The historic opportunity for the CLOs within the framework of the SFDR: the Great Leap Forward for the CLOs and the ESG | White & Case LLP
Secured Loan Bonds (CLOs) may soon be structured as Article 8 funds under the EU’s Sustainable Finance Disclosure Regulation (SFDR) as part of the historic turn of global capital to assets that promote environmental, social and governance (ESG) objectives.
To paraphrase a quote attributed to Yogi Berra, while it is difficult to make predictions, especially about the future, it does not take the prescience of a super forecaster to predict the rapid emergence of CLOs structured as funds. of Article 8 as part of the new disclosure of EU sustainable finance. Regulation. Indeed, we are already seeing Article 8 funds investing in CLOs and it is surely only a matter of time before the CLOs themselves are marketed as Article 8 funds (with the prospect of CLO Article 9 to to follow).
The SFDR aligns with the new EU taxonomy regulation and while the two work together on energy transition and tackling climate change, the SFDR is broader. The SFDR provides a regulatory framework to mobilize private capital for both the energy transition and the broader agenda of the United Nations 2030 Sustainable Development Goals (SDGs). As such, the SFDR can quickly become a global standard to help finance both the energy transition and the egalitarian transition. Within four months of the SFDR’s March 10, 2021 effective date, an astonishing € 3 trillion of funds had been classified as Article 8 or Article 9. This unprecedented growth for a new class of assets has already seen analysts predict that over 50%. of assets under management (AUM) in Europe will be managed through Article 8 and Article 9 funds from 20221.
The convergence of ESGs and CLOs has strengthened since the gradual emergence of negative ESG screening in 2019. This convergence exploded in 2021 to the point of becoming ubiquitous with negative ESG screening provisions in new issues and resets of CLO EUR . 2021 saw other significant changes to ESG provisions in CLOs, with forward-thinking managers introducing subjective ESG rating into 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 defining framework for issuers in all markets2 to access the huge demand for ESG assets. This prediction proved to be correct, first in the investment grade market in 3Q19, with Enel printing the first corporate bond linked to sustainable development to commit with reference to the SDGs. Then, in 3Q20, Mexico issued the first sovereign bond to include SDG provisions with its massively oversubscribed SDG 8 offering. Enel and Mexico both posted prices well below initial forecasts due to SDG commitments. 1Q21 saw the first signs of the SDG model in leveraged markets and CLOs with CLOs, including reports on assets covenants with the SDGs. The missing piece of the puzzle to facilitate price prioritization for CLOs has now been addressed by the SFDR which provides the framework for funds to aggregate ESG assets, including those that promote the SDGs.
To explain: while private and sovereign issuers may enter into direct commitments with reference to the SDGs (the EU taxonomy regulation further facilitating this by defining climate mitigation and adaptation), the challenge for funds, including CLOs, increased with a sufficient level of ESG assets for the pricing advantage to emerge (as has been the case in other markets). The SFDR definitively solves this enigma with the promulgation of the Article 8 fund structure.
Participants in the CLO market are all too familiar with the dichotomy under EU law between level 1 rules (such as the securitization regulation and now the SFDR) and the detailed level 2 rules promulgated in the Regulatory Technical Standards (RTS). The level 1 SFDR entered into force on March 10, 2021, but the detailed level 2 rules are not expected to enter into force until July 1, 2022. In the meantime, the European supervisory authorities have recommended in their declaration of 25 February 2021 that national authorities and market players use the draft RTS for guidance (including detailed provisions on asset reporting) pending the finalization of the RTS. This decision paved the way for 3,000 billion euros in assets under management to be included in Article 8 or Article 9 during the first months of the market.
Following the proposals made in the G20 white paper on sustainable securitization,3 which were greeted by G20 leaders at the Buenos Aires summit in 2018, the European Central Bank (ECB) adopted the main proposal of the white paper and started buying sustainable assets (including assets linked to the SDGs) . This ECB program further accelerates the flow of liquidity to the ESG asset market.
It took about 13 years until 2020 to print the first $ 1,000 billion in Durable Bonds and it looks like we will surpass $ 2,000 billion later in 2021. Whereas in 2019 we only had As a small number of leveraged borrowers making ESG commitments, the majority of primary leveraged issues in 2021 contain ESG covenants. This surprising acceleration of ESG in the non-investment grade market, along with SFDR and bond market demand, paves the way for CLOs to commit to minimum ESG portfolio concentrations. The only question that remains is: who will be the first to print an Article 8 CLO?
1 SFDR fund assets explode but the number of funds is “unexpected”
2 The Rise of SDG CLO: How to Use the Bond Market to Achieve the United Nations Sustainable Development Goals by 2030
3 White & Case advises the G20 SFSG on a historic initiative to create a sustainable market for CLOs