1. Introduction
Environmental, social and governance (“ESG”) considerations have taken centre stage in the European debt
capital markets this year. We have
previously written about this shift towards ESG in the context of ESG
bonds and social
loans. Arguably, the securitisation
markets have been somewhat slower to adapt to this trend. This is quickly changing though, and nowhere
is this more apparent than the collateralised loan obligation (“CLO”) market.
The European CLO industry has been exceptionally busy in recent
months and continues to grow, as evidenced by the number of new entrants to the
European CLO market over the last 18 months, with Ireland now being the sole
domicile of choice for European CLO issuers.
The industry has also been operating in a rapidly evolving legal
environment, as market participants have grappled with revised transparency
requirements under the Securitisation Regulation, the end of the Brexit
transition period and the re-establishment by the UK of its own securitisation
regulatory regime.
Now that the dust is beginning to settle from these changes, ESG
considerations are quickly becoming a main topic of discussion in the market
and, in many instances, this is being driven by investor demand. This article will discuss the emerging trend
of ESG-focused CLOs and some of the opportunities and challenges that may face market
participants as they seek to bring their own ESG CLOs to the market.
2. Early adopters
The PRI, an international organisation dedicated to the
stewardship and promotion of the United Nations’ Principles for Responsible
Investment, has recently published a
report on the incorporation of ESG principles in securitised products (the
“PRI Report”). The PRI Report focuses in particular on the
CLO industry and provides an interesting overview of progress in the ESG CLO
market to date. It includes a list of 16
ESG CLOs that have already launched in the European market.
Although the first CLO to include ESG principles in its
documentation (Providus CLO I) launched in early 2018, the pace of ESG CLO
issuance increased in 2019 and 2020. So,
too, did the level of incorporation of ESG principles into the
documentation. North Westerly VI, a CLO managed
by NIBC Bank and arranged by Mitsubishi UFJ Financial Group, launched at the
end of 2019 as the first CLO which went beyond the exclusion of certain
industries to incorporate the individual scoring and monitoring of borrowers
based on their ESG performance.
The industry response to these early adopters has been
positive. ESG CLOs have consistently
generated headlines in the main industry publications, and North Westerly VI was
recently announced as the Structured Finance and Securitisation Deal of the
Year at the IFLR
Europe Awards 2021. More recently,
North Westerly VI was followed by another NIBC-managed ESG CLO, North Westerly
VII, which follows broadly the same approach to the incorporation of ESG
considerations as North Westerly VI.
3. How do they work?
There is no standardised definition of an ESG CLO. Moody’s recently
noted that 85% of European CLOs issued in 2020 and 2021 incorporated ESG
criteria, to some extent. It is
questionable whether all such CLOs could be considered “ESG CLOs”, or whether something
more is required. Nor is there any
standardised approach to incorporating ESG considerations into CLOs; different
managers have sought to differentiate their deals in different ways.
One of the most common and basic forms of ESG screening is
industry-based screening. Collateral
obligations of obligors that operate in certain specified industries are
ineligible for inclusion in the deal. Coal-based
energy production, the manufacturing or trading of certain controversial
weapons or hazardous chemicals, tobacco, pornography and prostitution are
examples of commonly excluded industries.
However, deals differ in what additional industries may be excluded, in
the “materiality threshold” used to determine if an obligor belongs to an
excluded industry, and as to whether (and to what extent) the manager has
discretion in determining compliance with ESG-prescribed criteria under the
transaction documentation.
Going beyond industry screening, some managers are looking for
additional ways to ensure that their portfolios are ESG-compliant. The concept of ESG scoring of obligors
involves allocating each obligor an individual score based on various ESG-related
factors. Obligors who score poorly may
be excluded, and the manager may also apply portfolio-level tests based on the
aggregated ESG scores of obligors in the portfolio. Managers may further demonstrate a CLO’s ESG
credentials by monitoring obligors in the portfolio for ESG compliance on an
ongoing basis, and by undertaking periodic ESG reporting to investors, in
addition to other reports mandated under the Securitisation Regulation. By way of example, these are some of the key
innovations that were introduced in the North Westerly VI CLO mentioned above. However, there is currently no standardised
approach to the scoring or monitoring of obligors, or to periodic ESG
reporting.
Focusing on the assets in the portfolio is only one of several
approaches to enhancing a CLO’s ESG credentials. According to reports, one recent US CLO, CIFC
Funding 2021-IV, involved donations by several transaction parties – and their
lawyers – to a non-profit organisation dedicated to racial equality.
4. Regulatory considerations
Clearly, the most significant recent regulatory development in
this area is the EU
Sustainable Finance Disclosure Regulation (“SFDR”), which applies to a broad range of financial market
participants and aims to increase transparency and prevent “greenwashing” by
requiring enhanced disclosure in respect of ESG products. While CLO issuers themselves are unlikely to
be subject to the SFDR directly, EU-based CLO managers that are credit
institutions or investment firms are likely to fall within the scope of the
SFDR on the basis that they provide portfolio management services.
Broadly, such managers will be required to disclose certain
information about (a) how they integrate sustainability risks into their
investment decision-making process, and (b) whether (and, if so, how) they take
into account principal adverse impacts of investment decisions on
sustainability factors. These
requirements apply to all in-scope managers (whether or not the relevant CLO was
marketed as an ESG CLO).
Where a financial product promotes ESG characteristics or
objectives (commonly referred to as a “light green” product) or has sustainable
investment as its objective (commonly referred to as a “dark green” product), the
required disclosures must include information on how those characteristics or
objectives are to be met. Such financial
products (which may include ESG CLOs) will also be subject to periodic
reporting with effect from January 2022.
The precise details of the presentation and content of such disclosures
and reports will eventually be set out in regulatory technical standards, which
have not yet been finalised.
In a typical CLO structure, it is likely that the manager’s disclosure
and reporting obligations under the SFDR will be owed directly to the CLO
issuer, rather than the CLO investors. However,
the issuer may in turn be obliged to make such disclosure and reporting
available to investors, either by agreement or pursuant to the Securitisation
Regulation transparency requirements and / or the Market Abuse Regulation. The precise form of such disclosure and
reporting is likely to be a topic for discussion amongst managers, investors
and arrangers, at least until the relevant regulatory technical standards are
finalised.
It is significant that the UK has not implemented the SFDR into
its domestic law. Although specific
advice will need to be taken in each case, it is possible that many UK-based
managers of European CLOs will be outside the jurisdictional scope of the SFDR. Given that the aim of the SFDR is to enhance
and standardise ESG-related disclosure, it remains to be seen whether the
divergent regulatory regimes in the EU and the UK will lead to segmentation in
the sector and, if so, whether the increased requirements of the SFDR will
ultimately help or hinder EU-based managers attempting to bring ESG CLOs to the
market. In this regard, we have seen
some early evidence of non-EU managers committing to use commercially reasonable
efforts to comply with reporting provisions equivalent to those set out in SFDR
in their deals.
At present, the SFDR is the main regulation of relevance to ESG
CLOs in the EU (alongside the EU Taxonomy Regulation, which is intended to
provide a common language for firms and investors to identify which economic
activities are “environmentally sustainable”).
However, the regulatory response to the rise of ESG investing is arguably
in its early stages, and market participants will be watching closely for
further initiatives that may impact on the CLO sector. For example, the European Commission is
expected to complete its reviews of the Securitisation Regulation and the
Capital Requirements Regulation in early 2022 – it will be interesting to see
whether any ESG-related amendments to those regulations are proposed.
5. The road forward
All signs point to strong growth in the ESG CLO sector (and
other ESG financial products) in the near future. Moody’s recently predicted that ESG CLOs will
continue to evolve over the next two to five years, driven by regulatory
initiatives and strong investor demand.
However, there are numerous challenges that market participants will
need to overcome if ESG CLOs are to become truly mainstream.
The PRI Report identified several factors which market
participants consider to impede the growth of ESG CLOs. According to that report, a lack of adequate
data to enable ESG due diligence is one of the key factors preventing investors
from systematically incorporating ESG considerations into their analysis of
securities products. In the CLO context,
investors rely heavily on managers to undertake due diligence of underlying
obligors. It may therefore become
increasingly important that ESG CLOs contain comprehensive disclosure – in offering
documents, transaction documents and ongoing reporting – of the processes and
criteria used by managers to ensure that the portfolio is ESG-compliant
throughout the life of the deal, with the possibility of independent
third-parties verifying the data to ensure compliance and provide comfort to
investors. The PRI Report also pointed
to a lack of standardisation in deal documentation as impeding the proper
analysis of ESG CLOs.
More broadly, some have noted that, in practice, ESG criteria have
a very limited impact on portfolio composition.
Moody’s have suggested that this is due to the limited scope of the ESG
criteria in many deals, as well as the fact that the industries most commonly excluded
as part of ESG screening processes are not ones that CLOs typically invest
heavily in anyway. If this situation
continues, it may cause some to question the relevance of ESG criteria to
CLOs. However, as managers begin to
employ more sophisticated, prescribed and transparent techniques for assessing
the ESG performance of obligors, we may begin to see increased differentiation
between ESG and non-ESG portfolios.
Perhaps due to the factors outlined above, no clear price
differential has yet emerged between ESG and non-ESG CLOs, with ESG CLOs pricing
largely in line with their contemporaneous non-ESG counterparts. If and when approaches to ESG CLOs become
more standardised in the market, and increasing standards result in the
exclusion of more obligors from portfolios, the true value of the ESG label to
investors should become apparent, particularly if certain investors have a
fixed mandate to invest in ESG-compliant financial products.
6. Conclusion
The development of the European ESG CLO market is well under
way. Industry-based ESG screening is
fast becoming the norm for new deals, and the bar for ESG incorporation is continuously
being raised, helped by market innovations and regulatory initiatives. A number of technical, commercial and legal challenges
must be overcome if the pace of growth is to be maintained, and some of these
challenges may require cooperation at an industry level. However, the forces driving the growth of ESG
CLOs are strong, and it seems reasonable to conclude that this is a trend that
will continue into the near and medium term.
As Ireland is the leading European CLO issuer domicile of
choice, we have extensive experience on advising a broad and diverse range of CLO
issuers and managers on CLO transactions and, in collaboration with our recently
established ESG Advisory
Group, we have acted on a number of recent CLO transactions that
incorporate ESG elements.