De-mystifying Sustainability-Linked Loans and the advantages of entering into one

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AMY WEST: Welcome to Viewpoint, a TD Securities podcast. Today, we're discussing sustainability linked loans. My name is Amy West. And I'm the Global Head of TD Securities Sustainable Finance and Corporate Transitions Group. In the past 12 months, no product has caught the attention of the sustainable financial markets more than sustainability linked loans. Since the emergence of sustainability linked loans in 2018, the market has grown exponentially. While green bonds continue to be an extremely important and prolific part of the sustainable capital markets, increasingly, sustainably linked loans are taking a greater share of the overall market. With over $200 billion priced year to date, sustainability linked loans are on path to be the biggest portion of the overall sustainable capital markets in 2021. A market that's expected to surpass $1 trillion for the first time. As ESG has become a focus in every C-suite and boardroom, sustainability linked loans are a topic relevant to all clients globally across all sectors. With the market growing at a fever pace, focus is now shifting to how to maintain credibility with the sustainability linked loan product. And this has been reflected in the recent guidance by the LSTA and the LMA, which we're going to dig a little deeper into today with our guests. On that note, I'm pleased to be joined by Glenn Gibson, the Vice Chair and Regional head for TD Securities USA and Securities Global head of credit origination. We're also joined by Tess Virmani. The Associate General Counsel and Executive Vice President of Public Policy at the Loan Syndications and Trading Association. Glenn and Tess, thank you both for your time today.

TESS VIRMANI: Thrilled to be here, and discussing this exciting product.

GLENN GIBSON: Yeah, good morning, Amy. I've got my coffee, and I'm ready to roll.

AMY WEST: Perfect. Well, perhaps, we'll kick things off from here a bit by talking about the overall market for our listeners today. And I'd love to ask you both, when did sustainability linked loans first start to come up on your respective radar screens? And really, I think, in the last three years the trajectory of growth has been fairly impressive. How did this market evolve to where we are today?

GLENN GIBSON: I'll kick it off, Amy. We, in the bank market side, I think we saw some nascent activity late in 2017. And 2018 is really when we started to see the build out of the sustainable link loan market. And in 2019, it really took off kind of here in North America where we had over $150 billion US priced in the marketplace. Clearly the pandemic and the market came to a little bit of a slowdown in 2020 with the pandemic and volumes in the latter part of 2020 slowing down. But listen, in 2021, we're off to a roaring start I think as you indicated. And already have eclipsed $200 billion year to date. So volumes are really ticking up. Banks are formulating pools of capital to support the sustainable link market. And I think we're all going to see this trend continue into the back part of 2021 and into 2022.

TESS VIRMANI: Yeah. I mean, the explosive growth of these products has I think been pretty much unmatched by any kind of recent loan market development that I can think of. And where we've seen perhaps greater growth in Europe, you can see globally, including in Asia-Pacific that the trajectory has been clearly trending upward. And this year, the US has really just seen such growth in this product. It's quite interesting actually how we at the LSTA came to be involved in this because usually we are in the business of reflecting current practices creating standards based on the consensus the market had developed. Here, we were actually more at the forefront in terms of US activity. We joined with the LMA in Europe and the APLMA in the Asia-Pacific region where Europe was the only region that had really seen the activity to date. But I think we all recognized immediately that having a global standard would be very helpful. And that this is a product. And really all of the sustainable finance products are ones that are really in particular need of having recognizable parameters and core components that can preserve the integrity of these products. So when we entered the space, it really was before we saw any other activity. I think the first US sustainability linked loan was CMS Energy in June of 2018. And we had launched our inaugural principles in March of that year. So a little bit of an unorthodox approach, but I think it's worked well. And it's just so exciting to see the different types of loans. The different types of KPIs that are being used. And the way that this particular product is able to support borrowers of all stripes so long as they have a business plan that has already contemplated these KPIs, and the targets, and sort of where they're hoping to take their sustainability profile.

AMY WEST: There's no doubt. We know sustainability linked loans are a hot topic. Glenn, maybe you could add to what Tess said from the client side. Why are clients doing sustainability linked loans? I'd be curious if you could shed any light on the motivation for a corporate treasurer to look at this market. How does this product and the need to really tie back into corporate strategy-- how does this fit into a company's overall financing plan?

GLENN GIBSON: It's a great point, Amy. Sustainable products in general are really strategic. I mean, this is board, CEO, finance group. All the way through an organization. Stakeholders are focused on this. Shareholders are focused on it. Bondholders are focused on it. And frankly, the banks are focused on it. And so from a treasury perspective, these products traded at a premium if you will. And were a little bit more expensive. But I think you've seen these pools of capital formulate including in the bank market where now it's almost like it's been flipped on its head where whether or not it's sustainable linked bonds or green bonds. But certainly in the lending markets, on sustainable loans, there is an incentive built in that corporate treasurers can actually view this product now as there's an incentive or a slight discount to the issuer for them to be able to use a sustainable linked loan product. And really from a bank market perspective, banks are formulating these pools of capital to help incent our clients to achieve their KPIs. Meaningful KPIs that we work with together on. And as Tess indicated, building some standards into the marketplace I think is certainly helpful. But every corporate that we deal with is different. They all have a varying level of KPIs. And our job is to try and make sure we can weave that into their pricing structure. Give them a bit of incentive, i.e. discount. And the bank market has really taken this by storm. And all banks have strong ESG programs, including ourselves at TD, to really work with our borrowers and ensure that we're all moving the market to a lower carbon footprint. So from a treasurer perspective, it's efficient funding. And when you look at sustainable linked products, they can certainly be viewed strategically. Including in their M&E and their business development dialogues. And so really, it's a efficient funding for the overall group. It allows the Treasury Department to show their value. It is really C-suite and board level involvement in these because stakeholders kind of on a global basis are looking at this now it is the right thing to do. We all need to be focused on moving the overall environment to a lower carbon footprint. So it's a terrific product. And a lot of support for it.

AMY WEST: Tess, you mentioned earlier LSTA actually stepped into a role they were not historically playing, which is to actually be in front of the market and leading the market. So I'd love to just get your perspective on how do we ensure that borrowers are accessing this market in a material and ambitious way.

TESS VIRMANI: It's a great question, Amy. And something that the trade associations have been very focused on. And really is one of the key goals of the frameworks themselves. We really do watch as the market evolves. Market participants come together and create new features as the product itself becomes more popular. Just ensuring that we have the appropriate guardrails embedded in the frameworks. And I think a good example of that is in the May 2021, the most recent publication of The Sustainability Linked Loan Principles. We took an important next step in terms of the requirements for a sustainability linked loan. We had always strongly recommended that external verification be included where perhaps the KPIs and SPT information is not publicly disclosed or there's no limited assurance. But here, what we have done is we've actually said for going forward, once you have originated your sustainability linked loan, it's important that on an annual basis or whatever frequency you've agreed amongst the transaction parties, that at that review time it's not the borrowers simply saying, yes, this has been our performance. And, yes, we've met the target. It needs to be an independent party that is also weighing in. So this means that for going forward, that the borrower cannot check its own homework so to speak. That there needs to be some kind of external independent verification of that performance. And I think that can take different forms. But it's important that we see that to preserve the integrity of the product. And that was something that was very hotly negotiated in the working groups. Particularly when we look at the different jurisdictions represented because this is a global standard. So here, the jurisdictions came together because again, this is a global standard. And they worked together to kind of negotiate. Looking at the different stages of evolution of the markets in the different regions. But they came together and said, this is the right next step for the product to preserve the integrity of the product. And so we're willing to include this new requirement in the framework. We will see how the market reacts. But it's definitely now part of the sustainability linked loan framework.

GLENN GIBSON: It's so important. And I think this issue, there's alignment here. Because the stakeholders of our borrowers want to know that the borrowers are achieving their KPIs. And frankly, the corporates that we work with, the they also want to make sure that stakeholders and the markets know that they're doing their job in achieving the KPIs that they set forth. The sustainable reports that you hear about in almost all our borrowers across all industries today are really an important part of the corporate culture of our clients that are out there. So there should be alignment with respect to wanting to ensure that these are valid, and that they are achieving their goals as stated to earn that incentive if you will.

AMY WEST: It's a great point. And Tess, I'll actually jump in there with another question because it comes up a lot in our dialogue with clients, which is I'd love to have you elaborate on what the LSTA meant in the LMA by external verification. Are we looking at limited assurance the way that you see in our audited financial reports? Is that the direction we're heading? Are we looking for third party consultancies? We'd love if you could share some insights there.

TESS VIRMANI: It's a great question, Amy. And it's actually one that the trade associations have slotted as one of our next projects is actually to develop guides around external verifications. To give further guidance. I think the crux of the issue is that there needs to be a party aside from an independent from the borrower that is sort of weighing in. That can give reliability to the lender group what the performance has been and that the SPTs have been met. So I don't think that it necessarily has to be an external consultant that comes in. I think it's very much dependent on what the KPIs are, and how straightforward it is to understand their performance. You could look at something like board composition for a public filer. The composition of its board is released in its annual filings. And so it is quite straightforward to understand whether there is perhaps a diversity target that's been met or not. So there, I think one consideration could be perhaps the agent could take the role of looking at that report and saying, yes, we see this as having been met. The idea is really just to make sure there is another party weighing in to provide reliability. Now in other circumstances, other KPIs that perhaps lenders have less experience with validating themselves or are just more bespoke for that borrower, I think there are roles for more external verifications. More of external consultants. But I think it really does depend a little bit on the situation. So long as we keep at the forefront the idea that it should not be the borrowers say that's sort of the be all end all. And one other thing I would point out that just following on from something Glenn shared is these loans are a really great way of communicating a company's commitment to sustainability. And that's signaling is often very important for their broader stakeholders. And how they're seen within their own broader society and within their industry. And so while at first blush it may seem like, oh, this is an extra cost for the borrower to have to do, I think at the end of the day, if it helps to ensure that that particular sustainability linked loan is meeting all of the expectations of the industry, of the product. And to ensure that the loan is sort of onsides, I think that it's really short term cost for much more long term gain. Because no borrower wants to find themselves in a situation where there is any kind of questions being asked about the integrity of their loan. So I think it's important to keep that in mind too when we look at the incremental cost that external verification can require.

AMY WEST: So maybe actually taking that, Glenn I'd love to talk a little bit about the role that banks are playing here. Because often banks are either agenting or arranging these loans, and have a pivotal role to play on this topic of credibility. So I'd be curious to get your perspective on what role do you see banks playing as this market develops.

GLENN GIBSON: Listen, Amy, we've tried to be at the forefront of this. And you're a big part of that with TD. I mean we established a Sustainable Finance and Corporate Transitions Group that works with our loan syndications group that works with our origination groups to really work with the borrower to not only structure the facility, but really work with the borrower on kind of what are those KPIs that will be acceptable, if you will, in the bank market. That will be meaningful. That will be ambitious enough. And Tess mentioned some of the standardization just to make sure that we have a product that still meets the bar, if you will. In particular, in our large market, in the syndicated loan market. The other role I think that we play as the structuring agent, sustainable structuring agent, is really to understand the market and how this product will fit within their current banking group. I said a little bit earlier that there is certainly pools of capital, including lending capital, that is formulating. Our role as the sustainable structuring agent after working with the borrowers is really to ensure that we know what the market demand will be. The market demand couldn't be stronger. All three of us mentioned the strong market and whether or not it's ancillary to the borrower's corporate revolver in a more of a sidecar financing or incorporated into the borrowers corporate revolver. That sustainability agent role is really meant to provide guidance to our clients around those KPIs. Making sure that we get the right pricing mechanism on it. And then making sure that we can clear market with it. And that's really our involvement to this. And then, lastly, I'll say these KPIs are being used not just in the lending markets. Amy, in your past, you come up through the green bond market side. And the reality is trying to align these KPIs across all these sustainable linked products that are available now is going to be very important. Corporate treasurers and finance groups are always trying to bring alignment to the products they have so they don't have multiple targets that they have to track. So there is an alignment opportunity for us to help to make sure that they have their KPIs aligned across all of the sustainable linked products that are out there, which are significant. Sustainable linked derivatives. Now sustainable bonds. Sustainable linked loans. The market just is going to continue to evolve. And you do want some alignment so you don't have multiple tracking points.

AMY WEST: I couldn't agree more. I think that a KPI linked within these products is only going to continue. And I'd be curious from that perspective you're mentioning so many products. And a number of tools in a client's belt. From a client's perspective, it's easy to see the advantages of these products. Helping you achieve a pricing advantage, and really crystallize some pricing benefit for your corporate objectives. However, I have to confess from the lender side we get the question a lot. It feels like a pretty costly business model. So I'd love to get your opinion, Glenn, as the Global Head of Credit Origination, why are banks doing this?

GLENN GIBSON: Well, listen, I mean, the first answer is it's the right thing to do, Amy. Working with our clients to try and help them incent them to lower their own carbon footprint. Listen, it's an investment on the bank's behalf. I mean, at TD, we've got $100 billion commitment by 2030 to sustainable finance initiatives. Now we've made substantial progress in the first couple of years on that. We're going to definitely overachieve on that front. But it's important to our board, to our senior management, that we are incenting our borrowers. So there is a bit of a cost to it. It's acting as an incentive. From our perspective, listen, we've made a commitment to net zero by 2050. This is an important opportunity for us to step up and support our clients. And help them with their stakeholders to show that incentive. Listen, it's the right thing to do. Climate risk is a pretty significant aspect of what not only we look at as an organization, but also regulatory is looking at. This is a global initiative. It's not a regional initiative. And so anything we can do to help build kind of that momentum towards a lower carbon footprint is certainly-- the cost of it is marginal when you look at what we're trying to achieve as an overall business community to try and lower our greenhouse gas emissions across the board. And so we certainly see it as an investment in our clients, and an investment in what is hopefully bringing the world to a better place.

AMY WEST: That's great to hear. Well, we've talked a lot about the market. The sustainability linkage into products. I'd love to ask a question on where we're going from here. And Tess, in particular, I'd be curious since we have you today with us as a guest, where is the LSTA focus next? What are you watching closely in this space?

TESS VIRMANI: It's very exciting. And I know the market is going to surprise me too. But I guess there are a couple of areas that we're kind of focused on. The first is we've been really interested to see the rise of sustainability linked loans in the leveraged market in Europe. We're very keenly watching to see how these types of loans or how these types of sustainability links can find their way and perhaps find a home in the leveraged market in the US, which is, of course, a very robust significant market for us. And speaking with our members who are active, managers in the leveraged loan market, there certainly is a very keen focus on ESG all around. And so it does seem like these two trends are going to converge together at some point. And we'll be interested to see what form that takes and how that looks. And hopefully it's not in the too distant future for the US. We've already started to see a little bit of activity in some cross-border transactions. So that's definitely a space we have our eye on. The other thing, I think, is a little bit more of taking a macro look. But at the risk of sounding like the heavy on this, one thing is to really look at new evolutions in the market. And the way products are being offered. And to just to kind of confirm that they do sit within the four corners of the sustainability linked loan principles. One that comes to mind of a recent development is sort of an amendment structure. So for a regular corporate loan that does not have any sustainability link currently, there's started to be some movement where the ability to amend that loan at something of the lower lender threshold than 100% lender consent, that there is the ability to amend that loan in the future to embed a sustainability linked component. And there's nothing inherently wrong with that structure. And it's terrific that borrowers who are maybe not ready yet but are interested in joining this space, and doing the work that would need to be done, but just haven't been able to get it together at the time of originating their loan, that they've sort of created an ability for them to continue to pursue that objective. And certainly, we want to encourage as many borrowers that qualified that are able to meet the components of the framework to join this space, and to continue to encourage the improvement of companies across the board in terms of their sustainability profiles. However, it's also really important there that we balance that innovation with preserving the integrity of the product. And so there, one of the key considerations is that if the KPIs and SPTs are not going to be set at the origination of the loan facility, it's really important that once the amendment comes up, that the lender group has sufficient time to review and diligence the KPIs and SPTs as they would have if it was a newly originated sustainability linked loan. And so that's an area where I think the market is still sort of sorting through how this feature is going to work. But that's a perfect example of what we at the trade associations kind of look at and see, OK, we see a new evolution. Do we think the proper considerations are being put in place? Does the framework support these products or these new features properly?

AMY WEST: I love that that's one of the focuses. It's something that we're not seeing a lot of in the market. But the discussion dialogue around it is increasing. And agreed, I think it puts the lender community in a challenging position to make sure that we still have that materiality and ambition. So glad to see that LSTA is looking at it. And look forward to working with you guys more on that. And then maybe before we go, Glenn, I'd also love as a senior leader at a bank to just get your perspective. Where does the market go from here?

GLENN GIBSON: We've got so much momentum in these areas. All the sustainable linked products. And I think Tess touched on the leverage finance market. We're certainly working towards helping our clients and the leverage finance markets with opportunities as it relates to sustainable linked products. So I think that'll be an interesting area of development later this year into 2022. The other area that we spent a lot of time is on carbon credit trading. And carbon credit model is going to be one that I think will continue to be in focus, and our clients will use kind of across the board. And then the other area we talk about a little bit is rating agencies. I think there's going to be a focus on ESG elements within ratings that will be continuing to take focus as we move forward. Regulatory is going to continue to be a discussion point just on climate risk. But from our perspective, the reason we put together our Sustainable Finance and Corporate Transitions Group is really to try and bring this all together under the strategic dialogue. Because whether or not it's an M&A discussion, every time something comes up ESG related aspects have to be truly considered. And the sustainable linked products and how we can bring them all together is really the focus of some of our groups today. And I think the borrowers that ultimately get it right will not only have efficient capital to execute on their strategic programs. But again, a lot of the stakeholder involvement and the eyes on from stakeholders today I think are the borrowers and the issuers that get that right I think are going to be advantaged. So we're really excited about what it looks like. And listen, I'm quite proud of our organization and our focus on this. And as I said earlier, certainly the right thing to do in trying to move towards just this lower carbon environment moving forward. So exciting times I think in the next couple of years related to all of the sustainable products.

AMY WEST: Not sure I could have had better closing remarks. So I think we'll leave it on that note. But Glenn and Tess, thank you so much for your time today for sharing your insights. And look forward to monitoring the developments in this market with you both.

TESS VIRMANI: Thank you, Amy.

GLENN GIBSON: Thanks for hosting, Amy.

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