SFDR’s impact on Private Equity managers

The SFDR^[1] is a transparency exercise which requires standardized disclosures on sustainability topics at product and at entity levels^[2]. Composed of two levels, level I of SFDR already entered into force as of 10 March 2021, and level II, supplemented by Regulatory Technical Standards (RTS) is applicable as of 1 January 2023. Market participants have been requested by the local regulator to provide the RTS already by 31 October 2022, to allow the regulator to comment, review and ensure the approval by 1 January 2023.  

Where managers of traditional financial products found a certain alignment around SFDR with upcoming filings and reporting, alternative products managers such as private equity (PE), are still struggling to update their investment strategy to include ESG characteristics, monitoring and reporting, which will impact their distribution capacity as well as their brand image. The lack of clear definitions by the regulations coupled with poor ESG data quality, have led alternative managers approach the SFDR cautiously, in order to avoid over-commitments with the risk of product reclassification in the coming months.

The PE industry is poised to make a significant impact, as funds are traditionally more involved in the decision making process of their investee companies and are strategically positioned to advance the transition towards ESG integration. PE firms with a sustainable investment strategy use binding sustainability criteria to select their investments, and are able to deploy capital across the whole industry spectrum to achieve multiple environmental and social targets through portfolio companies. However, questions remain on how to determine the overall sustainability performance of investees and investment products and what are the minimum thresholds for asset allocation and risk management, accounting for capital expenditure plans over time. As a market practice, it is expected that E/S characteristics apply to a minimum of 75–80 percent of eligible assets and to 100 percent of sustainable investments for article 9 products, although the ESG data coverage observed is often lower. 

In addition, due to the lack of clear definitions by the RTS, PE managers are struggling with their products’ SFDR classification. 

For example, a good solution for article 9 products is to also use the 17 UN Sustainable Development Goals (SDGs) to assess and measure the E or S objectives and contributions for PE managers. Nevertheless, through the sustainable investment objective the actors need to demonstrate how they are contributing to the respective objective, by means of relevant sustainability indicators or by using an index that has been designated as a reference benchmark. 

Generally, PE firms employ in-house questionnaires to gather sustainability metrics data from their individual portfolio, and use this internal information to construct proprietary non-financial performance benchmarks. Subsequently, these in-house benchmarks are used to screen the financial and non-financial performance of portfolio companies, determining a comparable ESG score among investments, and to evaluate the ongoing status of the firm's sustainability.

Some PE firms choose to report on PAI to increase the ESG performance of their products and better address investors’ expectations, for example. Data is required from their individual portfolio and product investments which need to be aggregated at portfolio level. Some examples of chosen PAI are greenhouse gas emissions, hazardous waste, biodiversity etc. 

To ensure compliance, PE actors need to have well-defined metrics that are monitored and reported. Therefore, in the Due Diligence (DD) phase they need to verify that the investee company can report on the required metrics and that these metrics can be included in wraps and warranties. Active monitoring also includes divestment decisions in case of underperformance of the investee company, an additional obligation that could be covered from the DD phase.

While traditional financial products are mainly using ESG data providers, the private market is still figuring out an alternative. With an increasing demand from investors and regulators to disclose sustainable metrics, data management is the main challenge of private market players.

Due to the diversified investments of PE funds, tracking the ESG performance of portfolio companies requires a more holistic approach, employing standardized measurement metrics across the entire investee spectrum to determine the sustainability of the fund. The ESG Data Convergence Initiative identified core ESG metrics for portfolio companies to report on, standardizing the reporting and measurement methodology. Furthermore, monitoring the sustainability performance of portfolio companies includes measuring the compliance with AML, KYC and good governance practices, as defined by the SFDR. Ultimately, the establishment of common sustainability reporting practices allows for the comparison of the sustainability performance across portfolio, funds and investment firms, increasing the overall transparency of the industry.

At the exit level, PE companies can leverage the sustainability characteristics of their investments and the intrinsic value of impact investing to achieve better financial performance. However, the role of ESG characteristics in the valuation exit approach is still undefined. Specifically, it is unclear whether sustainable investments should be appraised at a higher value, applying a "green premium", or non-sustainable investments should be penalized through a valuation discount.

Integrating sustainability in the investment strategy through the SFDR was due to be bumpy, with risk adverse approaches rather than opportunistic ones. As the regulatory framework strengthens and market practices evolve, there is ground for optimism as alternative players will have access to more ESG data and performance measurements to avoid greenwashing and achieve the wider ambitions of the Paris Agreement.

This article was written in collaboration with Charlene Meyer and Domenico Pallotta.

[1] Sustainable Finance Disclosure Regulation, EU 2019/2088

[2] The RTS specifies the details and content and presentation of the information in precontractual documents and periodic reports (specific templates for SFDR Article 8 products and specific templates for SFDR Article 9 products); product level website disclosures (no templates are provided by the RTS, however the requirements are laid out for SFDR Art 8 products and SFDR Art 9 products). The publication of the Principal Adverse Impacts Statement (PASI) requires disclosures that does not distinguish on how a product is classified. However, as it regards the quantitative reporting on Principal Adverse Impacts (PAI) KPIs – KPIs will differ depending on the asset class.