European CLOs and the unstoppable impact of ESG | White & Case srl
New CLO issuance in Europe reached €38.5 billion in 2021, up 75% year-on-year
- New European Secured Loan Obligation (CLO) issuance in Europe grows 75% year-on-year, reaching €38.5 billion in 2021
- CLO issuance for refinancing and resets reached a record €57.5 billion over the year
- As of July 2021, 34% of total EU assets under management were compliant with the new regional Sustainable Financial Disclosure Regulation (SFDR), and this figure is expected to rise to over 50% in 2022.1
The European CLO market and environmental, social and corporate governance (ESG) objectives are rapidly converging, providing CLOs with unique opportunities to access the large and growing pools of capital for ESG-related investments.
The past 12 months have been good for European CLOs in general. New CLO issuance in Europe reached €38.5 billion at the end of 2021, up 75% year-on-year and peaking in November 2021 at €6.3 billion, its highest level ever. Debt by Wire registration. Refinancing and resets drove record CLO activity during the year, reaching €19.6 billion and €38 billion respectively for the year.
At the same time, ESG factors have become increasingly influential in global debt markets, first in the quality and sovereign segments before spilling over into the leveraged finance space. In 2019, Italian electricity and gas distributor Enel was the first corporate issuer to print a corporate sustainability bond linked to the United Nations Sustainable Development Goals (SDGs), and in 2020 the Mexico launched the first sovereign bond with reference to the SDGs. .2
As these high-level ESG-related financings have caught the attention of investors, CLO managers in Europe have started to incorporate ESG “negative screening” measures into their credit criteria. Loans from issuers in sectors such as nuclear weapons, coal and tobacco were excluded from the mix. Document research platform Dealscribe estimates that up to 15% of CLOs excluded credits due to ESG concerns in 2018. Since then, ESG has quickly moved onto the agenda – in 2021, Dealscribe set the number of CLO transactions with a negative ESG filter at the end of 100% in the UK and European market.3
The SFDR Game Changer
However, the European CLO industry is only at the beginning of its transformational ESG journey. The catalyst for this change is the EU’s Sustainable Financial Disclosure Regulation (SFDR), a policy initiative that accompanies the bloc’s taxonomy regulation.
The SFDR was designed to channel private capital into both the energy transition and the equality transition. In a nascent ESG market, which still struggles to benchmark and prevent greenwashing, SFDR is fast becoming a global standard, providing rigorous definitions of what qualify as environmental and social assets. It has been so successful that many investors in the United States are now adopting the SFDR as their benchmark, even if they are not directly subject to it.
The SFDR is relevant to CLO managers as it allows for the formation of so-called Article 8 and Article 9 funds. Article 8 funds are more broadly defined as those that promote environmental or social characteristics, while Article 9 funds have a stricter primary objective of sustainable investing.
The appetite for all funds that meet the ESG criteria required to qualify as Article 8 or Article 9 vehicles has been deep. Within four months of the SFDR coming into force in March 2021, assets under management (AUM) for Article 8 and Article 9 funds had already soared to 3 trillion euros, according to Morningstar figures, with the expectation that more than 50% of total AUM in Europe will be held in Article 8 and Article 9 funds later this year.4
For the European CLO market, this influx of capital into what is effectively an entirely new ESG asset class could trigger an unprecedented influx of liquidity into CLOs that are structured as Article 8 or Article 9 funds.
At press time, CLO assets under management in the EU stood at €182.4 billion, according to Creditflux. If even a fraction of the €3 trillion already invested in SFDR-compliant funds ends up in the CLO market, the size of the segment will increase by multiples.
View full image: European New Issue CLO Volume (Annual) (PDF)
Start the change
Meeting the criteria set out in the SFDR is already well within the reach of CLO managers, most certainly as far as Article 8 status is concerned.
Reporting and compliance are relatively light, with managers required to provide a brief pre-contractual disclosure committing to meeting their ESG criteria and then report quarterly on their progress towards those goals. This is well within reach of CLO managers, who will already have an infrastructure in place to meet securitization reporting requirements.
Recent guidance from the European supervisory authorities, the Joint European Regulators, confirms that the inclusion of an ESG exclusion filter is sufficient to qualify for Article 8. The filter is a minimum entry level, but the Article 8 is structured to be flexible and allows for varying ‘Shades of Green’. For example, the ESG screen of Article 8 funds is at the “light green” end of the spectrum, while darker green Article 8 funds (e.g. those with a slice of investments durable minimum high like 99.9%) are only one shade lighter than the fully dark green Section 9 Fund.
This removes barriers to entry, as managers do not have to commit to a complete overhaul of their investment strategies, but can position themselves across the spectrum as long as minimal hurdles are cleared. It is also important to note that not all CLOs a manager manages need to be Section 8 compliant – the plan is voluntary and applies per product rather than necessarily to the entity level manager.
Even before the SDFR took effect, the market saw Neuberger Berman launch a new European CLO linked to the UN SDGs, considered the first of its kind. The flexibility of the SFDR regime, its global credibility and the large pool of funding it opens up will only accelerate this ESG investing theme.
We can expect to see the first Article 8 CLOs emerge perhaps as early as the first half of 2022, with the potential for the CLO market to migrate en masse to Article 8 within the next 12-15 months.
1 “Assets in SFDR funds are exploding but the number of funds is ‘unexpected'”. July 27, 2021. Europe Fund.
2 “The historic opportunity for CLOs under the SFDR: the big leap forward for CLOs and ESG”. Chris McGarry. August 27, 2021. White and case.
3 “Ethical Investors Pose Funding Risk for Oil and Defense Companies”. Tom Rees. 14 November 2021. The Telegraph.
4 “Assets in SFDR funds are exploding but the number of funds is ‘unexpected'”. Op cit.