LIBOR, ESG: Creating Sustainability-Linked, Risk-Free Rate Loans
This article draws on public information only, made available by the Loan Market Association (LMA) [1] and is for educational purposes only.
This article reviews the new Tesco ￡2.5bn sustainability-linked and risk-free rate (RFR) linked multi-currency syndicated loan facility. We’ll draw out principles on constructing firstly a sustainability-linked revolving credit facility (RCF) and then secondly the features of a day one RFR-linked RCF (rather than using a rate-switch mechanism).
For more information on syndicated loans or the use of LIBOR reference rates in loans please refer to my previous article ‘Transitioning Legacy LIBOR Loans’ (https://www.dhirubhai.net/pulse/transitioning-legacy-libor-gbp-loans-travolta-mohan/).
Sustainability-Linked Lending
Why a sustainability-linked loan and what are it’s key features?
“For us it’s another way of demonstrating our commitment to targets, as well as embedding them in another area of the business”Natasha Vowles, Tesco Head of Treasury Funding
Tesco’s purpose and values around sustainability as it integrates into the core operations of the business and stakeholder engagement are built around 4 pillars: People, Product, Planet and Places. Each of these pillars has a number of commitments. Each commitment has a key performance indicator (KPI) that converts the qualitative commitment into a quantitive metric. These components form the company’s sustainability framework, known as the Little Helps Plan [2]. The reporting of each KPI is annual and governance of the framework by the Corporate Responsibility Committee, chaired at Board level by Non-executive Director Lindsay Pownall.
The Tesco and its sustainability coordinator, BNP Paribas, assessed which of the KPIs aligned with the LMA Sustainability-Linked Loan Principals (SLLP) [3]. The four core parts of the SLLP are: 1) relationship to borrower’s overall corporate social responsibility (CSR) strategy, 2) target setting to measure the sustainability of the borrower, 3) reporting sustainability target performance and 4) external review agreed by borrower and lenders on a deal-by-deal basis.
Considering the LMA SLLP and the specific KPIs relevant to Tesco as a food retailer, the three KPS were picked for the loan transaction - reducing greenhouse emissions with agreed science-based targets, sourcing renewable energy and reducing food waste in its UK operations. Tesco note that it was important that these KPIs had assurance statements associated with them. These statements are external reviews of a company’s performance against is published sustainability performance targets. The LMA SLLP notes that for public traded companies, the borrower’s public disclosures on KPI performance may be sufficient for lenders but external verification may be desirable.
A point for market practitioners is converting a corporate’s often long-term sustainability targets and linking it to short/medium-term transactions. In Tesco’s case, having been involved in wider ESG-type activity since 2006, the selection of KPIs to adopt for the loan transaction was perhaps more straightforward than other corporates with less developed ESG activity. It then becomes a nuanced discussion for the borrower’s industry sector’s sustainability KPIs by peers. For the Tesco transaction, annual target thresholds from the agreed base year were negotiated in the context of loan maturity (up to 5 years), known projects and announced business disposals.
From lenders’ perspectives, sustainable lending is now becoming mainstream in the loan market, with internal teams engaging with clients on latest developments in both the loan and bond markets. As the ecosystem of bank sustainable finance, ESG-rating and ESG-validation firms matures, sustainability-linked transactions will be benchmarks for more established markets.
Risk-Free Rate (RFR) Lending
Rather than use a rate-switch mechanic (the mechanism to convert a LIBOR-linked loan to RFR) a complete new RFR RCF was used for the Tesco RCF refinancing.
Natasha Vowles, Tesco Head of Treasury Funding, comments that “we knew we would be refinancing in Q3 [2020] and had anticipated that there would be multiple precedents for us to observe. This wasn’t the case and had become increasingly clear as the year went on there wouldn’t be other examples. We decided we wouldn’t let this deter us and had been talking to our bank group as one of the key discussion areas with the panel. The response from the panel was positive.”
NatWest was facility agent on the new RFR loan. Nick Kent, NatWest LIBOR Transition Delivery for Lending Product Franchise, summarised NatWest’s responsibility as facility agent on a new RFR syndicated loan as 1) ensuring it has the operational capability to support the loan given what Tesco as borrower was looking to achieve and 2) confident its agency offering was aligned and expected where the market would be going for the specific transaction, 3) ensuring documentation, agency expectation and system capabilities were aligned and 4) provide guidance and support to syndicate banks.
With regards to the negotiation of a live-transaction whilst trying to observe an evolving RFR market direction, during the transaction the LMA Exposure Drafts of Compounded RFR Facilities recommendations on SONIA conventions was published [4]. Although the Exposure Draft of Compounded SONIA Document was addressing conventions on rate-switch mechanics, Greg Brown from Allen & Overy said the deal team felt the market would expect them to incorporate these conventions.
Negotiating Perspectives Given the LMA Exposure Drafts
Borrower: “We were very happy to align with what would become best practice and we retained an open mind to what this would be as the process went on.”
Legal: “Banks are coming up the curve” on RFR deals. “We produced a review guide for lenders to pre-empt questions when they received documentation”.
Facility Agent: “Once we had the key terms we spoke to each of the lender banks individually before providing the final terms”. “We were able to confirm early on there was strong consensus for the ‘lag’ methodology”. “There were important commercial points to address, such as finding mitigants for break costs.” (Caroline Kennedy, NatWest Structured Finance)
Negotiating Perspectives on multi-period interest period RCF availability using RFRs
Borrower: “We use this as a back up facility. However if we ever wish to draw it we want the flexibility to draw for the time we actually require the money for. It was important for us to retain multiple interest periods and important for us to keep that flexibility, to show it doesn’t have to go for a risk-free rate facility”
Facility agent: “There was a real balance to strike between flexibility sought by Tesco and everyone [in the syndicate bank panel] being able to deal with the complexity from an operational perspective across the multiple tranches. We ensured operationally we could cater for this increased flexibility [for multi-periods].”
Key Points for Multi-Currency RFR Loans
The Tesco RCF refinancing deal initially began with the RFR rate lookback with observation shift method but then during the negotiation moved to lag methodology (lookback without observation shift) [1].
The LMA Exposure Drafts allows either rate compounding or notional compounding. Rate compounding was decided on the Tesco RCF without issue by the panel banks.
More of a challenge, however, according to Greg Brown from A&O was on deciding between the use of daily non-cumulative compounded rate approach (NCCR) or the cumulative compounded rate approach for the interest calculation. This was a new point to work through for his legal team as the option to use either approach came about from the LMA Working Group recommendations. The LMA Exposure Draft on multi-currency rate switch facilities, inline with the SONIA Loan conventions, adopted a preference for the daily non-cumulative compounded rate approach (NCCR). NCCR was preferred due to the flexibility allowed for mid-period interest breaks, such as those that may arise from loan prepayment or secondary loan trading [5].
The Tesco RCF refinancing to remain economically neutral (as per regulatory IBOR transition guidance) on RFR compared to LIBOR pricing required Credit Adjustment Spreads (CAS). CAS is covered in depth in my previous LinkedIn article (link at the beginning). The Tesco transaction being a multi-tenor RCF, needed 4 different interest tenors each for both Sterling and US Dollar financing. These were set into the loan docs using the published CAS for the respective tenors a day prior to sign the refinancing loan agreement. Tesco noted that in a a post-LIBOR world, CAS will disappear, but the current refinancing required incorporating it for pricing and fee structure purposes and is a necessary step towards truly RFR-only future pricing end state.
An additional area of complexity for RFR-linked loans compared to LIBOR-linked loans is the use of interest-rate floors. On a Libor deal, the floor is set on the Libor rate setting which is usually the same tenor as the interest period. On a RFR deal, however, defining the timing is critical - is the RFR-linked floor to be set over an interest period date (e.g. 90 days) or daily-rate flooring? Also what is the relation of the RFR-linked floor to CAS? Historically an adjustment spread is additive to the LIBOR fixing, after which the floor is applied - but how does this change with CAS on RFR that’s floored? Imagine that the RFR rate for the period is -0.10% and CAS +0.08% to give a combined rate of -0.02%. Question is then will the floor be applied on the RFR rate or on the CAS? It’s important to define as the RFR rate is compounded whilst CAS is not and the decision has economic and operational implications. On the Tesco RCF the decision was taken to floor RFR rather than floor CAS and is inline with LMA Working Group recommendations as preference.
Consideration is needed for including different mechanics for non-RFR currency benchmarks in a multi-currency facility. EUR drawdowns still continue to use EURIBOR as the reference rate, given that it has been added to the Benchmark Regulation (BMR) compliant register by ESMA. The Working Group on EUR risk-free rates may have more information on EUR fallback recommendations. This will be published on the ECB website on 18th February 2021 [6].
To conclude, the requirement to construct a similar sustainability-linked RFR-RCF will depend on the borrower’s unique ESG strategy and operational Treasury Management Systems (TMS) capability. Bank lenders are successfully constructing, pricing, documenting and executing such lending operations and will continue to innovate into 2021 as the dependence of LIBOR rates draws to a close.
Travolta Mohan
Disclaimer: all views expressed in this article are my own and do not represent the opinions of any entity whatsoever with which I have been, am now or will be affiliated with. The information is for educational purposes only. No legal, regulatory or commercial advice is given.
References:
[1] https://www.lma.eu.com/lmaplayer?t=137#item-137
[2] Little Helps Plan:
https://www.tescoplc.com/sustainability/overview/
https://www.tescoplc.com/sustainability/download-report/
[4] LMA Exposure draft on SONIA conventions
https://www.lma.eu.com/application/files/2315/7925/6221/LMA_Exposure_Compounded_RFR_Commentary.pdf
https://www.lma.eu.com/libor/lma-ibor-transition
[5] Cumulative conventions
https://www.lma.eu.com/news-publications/press-releases?id=181&search_str=cumulative
[6] Working Group on EUR risk-free rates
https://www.ecb.europa.eu/paym/interest_rate_benchmarks/WG_euro_risk-free_rates/html/index.en.html
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3 年Nicely put together Trav, interesting issuance. ESG and RFR are going to be key considerations for the next decade's issuances for sure. Thanks for the article.
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3 年Very interesting and well done.