial impact of ESG is as important as anything else — firms are subject to fines if they're polluting, for example," said one senior investor. “We're pushing with arrangers and sponsors for a greater focus on sharing more information, being more transparent, and sharing more up front so we can get a handle on the risk we're taking on.”

Others agree on the importance of the environmental issues, but suggest other ways to incorporate ESG criteria into a transaction's documentation, including in a deal's covenants, while some market participants are less keen on creating hard and fast limits. “I would hope that all the companies that we're investing in are already pushing to reduce their CO₂ more generally,” said one investor.

ESG outlook
Certainly, ESG has become increasingly important to the leveraged finance markets — as it has to the wider financial world — over recent years, with the topic becoming more frequently discussed across the sector, and a growing number of firms incorporating ESG criteria into their lending guidelines. But not everyone is convinced by the substance of the push to ESG, and there are concerns that many participants are just paying lip service to the cause.

“I’m very cynical about ESG,” said one investor. “To my mind it's virtue signalling by the loan market as everyone wants to shout from the rooftops about ESG because it's the flavor of the month. I've been to many LP meetings where we get a grilling, yet all the trustees are sat there sipping from plastic water bottles and all own petrol or diesel cars.”

Others disagree with this point of view, and see sustainability as key to the market's future. “This is definitely the direction that our market as a whole is moving in,” said a senior investor. “ESG should be at the heart of our business. Ethically and morally, people will take a 25-basis-point hit on the coupon if they know that they're saving CO₂. No investor would say no to investing in us because we're too focused on ESG.”

As the leveraged finance markets move to embrace sustainability issues, Europe has seen a handful of green high-yield bonds over recent years, but the European leveraged loan space has been slower to adapt. Last year, Spanish telco MASMOVIL Group became the first leveraged loan borrower in Europe to incorporate ESG criteria into its financing, with a €100 million revolver and a €150 million capex line both including an ESG rating from a third-party provider with a linked margin ratchet.

Following that deal, a funded term loan backing The Carlyle Group's takeover of a minority stake in Spain-based Jeanologia S.L. marked Europe’s first sponsored transaction with ESG-linked pricing. The euro-denominated holdco TLB had a margin directly linked to a sustainability performance indicator produced by the denim technology company itself, linked to its water-saving processes.

This story was written by Nina Flitman, who covers leveraged finance for LCD.