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Private-equity backed companies: The evolution of ESG-linked financial incentives

Private-equity backed companies: The evolution of ESG-linked financial incentives


The environmental, social and governance (ESG) performance of a business is both a financial matter and an ethical one. As a result, responsible investment is right at the heart of the private equity investment agenda. As LPs increasingly look to achieve their returns through investment in businesses that are good corporate citizens, GPs must think creatively of ways to incentivise behavioural change at the portfolio company level to achieve the sustainability outcomes promised to their investors.

As we emerge from the pandemic, the importance of responsible business and sustainability has never been so clear. From the growing efforts worldwide to avert the climate emergency (the IPCC's newly published climate change report being dubbed a "code red for humanity"), to public action on racial injustice, society at large is increasingly focused on confronting a broad range of issues. And, of course, there is growing expectation that investors and corporates will play their part.

The evolving regulatory environment also continues to push ESG issues to the top of the agenda, but increasingly there is emphasis not just on the legal liability and reputational damage that may result from poor ESG performance, but also the opportunities that strong ESG performance may provide for a business to flourish. Companies that embrace the challenges of the future will be more resilient and saleable – or, put another way, companies do well by doing good.

Private equity sponsors are particularly well placed to promote sustainable and responsible practices through active management of their portfolio companies. They increasingly recognise that – as well as being the right thing to do – these objectives are often aligned with positive financial outcomes, especially since they will have to find a buyer for their business in a rapidly changing environment. It is also what their investors want – not always with an emphasis on financial outcome, but also because they are concerned about the impact of the activities they are financing. A recent survey of global investors by Capstone Partners serves to highlight LPs' increasing demands for ESG focus by the funds in which they invest, particularly in Europe: interestingly, 29% of European LPs taking part in the survey indicated a willingness to trade lower performance for excellent ESG credentials, showing that, even though ESG credentials increasingly equate with higher values, the moral case continues to be a compelling one. Increasingly, LPs in Europe are including opt-out rights allowing them to be excused from investing in specific assets where ESG criteria are not met, and in the secondaries market we are seeing ESG-focused LPs divesting positions in funds where they perceive ESG efforts to be lacking.

Of course, the importance of ESG, and particularly the downside risk associated with it, is not news to private equity. For years, due diligence efforts have focused on ESG issues (albeit the list of issues is continually expanding) and governance rights in equity documents have guided best practice and legal and regulatory compliance. Beyond this, what can GPs now do at the portfolio company level to proactively engage with ESG issues? How can they take advantage of the significant opportunities that regulatory intervention and society's focus on sustainable business will deliver in the coming decade?

One way of embracing these opportunities would be to include ESG-linked financial incentives in the deal documents. If done well, this could drive accountability and culture change at the portfolio company level, securing alignment between LPs, GPs and their management teams in respect of ESG goals. On the other hand, GPs need to be wary of superficially attractive targets that do not deliver meaningful change, or ones that inadvertently create perverse incentives.

In this article we explore potential ways in which ESG KPIs might be used by GPs to improve alignment in relation to ESG goals at the fund level (being the commitments made to investors) and at the portfolio company level, providing an effective framework for holding portfolio companies to account. We also explore some of the challenges that may arise in doing so.

What's already out there?

ESG-related KPIs are already a feature of bonus and remuneration schemes in listed companies. We are also seeing a surge in ESG-linked lending facilities and an associated increase in ESG-linked hedging products. More significantly in the private equity context, managers, particularly impact investing specialists, are starting to consider whether to link their carried interest structures to ESG performance. We expect GPs will follow this trend by introducing bonus schemes or ratchets running off metrics which include ESG criteria.

Listed companies linking executive pay to ESG targets

Linking executive pay to ESG targets (as well as financial targets and other relevant measures) is an increasingly common method of embedding a focus on ESG performance in the FTSE 100. According to recent research published by PwC (in respect of disclosures made in 2020, relating to the 2019 performance year), almost half of FTSE 100 companies have an ESG target in the annual bonus and the Long-term Incentive Plan (LTIP) or both, and it is expected that a greater number of companies will include ESG measures in their 2021 disclosures. This is reflective of a growing expectation, particularly amongst institutional shareholders and their representative bodies, that listed companies will include some ESG-based performance measures as a condition to bonus entitlement or the vesting of share-based incentive awards (particularly for senior employees and executives).

Travers Smith recently worked on the drafting of Scarlett's Clause for The Chancery Lane Project, which contains sample performance conditions that provide for part of a share-based incentive award to vest dependent on the meeting of ESG targets. This is generally aimed at listed companies but could potentially be used more widely.

It remains to be seen whether this will emerge as a trend in remuneration packages in the private equity space – it might seem unlikely given the short-term focus of PE-backed company bonus schemes, which rarely include rigid KPIs and are instead operated on a discretionary basis and usually linked to exit. However, there are some useful constructs that could be adapted for private equity incentivisation structures – consider, for example, the emergence of ESG-linked financial instruments such as the equity ratchet (Bella's Clause), also designed by Travers Smith as part of The Chancery Lane Project.

Selecting the right ESG metrics is no easy task, however. They will be, of course, bespoke to the business and its overall purpose and strategy, but it is also a matter of identifying what truly drives long-term sustainable value creation. While longer-term incentive plans lend themselves well to environmental goals such as reductions in emissions or a drive towards zero carbon, shorter term bonuses may be tied to social goals such as improvements in diversity and inclusion. However, care is needed, particularly in relation to shorter term incentives, to ensure meaningful engagement from employees (rather than embedding a culture of quick wins).

When linking pay to social goals such as diversity, it is important to avoid infringing anti-discrimination law in defining the targets. Positive action (for example taking steps to encourage women or ethnic minorities into senior positions) is lawful in the UK, whereas positive discrimination (for example, hiring or promoting people because of their race, sex or background) is unlawful.

ESG-linked debt facilities

ESG-linked debt financing packages are growing rapidly in popularity. As well as sustainable or green loans specifically provided to borrowers who are financing a "green" project or to companies in "green" industries, we are also seeing loans with ESG-linked margin ratchets and associated KPIs being used as a means of incentivising improved ESG performance of borrowers while also providing an opportunity to reduce financing costs.

In the fund finance space, Travers Smith advised Investec Bank plc on an ESG-linked subscription facility provided to Investindustrial, one of Europe's leading investment groups. The facility was one of the first ESG-linked subscription lines in the European fund finance market and was structured so that reduced interest payments apply when specified ESG goals are met (in areas such as environment, gender diversity and governance) and any interest cost savings are then ring-fenced by Investindustrial for investment in carbon reduction initiatives, including continued development of its portfolio of nature-based carbon reduction projects. When implemented at the fund level, lenders and borrowers are able to design KPIs which straddle both the manager's own behaviour and the ESG credentials of the relevant fund's portfolio investments.

Earlier this month, Carlyle Group announced that it had secured a €2.3bn ESG-related credit facility for its European private equity and real estate funds, to support the firm's board diversity target (noting that, according to its own research on the earnings of its portfolio companies, there is a positive correlation between board diversity and performance). Carlyle's new credit facility is also linked to tackling climate change (by having more accurate and comprehensive measurements of greenhouse gas emissions across all portfolio companies) and improving ESG outcomes through better governance (for example, providing ESG-competent board training for all Carlyle board directors).

In recent months we have also seen a significant number of large leveraged finance transactions with ESG-linked margin ratchets and associated KPIs. European ESG-linked leveraged finance volumes have increased from $6.7bn in 2020 to $25.2bn year to date, according to Dealogic.

Travers Smith recently advised RSK Group (the UK's largest privately owned multi-disciplinary environmental business) on its £1 billion sustainability-linked debt package from Ares Management Corporation, the largest private credit-backed sustainability-linked financing to date. The facilities include an annual margin review based on the achievement of sustainability-linked targets broadly focused on carbon intensity reduction and continual improvement to health and safety management and ethics. Not less than 50 per cent. of any margin saving must be spent by RSK on sustainability-related initiatives or charitable purposes.

The trend for ESG-linked leveraged finance transactions initially applied only to investment grade loans (and bonds) where the issuer had a high credit rating but is now increasingly a feature of loan financings for sponsor-backed issuers with lower credit ratings.

With the Loan Market Association (LMA) fully engaged with the ESG agenda – it now has a dedicated Sustainable Lending microsite to promote growth and innovation in this area – we can expect the continued growth and rapid expansion of ESG-linked financings, including on leveraged buyouts, where private equity will benefit from a reduction in their interest costs in return for meeting targets linked to ESG goals.

There are, however, some difficulties when adopting ESG-linked terms in leveraged finance transactions, particularly where the deal is done on an accelerated timetable. There are limits to the detail which can be set out at term sheet stage and detailed KPI terms require significant input from management. That said, an "agreement to agree" provision, whilst not strictly enforceable in law, displays the parties' willingness to commit to ESG-linked economics, notwithstanding the tight timeframes, enabling the detail to be agreed post-closing but with the relevant ratchet and ESG reporting architecture baked into the finance documentation from signing. There is also a lack of standardisation of approach and market terms, with significant diversity in the KPIs that trigger a margin adjustment (reduction in emissions, renewables targets, deforestation, health and safety, product traceability and social governance to name a few) and differing approaches to monitoring and reporting against the agreed KPIs, in particular regarding whether to outsource such functions to specialist providers or not - that said, there have been advances in this regard, for example with the publication of the Sustainability Linked Loan Principles by a joint working group of the LMA, the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA).

As the trend in ESG-linked lending continues to expand, lenders need to be careful not to be seen to be profiting from poor ESG performance (for example, lenders will usually think carefully about including two-way margin adjustments in this context and/or their own use of any margin increase attributable to the failure to meet KPI targets). There is also a question as to whether failure to meet ESG targets linked to financing should trigger an event of default – so far, lenders have not tended to go down that route. And for borrowers, it is important not to be accused of "greenwashing" (particularly where the relevant margin adjustments achieved may be relatively modest when looked at against market pricing), something which recent EU regulatory initiatives seek to guard against.

ESG-linked derivatives

ESG-linked derivatives have a pricing component tied to ESG targets, making them distinct from derivatives which are simply linked to an environmental underlying asset such as emissions trading. ESG-linked derivatives incentivise counterparties to achieve ESG targets by correlating the pricing on trades to whether the relevant targets are met. For example, for FX or interest rate derivatives, a counterparty may offer different discounts or premiums to the relevant rate dependent on whether pre-agreed ESG targets are met. Alternatively, counterparties can be incentivised to meet ESG targets by requiring a penalty payment to be made to an ESG charity or towards an ESG investment if targets are not met. Such incentives seek to offset the negative ESG impact of targets not being met.

With the increase of issuances of green bonds and ESG-linked loans there has been increasing need for associated sustainability-linked hedging products as the hedging may need to reflect ESG mechanics in the underlying instrument. ESG-linked derivatives allow for the risk associated with green bonds and ESG-linked loans to be transferred to a hedge provider while still maintaining the ESG credentials of the underlying instrument. Typically, the hedge provider will offer better commercial terms in exchange for a commitment from the relevant counterparty to meet ESG targets or activities.

There are an increasing number of ESG-linked derivatives being offered in the market. Such products are typically bespoke, depending on the ESG targets motivating the counterparty. Recent examples include: a sustainability-linked derivative product launched by ANZ in Australia, Hong Kong, Japan and Singapore, which includes swaps, forwards, cross-currency swaps, interest rate and foreign exchange options executed alongside sustainability-linked loans or bonds. As an example of a recent transaction, French food hygiene company Kersia has hedged the interest rate exposure of a €520m sustainability-linked leveraged buyout loan using a sustainability-linked derivatives hedge with the same KPIs that were set on the loan. If Kersia pays a penalty for missing or partially achieving the KPIs, the banks providing the hedge will invest the penalty in projects with a positive sustainable impact. As the market and regulation develops, standardised approaches to the documentation and to the relevant ESG metrics will likely evolve.

Carried-interest structures – impact funds

A growing number of funds, in particular impact funds, are weighing up whether to link GPs' compensation to performance on ESG issues as a novel strategy to make sure that the firms they back are good corporate citizens, effectively tying their sustainability promises to their pay. 

As an example, European private markets firm Capza recently announced that the carried interest structure of its soon to be raised sixth private debt fund will be linked to ESG KPIs. Effectively, this will see part of the carried interest being forfeited if ESG incentivisation programmes at the portfolio company level (carefully tailored through an ESG diagnosis to be carried out alongside investor due diligence) are not successfully implemented. 

According to placement agent Campbell Luteyns, there are now 15-20 global private equity and infrastructure funds with impact linked carried interest and, with standard form clauses beginning to emerge, we could potentially see further development, perhaps – in more limited form – even spreading to the mainstream market in time. That said, executives may be unwilling to give up carry where there is too much reliance on factors outside of their immediate control. Unless the GP is very much leading the charge through an impact strategy (where the KPIs and measurement framework might naturally follow from that strategy), there may be too much doubt at the moment for more generalist managers to offer something along these lines.

Nevertheless, the growing interest in such ESG-linked carried interest structures is a sign that investors are increasingly looking to hold private equity firms to account on their sustainability promises, and ESG performance is likely to be used as a key factor in manager selection by many allocators of capital.

What else could be explored in relation to GP investee companies?

Good ESG performance at the portfolio company level requires more than the checks and balances that are typically covered in the governance provisions of equity documents to cover downside risk. To capitalise on ESG opportunities, and to ensure management teams and GPs are aligned in acting on ESG commitments to investors, GPs need to take proactive steps to embed a culture of achieving ESG goals in their portfolio companies.  

Management teams in private equity-backed businesses are typically incentivised to achieve the business' growth objectives (usually through bonus arrangements or share-based schemes). The value of such schemes is typically dependent on financial performance, growth in value and/or the returns achieved by the sponsor, but they would also lend themselves to ESG-related targets.

As mentioned above, Travers Smith recently worked with the Chancery Lane Project to create "Bella's clause", a template equity ratchet provision designed to incentivise management teams to meet targets which are linked to climate change and environmental issues. The clause is designed as an "equity ratchet" which could increase the size of the management team's stake in the company at exit if the business has achieved its climate change related targets during the life of the investment. The same structure could be used for meeting other ESG goals, including workplace diversity. There is certainly increased interest in such arrangements among our clients, and we can see significant potential for expanding the incentive structures of management teams in this way.

Another solution would be to link hurdle share mechanisms to ESG performance, effectively rewarding managers through an entitlement to a return on their hurdle shares when specified ESG targets are met. As with other ESG-linked financial instruments, the key challenge will be to link the hurdles to measurable and clearly defined ESG targets.


To give teeth to the promises being made to LPs on ESG performance, the first challenge for GPs will be to build in meaningful ESG-linked KPIs to management incentivisation structures to drive behavioural change and improved ESG performance. The second will be to measure the impact.

In introducing incentivisation structures linked to ESG targets, a couple of questions need to be asked:

  • is the incentivisation structure compatible with the target being set? Environmental goals such as climate change will generally be better suited to longer term incentivisation arrangements, whereas shorter term goals may encompass social issues such as improving diversity and inclusion.

  • are the ESG goals being considered aligned with overall business strategy and any integrated ESG policies or targets of the portfolio company, as well as the commitments made to investors on ESG issues?

Some may argue that such incentivisation structures are not necessary in a world where there is now widespread recognition of the fact that ESG performance is financially material and hence that improving ESG performance generates value for shareholders. However, while some ESG matters are clearly financially material, the existence of a direct link between social goals and value creation may be less clear and so a more structured approach to incentivisation may be helpful in generating improved ESG performance. A carefully considered ESG-linked incentivisation structure can also provide a useful teach-in for management and ensure that the ESG goals set by the investor remain "front of mind" for those responsible for the day-to-day management of the business.

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