Collateralised Loan Obligations (CLOs) may soon be structured as Article 8 funds under the EU Sustainable Finance Disclosure Regulation (SFDR) as part of the historic rotation of global capital towards assets which promote environmental, social and governance (ESG) objectives.
To paraphrase a quote attributed to Yogi Berra, while it is tough to make predictions, especially about the future, it does not take the prescience of a superforecaster to foresee the rapid emergence of CLOs structured as Article 8 funds under the EU's new Sustainable Finance Disclosure Regulation. Indeed, we are already seeing Article 8 funds investing in CLOs and it is surely only a matter of time before CLOs themselves are marketed as Article 8 funds (with the prospect of Article 9 CLOs to follow).
The SFDR dovetails with the EU's new Taxonomy Regulation and while the two work together on the energy transition and arresting climate change, the SFDR is broader. The SFDR provides a regulatory framework to mobilize private capital for both the energy transition and the broader UN 2030 Sustainable Development Goals agenda (the SDGs). As such, the SFDR may rapidly become a global standard to help finance both the energy transition and the equality transition. Within four months of the 10 March 2021 effective date of the SFDR, an astonishing EUR 3 trillion of funds had been badged Article 8 or Article 9. This unprecedented growth for a new asset class has already seen analysts predicting that over 50 per cent. of the assets under management (AUM) in Europe will be managed through Article 8 funds and Article 9 funds as soon as 20221.
The convergence of ESG and CLOs has been building since the gradual emergence of ESG negative screening in 2019. This convergence exploded in 2021 to the point of ubiquity with ESG negative screening provisions in EUR CLO new issuances and resets. 2021 has seen further step changes for ESG provisions in CLOs, with forward-thinking managers introducing subjective ESG scoring across CLO portfolios as well as the emergence of objective ESG reporting on CLO assets.
White & Case predicted in 2019 that the SDGs could provide the definitional framework for issuers across markets2 to access the huge demand for ESG assets. This prediction proved accurate, first in the investment-grade market in 3Q19, with Enel printing the first sustainability-linked corporate bond to covenant by reference to the SDGs. Next in 3Q20, Mexico issued the first sovereign bond to include provisions relating to the SDGs with its massively oversubscribed SDG 8 offering. Both Enel and Mexico priced well inside initial guidance as a result of the SDG commitments. 1Q21 saw the first signs of the SDG model in the leveraged and CLO markets with CLOs including reporting on SDG-covenanted assets. The missing piece of the jigsaw to facilitate pricing tiering for CLOs has now been filled by the SFDR which provides the framework for funds to aggregate ESG assets, including those which promote the SDGs.
To explain: while corporate and sovereign issuers can make direct covenants by reference to the SDGs (with the EU Taxonomy Regulation further facilitating this by defining climate mitigation and climate adaptation), the challenge for funds, including CLOs, has been ramping with a sufficient level of ESG assets for the pricing benefit to emerge (as it has done in other markets). The SFDR solves this riddle definitively with the promulgation of the Article 8 fund structure.
CLO market participants are all too familiar with the dichotomy under EU law between the level 1 rules (such as the Securitisation Regulation and now the SFDR) and the detailed level 2 rules promulgated under regulatory technical standards (RTS). The level 1 SFDR became law on 10 March 2021 but the detailed level 2 rules are not due to become law until 1 July 2022. In the interim, the European Supervisory Authorities recommended in their statement on 25 February 2021 that national authorities and market participants use the draft RTS for guidance (including the detailed asset reporting provisions) pending finalisation of the RTS. This move paved the way for EUR 3 trillion of AUM to be badged Article 8 or Article 9 within the first few months of the market.
Following the proposals made in the G20 white paper on sustainable securitisation,3 which were welcomed by the G20 leaders at the 2018 Buenos Aires summit, the European Central Bank (ECB) adopted the main proposal from the white paper and began purchasing sustainable assets (including SDG-linked assets). This ECB program further accelerates the supply of liquidity to the market for ESG assets.
It took some 13 years to 2020 to print the first USD 1 trillion of sustainable bonds and it looks like we will pass USD 2 trillion later in 2021. While, in 2019, we had only a trickle of leveraged borrowers making ESG commitments, the majority of leveraged primary issuance in 2021 contains ESG covenants. This startling acceleration of ESG in the non-investment-grade market, together with the SFDR and the demand from the bond market, paves the way for CLOs to commit to minimum ESG portfolio concentrations. The only question remaining is: who will be the first to print an Article 8 CLO?
1 Assets in SFDR funds rocket but number of funds is "unexpected"
2 The rise of the SDG CLO: How to use the bond market to deliver the United Nations' Sustainable Development Goals by 2030
3 White & Case Advises G20 SFSG on Landmark Initiative to Create Sustainable CLO Market
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