The rise of the SDG CLO:

In 2015, the United Nations General Assembly adopted 17 sustainable development goals to be achieved by 2030 ("SDGs"). The SDGs include ending poverty and hunger, promoting gender equality, tackling climate change and promoting life on land and below water. The UN estimates that achieving these goals will require between US$3 trillion and US$5 trillion of additional investment in developing countries each year.¹ In Africa, the "2019 Africa SDG Index and Dashboard Report" identifies funding as the biggest obstacle to realising the SDGs by 2030. Given the amount of investment required, the US$100 trillion bond market is the only pool of capital deep enough to deliver the SDGs by 2030. Building on our work as Knowledge Partner to the G20 Sustainable Finance Study Group (which addresses SDG No. 13 (Climate Action), SDG No. 7 (Affordable and Clean Energy) and SDG No. 9 (Industry, Innovation and Infrastructure)), we are now helping clients to develop new bond market products to advance the other SDGs.

Two new products can connect the bond market (including the US$30 trillion of investments managed under a sustainable investment strategy²) to SDGs:

• the Sovereign SDG Bond
• the SDG CLO

In this article we focus on the SDG CLO, describing five CLO structures which we expect to be developed to target investment in the SDGs. A sixth structure (the synthetic alternative) can be deployed where there are issues around the assignment of the underlying loans.

The SDGs

The SDGs were adopted by the UN as part of its 2030 Agenda for Sustainable Development and encompass 17 principal goals for sustainable development along with 169 sub-targets and 232 indicators which measure progress towards the SDGs. The SDGs fall into six broad categories (with additional overlap between categories):

• Relief of Poverty and Hunger: SDG No. 1 (No Poverty) and SDG No. 2 (Zero Hunger)
• Health: SDG No. 3 (Good health and Well-Being) and SDG No. 6 (Clean Water and Sanitation)
• Equality and Education: SDG No. 4 (Quality Education), SDG No. 5 (Gender Equality) and SDG No. 10 (Reduce Inequalities)
• Economic Opportunity: SDG No. 8 (Decent Work and Economic Growth) and SDG No. 9 (Industry, Innovation and Infrastructure)
• Environment and Climate Change: SDG No. 7 (Affordable and Clean Energy), SDG No. 11 (Sustainable Cities and Communities), SDG No. 12 (Responsible Consumption and Production), SDG No. 13 (Climate Action), SDG No. 14 (Life Below Water) and SDG No. 15 (Life on Land)
• International cooperation: SDG No. 16 (Peace, Justice and Strong Institutions) and SDG No. 17 (Partnerships for the Goals)

SDG CLOs

CLOs are funds which purchase corporate loans and which are structured as securitisations. CLOs can either purchase loans from a single originator ("balance sheet CLOs"), allowing the originating entity to reinvest the proceeds in new lending, or purchase broadly syndicated loans in the secondary market ("BSL CLOs"). In 2018, the total volume of new issuance in the BSL CLO market in the US was US$128 billion and in Europe was €27 billion.³

Since 2018, some CLOs have started including environmental, social and governance ("ESG") criteria in their investment strategies; often, these ESG criteria are consistent with SDGs. However, there remains significant scope to develop the product further as a means to achieve the SDGs by 2030. In particular, we have identified five types of SDG CLO which we expect to see coming to the market over the next few years:

• Negative ESG BSL CLOs: These CLOs include eligibility criteria prohibiting investment in borrowers in sectors which are harmful to ESGs (e.g. extracting hydrocarbons). We first saw these types of deals in Europe in 2018.
• Positive ESG BSL CLOs: These CLOs will include eligibility criteria positively requiring investment in borrowers whose businesses advance ESGs. We see this product as a natural evolution from the Negative ESG BSL CLO and it will likely replace the Negative ESG BSL CLO over time.
• Sustainable CLOs ("SCLOs"): These CLOs are collateralised by clean energy (mainly solar and wind) loans and are focussed on SDGs No. 13 (Climate Action), No. 7 (Affordable and Clean Energy) and No. 9 (Industry, Innovation and Infrastructure); SCLOs were the focus of the G20 White Paper on Sustainable CLOs which we co-authored in 2018.
• SDG infrastructure CLOs: These CLOs are an evolution of the SCLO; they comprise more diverse infrastructure portfolios beyond clean energy and may include any infrastructure advancing SDGs.
• SDG microfinance CLOs: These CLOs invest in loans to microfinance institutions and SME banks, which, in turn, provide microfinance loans to borrowers in developing countries. The first microfinance CLO since the financial crisis, responsAbility Financial Inclusion Investments 2019, was issued in July 2019. The majority of the borrowers in microfinance portfolios are usually women and so these structures naturally address SDG No. 5 (Gender Equality) as well as SDG No. 1 (No Poverty) and SDG No. 2 (Zero Hunger).

Regulatory initiatives and a new investment paradigm

The bond market is growing more compassionate and the days of maximising returns for shareholders as the primary objective of capitalism are ending.⁴ We expect the market for SDG CLOs to be boosted in the coming years by various regulatory initiatives. The recommendations contained in the G20 Sustainable Finance Study Group white paper on SCLOs which we co-authored were welcomed in the G20 Leader's Declaration of 1 December 2018.⁵ European pension funds are now required to consider ESG factors when investing,⁶ something which CLO managers report is already affecting investment decisions.⁷ Similarly, the new EU Securitisation Regulation,⁸which came into force on 1 January 2019, requires sponsors or originators of securitisations to publish information on the energy efficiency of the underlying assets in RMBS and auto-loan securitisations designed to receive beneficial regulatory capital treatment under the STS (simple, transparent and standardised) regime. Whilst this is just the start, the direction from both the regulators and the market is clear.

Conclusion

The market demand is there and regulatory initiatives have the potential to further supercharge demand for SDG CLOs. SDG CLOs offer the possibility of harnessing the power of the bond market to transition the world to a fairer and sustainable (in every sense) economy.

¹ SDG Bonds & Corporate Finance: a Roadmap to Mainstream Investments, UN Global Compact Action Platform on Financial Innovation for the SDGs, 2018.
² Global Sustainable Investment Review 2018.
³ Source: LCD.
⁴ 'Group of US corporate leaders ditches shareholder-first mantra', Financial Times, 19 August 2019.
⁵ 'White & Case Advises G20 SFSG on Landmark Initiative to Create Sustainable CLO Market', 10 December 2018: https://www.whitecase.com/news/press-release/white-case-advises-g20-sfsg-landmark-initiative-create-sustainable-clo-market
⁶ Recital 58, Directive (EU) 2016/2341 (IORP II).
⁷ 'Third ESG CLO prices, as managers mull criteria's benefits', LCD News, 11 June 2019.
⁸ Regulation (EU) 2017/2402.

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