How the SFDR is changing the dynamics in Private Equity

What’s the purpose of the SFDR?

The new regulation aims to foster the integration of ESG factors into investment and advisory processes and to make investment products more transparent. The rules shall enable investors to compare sustainable funds more easily and prevent greenwashing. The SFDR is the disclosure tool in the EU’s broader sustainable finance framework, along with the EU Taxonomy Regulation and the Corporate Sustainability Reporting Directive (CSRD). The disclosure obligations in the SFDR are divided into three main areas:

1. Integration of sustainability risks in the investment decision-making and advisory process
2. Consideration of Principle Adverse Impacts (PAIs) in investment decisions and investment advisory on sustainability factors
3. Transparency when products either promote ESG characteristics (Article 8) or target sustainable investments (Article 9)

The challenges one year on

Since 10 March 2021, the SFDR (without the Regulatory Technical Standard or RTS) leaves significant room for interpretation and therefore often leads to generic and qualitative disclosures and ample room for interpretation. Implementation of the RTS, which includes more detailed quantitative disclosures, has also been postponed several times and will now start to apply on 1 January 2023. In order to comply with the SFDR, we are still lacking accessible, definitive guidance and industry agreement on comprehensive quality data related to environmental, social and governance (ESG) investments. The complexity of the legislation, as well as the difficulty of gathering the required data means private equity firms are facing a lot of uncertainty with regard to SFDR reporting requirements of their Limited Partner (LP) firms.

ESG data struggles

Extensive ESG reporting is already essential for many LPs, despite the changing timeline and lack of alignment. SFDR’s quantitative PAI disclosures require larger LPs to report on 18 mandatory PAIs (including 9 environmental, 5 social, 2 sovereign and 2 real estate indicators) for direct and indirect investments for the year 2022. The reporting is based on quarter ends and must be published by 30 June 2023, requiring PAI data to be already gathered from private equity funds for FY 2022. If funds do not integrate PAI considerations in their investment approach, and while collecting and managing standardized data from a diverse range of portfolio companies, LPs face significant challenges with SFDR data compliance.

For FMPs with fewer than 500 employees, the SFDR allows them to choose between a “comply” or “explain” basis to publish a PAI statement on the due-diligence policies outlining the PAIs of their investment decisions on sustainability factors. Given most private equity companies have fewer than 500 employees, a significant proportion of the sector can opt out of the regime and disregard PAI issues altogether. Based on Deloitte’s analysis, most private equity companies have issued a negative PAI statement, i.e., “no consideration of PAI,” which suggests sustainability is still relatively low on their agenda, or they do not have the processes in place to gather the relevant data to consider these impacts. Complying with SFDR is vital for private funds to protect their reputation, attract investors who want to allocate their money sustainably, and meet the data demands of their LPs.

By contrast, most institutional investors (like LPs) employ more than 500 people and are therefore obliged to issue information on adverse impacts, leading to a positive PAI statement, i.e., “consideration of PAIs.” In the case of insufficient data, LPs must conduct “best efforts” to ensure that the data is made available, using sources such as engagement with investee companies themselves, their own research, third-party data providers or reasonable assumptions. One common misunderstanding that we observe is that PAI data only apply to sustainable funds. However, as the PAI reporting applies on entity levels, it aggregates all sustainable and non-sustainable products. As a result, private equity companies will face multiple requests for fund PAI data from LPs who are obliged to collect and aggregate the information. ESG has become an integral part of the investment decision-making process for LPs, and it is unsurprising that General Partner (GPs) routinely receive extensive questions focusing on various ESG-related themes. Adding to the complexity, GPs actually attempt to answer these questions while many LPs are still working out what exactly they are looking for and why it is important to them.

Entities use different approaches to sourcing the data, causing significant discrepancies in the PAI indicators reported by similar funds. Without easily available and comparable data and appropriate guidance from regulators, private equity firms may be using different information based on unrelated criteria, making it difficult for investors to rely on and compare the data disclosed.

Companies’ sustainability reporting under CSRD could serve as a potential data source for investor PAI reporting under the SFDR. The new directive (first draft published in April 2021) will amend and enhance the existing sustainability reporting requirements stipulated by the Non-Financial Reporting Directive (NFRD). It will not only significantly expand the companies in scope but also introduce harmonized reporting standards developed by European Financial Reporting Advisory Group (EFRAG). However, the timelines of the SFDR and the CSRD are not aligned: ESG reporting for the latter is not required until 2025 (for FY 2024) for most portfolio companies.

Regulation complexity and uncertainty

Private equity firms’ challenge in sourcing ESG data from private holdings is further exacerbated by a lack of clarity in the regulation’s language. Ambiguities and uncertainties remain, whether it is how products are classified (using Articles 6, 8 and 9) or the way the regulation applies to some firms and products.

While the SFDR is a disclosure regulation and shall provide greater transparency about ESG factor integration, discussions about potential minimum requirements for sustainable products (i.e., for Article 8) are ongoing. Without a clear definition, we see a wide range of interpretations and further confusion among investors. SFDR requirements are complemented by reporting requirements from the EU Taxonomy, but neither provide clear criteria, definitions for eligible investments or minimum strategies for so-called ”light green” financial products. Even the regulator pointed out that the effectiveness of the strategies varies significantly among “light green” financial products.

It is essential for private equity firms to implement sufficient processes that will allow them to determine where they can access all necessary ESG data and navigate data costs and how to integrate scoring into their portfolio systems. That said, non-financial portfolio companies must also embrace a more professionalized approach to ESG data management to satisfy investor demand for SFDR-compliant data. Including comprehensive ESG data in the due-diligence work has gone from being a “nice-to-have” to more of a “must-have for both GPs and LPs. Now it is up to private equity firms to implement the necessary processes, frameworks, systems, and data to meet these requirements. This is especially vital, as the private equity sector has a pivotal role in the transition to more environmentally and sustainable economy.