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The Importance of KPIs and Outcomes Based Metrics in Sustainable Finance

iStock 1283279349 - Global Banking | Finance

By Marc Naidoo, partner in McGuireWoods

Credit protection and protection of return have always formed the basis on which financiers predicate debt finance transactions. Eager transactors have been known to dread presenting potential transactions to credit committees, with borrowers equally sharing that dread knowing that there may be raft of new terms that will ultimately be presented to them. It is a credit committees’ role to protect their organisation’s balance sheet and reputation, while transactors are there to ensure that that balance sheet grows, and that growth is protected. However the distinction between these two functions is starting to blur, and in some ways reverse, especially in the context of sustainable finance.

The catalyst for this change is multi-faceted and complex. One could point to increased competition in the financial sector, including the rise of more agile risk-taking private lenders, or similarly to the large amount of deployable liquidity held by large banks because of a slowdown in lending during the pandemic. These represent topics in themselves, however the focus of this article is the role of sustainability in this shift.

As sustainable finance moves further towards the centre of the ESG spotlight, institutions are taking the time to educate their staff on the role that financiers can play in helping move the ESG agenda. Conversely, institutions are also educating their staff on the role that ESG can play in shaping that institution’s agenda and prospects. What were perceived to be risky transactions, whether in terms of geography or sector, are now seen as low hanging fruit for institutions to pick and throw into their basket of ESG deals. Credit committees have tacitly received this mandate and, in most instances, will look past previous misgivings on what was once considered risky, and to push through pipeline ESG deals. Ultimately the more ESG deals an institution can complete, the better the long-term prospects for that institution, as large corporates navigate their way through stakeholder and activist pressure. Thus, in the long run, credit committees are ensuring that the balance sheet of an institution grows by allowing more deals to be put through (within reason).

Transactors are then left with the task of shaping ESG deals in a way that protects the return as well as the credit offered to a borrower. The challenge being that what was previously considered as “market” terms are no longer applicable given the market shift relating to credit committees. Some may see this as looking for something but not knowing what that something is, as there are no longer market precedents to leverage off when negotiating terms. Others will see this impasse as an opportunity to chart a new course with terms that are so bespoke that market participants would be hard pressed to find them elsewhere. These creative solutions are the bedrock of sustainable finance, as financiers and borrowers attempt to come to agreeable and creative solutions to their negotiations. These creative solutions can no longer revolve exclusively around maintenance and incurrence covenants but must relate to the additionality of what and whom is being financed.

Key performance indicators (or KPIs) are not new in the context of financings. Objective metrics on how a business is performing are usually a reliable gauge on the health of that business (including how well that business is being run). The transition is now incorporating the use of these key performance indicators into determining whether a borrower is achieving sustainability targets (which are usually the foundation of credit committees’ approvals). These could work hand in hand with more conventional maintenance and incurrence covenants or could be stand alone. Either which way, these sustainable key performance indicators must be bespoke and be relevant to the nature, geography and sector of the business in question, especially considering that these KPIs are usually linked to some form of margin ratchet, or even debt forgiveness in certain circumstances.

Structuring these KPIs provides a degree of difficulty where there is no reference point. Carbon offset does seem to be the most prevalent type of KPI, which is ultimately linked to a ratchet of sorts. But even these more common KPIs, especially relating to Scope 3 emissions, are hard to measure and monitor as there are various hydrocarbon measuring methodologies. Each of these methodologies has positives and negatives, but what Scope 3 emissions introduces is a foundation on which to base those methodologies on, which is particularly helpful when addressing the idea of granularity in KPIs.

KPIs in the context of sustainable finance should be viewed as objective outcomes based metrics which are pre-defined. What is important to consider is that the outcome metric does not always have to link back directly to the underlying financing or the business of the borrower. As always, this must fall in the realms of what is reasonable. It can hardly be considered sustainable if a loan facility is used for a prohibited activity, but attached to that loan is a non-linked KPI that can be met. The approach then must consider the nature of the business operations of the borrower, the sector as well and the geography. The best possible scenario is where the KPIs introduced are directly associated with those three factors. An example being a renewables project having a quota of local contractors and conservating the environment around its project. However these KPIs are not always accessible, and other options not directly related to the business are similarly adept to incentivising borrowers to promote sustainability. These could take the form of community development, wildlife and forestry conservation and nation building (especially in the context of developing markets). We have seen a version of this being used by development finance institutions, who would make it incumbent on borrowers to submit development outcome reports which would reflect their actions in relation to sustainability. These however were information undertakings, whereas the market has shifted to a point where these covenants (whilst still reportable in nature) could have a direct impact on the cost of debt.

As discussed previously, there is no precedent for these types of KPIs, thus transactors have a blank canvas to structure covenants around deals. However these KPIs need to be meaningful and in themselves add value to a transaction. Outcomes based metrics are easy enough to set, but the challenge arises in measuring them. For instance, assume a corporate enters into a loan transaction in a developing economy. The financier in question sets a KPI of building a school for young women in that jurisdiction, even though the underlying loan is a general corporate loan that has no sustainability aspect. What is then considered success by the parties involved, and what would justify an impact on pricing? An outcomes based metric is easy enough to set, but measuring the actual outcome is difficult.

Back to our borrower, it builds the school and then reports this to the financier. The issue with KPIs is that they have to be clearly defined and linked to the outcome that is trying to be achieved, and this has to set upfront. An empty school building would on the face of it satisfy a simple KPI, but the importance of measuring success lies in granularity, which is arguably the hardest aspect in setting sustainability outcome metrics in transactions. So what can be defined as success? Is it the school being built? Is it how many female learners enrol into the school over a period? Is it how many of these learners pass, either as a number or as a percentage of learners enrolled? Is it how many of the learners then go on to participate in the economy and thus increasing the number of females that are included financially in the economy? These outcomes are all relevant, however the issue is granularity. The list could go on and in further detail, which is why the KPIs need to have a set measurement on the outcomes of the activities in question. This is even more so for impact bonds and philanthropic / recyclable capital where the financing relates directly to the KPIs in question. The answer to granularity is to go back to the three considerations relating to a recipient, namely the nature of business, the sector and the geography.

Consideration of these three factors would then give a financier an idea of the “something” it is trying to find, and in essence to identify a problem that requires a solution. Once there is a fundamental understanding of what is being solved for, outcomes based metrics can be more easily identifiable and in some instances limited. That is solution to the issue of granularity, as once the actual problem is identified, market participants will have an idea of how to solve for it. So back to our example, the issue is the lack of literate young females in that geography, therefore the outcomes based metric would be a confirmation of the number of young female learners that become literate through the school.

Financiers and borrowers alike need to first decide on what problems require solutions before setting KPIs. This would avoid the “how long is a piece of string” conundrum when it comes to granularity. The achievement of these goals would also represent true value in the context of sustainability, as opposed to setting an abstract target that the parties dispute the success of. Business facing members of the finance industry will need to start employing the problem solving approach at the onset of engaging in discussions with potential borrowers, even before these possible deals get to credit committees. As we discussed earlier, credit committees are pushing more ESG deals through, thus the onus now lies on the transactors to protect the reputation and credit of the bank through innovative outcomes based structures, which inadvertently also protects sustainability as well.

About Author:

Marc Naidoo is a partner in McGuireWoods’ London office and has significant experience advising leading banks and other clients on complex financing transactions. His practice focuses on emerging markets, with a particular emphasis on Africa and sustainable finance.  He can be reached at [email protected]

Global Banking & Finance Review


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