Asset based loans as sustainability-linked loans

An asset-based lending facility (“ABL”) as a sustainability-linked loan (“SLL”) represents an innovative approach to financing that combines the traditional collateral-backed structure of asset-based lending with the performance-oriented features of sustainability-linked financing. This integration could allow borrowers to leverage their assets (such as inventory, receivables, or equipment) to secure financing, while also committing to achieving predefined sustainability performance targets (“SPTs”).

Businesses with rapid growth, fluctuating earnings, or marginal cash flows often choose ABL due to flexibility in the loan structure by way of minimal financial covenants and enhanced liquidity compared to traditional cash flow lending. ABL is prominent across a wide range of industries, particularly in:

• Retail
• Distribution, logistics, and transportation
• Commodities such as forestry products, chemicals, steel, and grains
• Food processing
• Manufacturing
• Rental equipment

Many of these industries are energy and resource intensive. Firms can benefit from having a sustainability adviser identify and integrate SPTs into core business model that would also reduce borrowing costs when these targets are achieved.

According to the 2023 Secured Finance Market Sizing and Impact Study published by the Secured Finance Foundation, the total ABL commitments in the United States in 2022 was US$502 billion, an increase of 10.0% over 2021, compared to US$5.3 trillion of bank commercial loan commitment and year-over-year increase of 6.9%.¹

While statistics for Canadian ABL market is not readily available, the consensus among market participants is that ABL market in Canada is comparable to the US in market share, i.e ~9.5% of total ABL commitments compared to the total bank commercial loan commitment, and growth rate.

ABL is expected to continue to gain market share due to economic and associated credit challenges, the demand for working capital financing, business cyclicality, and restructurings and turnarounds.

In the U.S., SLL issuance totaled US$222 billion between 2021 and 2023, of which only US$5.7 billion were ABLs. Approx. US$44 billion of current SLL issuances could be structured as an ABL based on industry.² Globally, across “ABL-friendly” jurisdictions.³

Source: Bloomberg

While ABL is a mature product in the Canadian lending market, an ABL as an SLL is in its infancy. Approx. C$12 billion of total C$45 billion SLLs in Canada could be structured as an ABL.⁴

For borrowers who have set out certain sustainability objectives and targets, an ABL as an SLL could be an interesting option for the business. Here’s how such an instrument could work and some initial planning considerations.

1. Securing the loan: The loan would be secured against the borrower's assets, which means the amount of credit available can fluctuate based on the value of the collateral. This is typical of ABL.
2. Linking to sustainability: The unique aspect of an SLL is that the terms of the loan, particularly the loan margin or credit spread, are tied to the borrower's performance against specific sustainability-related criteria or targets. These targets can be related to environmental, social, and governance ("ESG") goals, such as reducing carbon emissions, improving energy efficiency, or enhancing labor practices. The SPTs are agreed upon at the outset of the loan and are designed to be ambitious yet achievable, pushing the company to make material improvements in its sustainability performance.
3. Monitoring and reporting: Borrowers are required to regularly report on their progress towards meeting the SPTs. This reporting is often verified by an independent third party to ensure transparency and accuracy. This would be in addition to the reporting requirements under the ABL facility.
4. Pricing mechanism: The loan margin or credit spread on the loan may decrease as the borrower meets or exceeds its SPTs, providing a financial incentive for the company to enhance its sustainability performance. Conversely, failure to meet these targets could result in higher borrowing costs.

• Financial and environmental incentives: Companies are financially incentivized to improve their sustainability practices, which can lead to operational efficiencies, reduced environmental impact, and enhanced corporate reputation with stakeholders.
• Flexible financing: ABL provide flexible financing options that can adjust with the company's asset base and liquidity needs.
• Market differentiation: Adopting such innovative financing can differentiate a company in the market as a leader in sustainability, potentially attracting more investors and customers interested in sustainable practices and SPTs. By leveraging SLL's, a company can demonstrate its dedication towards environmental and social responsibility. This proactive approach appeals to a growing segment of consumers and business customers who prioritize sustainability when making purchasing decisions. Consequently, embracing innovative financing not only enhances a company's reputation but also opens up opportunity for increased investment and customer loyalty, ultimately driving long-term success in a rapidly evolving marketplace.

• Developing the use case: Borrowers will need to review existing financing agreements and business / capital expenditure plans to determine eligibility for enhancing to an SLL.
• Setting appropriate targets: The SPTs must be carefully designed to be both challenging and achievable, requiring a deep understanding of the company's operations and sustainability potential and align with the lender or lending syndicate's requirements.
• Transparency and verification: Robust mechanisms for monitoring, reporting, and verifying sustainability performance are essential to maintain the credibility of the loan structure.
• Regulatory and market changes: Companies must stay informed about changing regulations and market expectations regarding sustainability to ensure their targets remain relevant and ambitious.

KPMG Corporate Finance Inc.'s Debt Advisory Team can assist management in adapting an existing or arranging a new ABL to a SLL. Combining an ABL with SLL criteria represents a forward-thinking financing strategy that aligns financial incentives with environmental and social governance objectives.