Every Sheet Counts
Leveraged Finance is a key source of financing for companies, especially aviation and the automotive industries, however in a world embracing ESG standards all of these industries are under fire due to environmental concerns. In fact, New York, California, and the European Union have all proposed ending the sale of gas-powered vehicles by 2035 citing their environmental impact. Although it is unclear how the transition to electric vehicles itself will impact the automobile industry, from a financial standpoint, issuance of high-yield bonds and leveraged loans to the industry in Western and Southern Europe reached $31.28 billion (38.1% of overall issuance) in 2021 which was up from $10.60 billion (22.64% of overall issuance) in 2018. Despite this uncertainty for automobile suppliers and manufacturers, as all-time Electric Vehicle (EV) sales top $1 trillion in 2023, it is clear that the future of the car is electric. It should come as no surprise that automobile manufacturers are embracing ESG metrics, even when it comes to lending. Over the past two years, many automobile manufacturers and suppliers opted for ESG-linked financing where costs are reduced if ESG criteria for the borrower are met. In 2021 Valeo raised a €700 million ESG-linked bond, with a maturity linked to reducing CO2 emissions, becoming the European automotive supplier to pursue this type of financing. In late 2021 Volkswagen followed suit with a €1.8 billion loan with an interest rate tied to their success in meeting CO2 emission targets.
The airline industry is facing criticism similar to the auto industry over its environmental impact, with Israel even banning four-engine planes from entering the country altogether due to concerns about air pollution. The European Environment Agency’s 2022 report on aviation stated that “sustainability [is] critical for long-term viability of the [aviation] sector”. Fortunately, both airlines and the aircraft industry itself are making strides toward a more sustainable future. Boom is leading the charge by bringing supersonic aircraft back into our skies and charting the course for net-zero carbon flight through Sustainable Aviation Fuels (SAF). Major airlines such as American, United, and Virgin Atlantic have already ordered several Boom Supersonic jets with delivery slated for 2025 and commercial passenger flights as early as 2029. In 2021 Etihad raised $1.2 billion in ESG-linked debt, having previously raised a $100 million loan tied to the United Nations Sustainable Development Goals (SDGs) in 2019, with KPIs tied to Environmental, Social, and Governance (ESG) that will affect the terms of the loan.
Leveraged Finance is no exception to the newfound embrace of ESG, which some say began in 2019 with MásMóvil Group becoming the first leveraged borrower in Europe to include an ESG component. In the case of MásMóvil Group a ratchet, now known as an ESG margin ratchet, on the loan’s interest rate causes the rate to rise as the firm’s ESG rating deteriorates with the opposite occurring if the ESG rating improves. Since a deteriorating ESG score is correlated with a higher cost of borrowing (where the opposite is also true), firms such as MásMóvil Group now have the incentive to improve their ESG scores as opposed to simply maintaining them. According to Covenants Monthly from 2021 to H1 of 2022 16% of European High Yield Bond issuances were sustainability-linked bonds while 43% of European Leveraged Loans from 2021 to Q1 2022 had sustainability-linked ratchets. The question is no longer if ESG lending practices will take off, instead industry experts are asking questions about what metrics should be used for ESG margin ratchets, how they should be verified, and how often. Leveraged Finance clearly shares the same enthusiasm the automotive and aviation industries have for sustainable lending, sadly the industry differs when it comes to reducing the carbon footprint of its underlying technology.
The main environmental concern about Leveraged Finance is the amount of paper used during the loan settlement process. While most financial markets have modernized to adopt electronic settlement, the leveraged loan market lags behind in the “Seinfeld software” era of fax machines and mountains of paperwork. However, as ESG scores become more relevant, impacting everything from floating rates to being included in certain stock indexes, financial services firms are working to improve their ESG ratings even by means of reducing paper use. In terms of paper consumption JPMorgan Chase has pledged to reduce office paper use by 90% (compared to a baseline of 2017) by 2025, TD Bank Group successfully pledged to reduce their total volume of paper used by 40% by 2020 (compared to a 2010 baseline), and Morgan Stanley has a target of reducing printed paper use 30% by 2023 (compared to a 2018 baseline).
When money is on the line every sheet counts.
The roots of ESG can be traced back to religious and anti-war movements of the 1970s where conscious investors wanted to ensure their values and investments aligned. However, by 2020 European flows into ESG funds amounted to €233 Billion while in the United States sustainable funds had net flows of $51.1 Billion, more than twice the previous record set in 2019. In 2020 nearly one-fourth of all fund flows in the United States went to sustainable funds. Clearly, this framework is becoming increasingly important to investors, and as a result, companies are beginning to focus more on ESG metrics. ESG is still in relative infancy with fund exclusions reserved for the “worst offenders” such as tobacco companies, gambling firms, and weapons manufacturers. However, as ESG investing matures these exclusions will become more restrictive and demanding with respect to more positive measures such as net-zero compliance and maintaining a small corporate carbon footprint. Firms will be required to show improvement in ESG goals or risk exclusion from ETFs and indexes. Just ask Meta and Tesla, both of which have been removed from the S&P 500 ESG Index in recent years. Last year alone, thirty-five companies were removed from the index. One sheet of paper conserved could make all the difference.
Despite high paper consumption going against the ESG tide, the leveraged loan market has grown significantly in recent years. This is due to increased demand for this type of financing in a climate of rising interest rates as well as many businesses utilizing leveraged loans for mergers, acquisitions, financing projects, and to refinance existing debt. Forest Park is leading the way in this sector with Parlake, their new loan settlement platform. Parlake is a paperless platform, with seamless trade file sharing, that reduces the settlement time for leveraged loans. This brings much-needed liquidity to the market and helps companies improve ESG scores by shrinking their carbon footprint. In fact, TD Bank, following an employee recommendation through their iD8 program, similarly implemented the capability for customers to send mortgage documentation through a secure email platform, in a shift from customers providing hard documentation which then had to be scanned by a bank employee. TD Bank cites that “Documentation for each mortgage application can require 10–100 sheets of paper; this idea saved time for colleagues and customers, decreased unnecessary visits to branches, helped drive increased efficiency, and reduced the amount of paper being used by TD”.
In 2017 TD Bank not only met its target to reduce paper use by 40% (compared to a 2010 baseline) but did so two years ahead of schedule by embracing new technology and innovation. Parlake allows for Leveraged Finance to follow a similar path, reducing paper use by cutting back on veritable forests worth of paper stacked mountain high on someone’s desk. This is also to say nothing about the reduction in the volume of emails sent back and forth, which is an often overlooked contributor to climate change.
Decades ago, the concept of going paperless was a theoretical reality. Although we live in a world where going paperless is feasible, in the ESG era companies must go paperless in accordance with their fiduciary duty to shareholders. The COVID-19 pandemic in particular brought attention to broader societal issues from the way we work, how we interact with others and our overall impact on the environment. Previously, few organizations were willing to adopt radical changes on environmental policies. Now banks are laser-focused on their own ESG metrics and goals, some are even going the extra step to reduce our carbon footprint by financing our low-carbon future. Notably, Bank of America has committed to deploying $1.5 trillion in financing by 2030 ($1 trillion of which will go strictly towards environmental transition) to assist businesses of all sizes in achieving their ESG goals and adopting more sustainable business practices which include the decarbonization of their business models.
Parlake is the paperless solution to the environmental qualms and inefficiencies plaguing Leveraged Finance. With Parlake long gone are the days of emails, fax machines, and spreadsheets being the backbone of Leveraged Finance. Parlake utilizes the innovation of Blockchain to bring loan settlement time down to T+3 days as opposed to the average of T+21.3 days. Additionally, Parlake has innovative features designed to streamline efficiency including improved search functionality, seamless file sharing, automated allocation checks, the ability to add closing notes, and even a designated Portfolio Manager signing section.
Countless industries are moving quickly to both obtain net zero and meet their ESG goals. Leveraged Finance has made great strides to hold borrowers accountable for their ESG metrics, however, it is time for Leveraged Finance to catch up to other industries by adopting technology that promotes the framework of ESG while concurrently promoting greater industry efficiencies. Parlake is the electric vehicle that will drive Leveraged Finance to ESG compliance, all while bringing the outdated software the industry presently relies on into the 21st century at supersonic speed.
