This article is sponsored by Apex Group.
How are investors demands for transparency and ESG reporting evolving?
The first word that comes to mind is rapidly. In the three years that I have been involved with this, the speed with which the market has moved is incredible. That is in part driven by regulation, and of course the EU’s Sustainable Finance Disclosure Requirement (SFDR) is the primary legislation of the moment. That has caused investment managers to sit up and recognize that if they are going to talk about themselves in relation to sustainable impact, they are going to be scrutinized and need to think about demonstrating that impact.
The requirements around ESG reporting, transparency and data collection are increasing, and the demands of SFDR continue to escalate. One recent report in Morningstar suggested that as many as 1,500 funds have declassified from Article 8 and Article 9 of SFDR because they acknowledged the scale of the data collection and reporting challenge for underlying entities and didn’t feel they could achieve it. That just demonstrates the scale of what is required.
So investor demands are increasing as a result of regulation, but they are also ultimately answerable to their own customers, whether those are individual investors, pension holders or whoever. We all want to know exactly where our money goes and we want to understand that if our pension is in a sustainable fund, we know what that means. We as customers are putting demands on pension funds and expecting the data to reach us from the underlying companies that GPs are investing in and lending to. The scrutiny starts with us and goes all the way through the financial supply chain to those companies.
Ultimately, we need to get to a position where companies have an understanding of an achievable level of ESG data that they need to report, because right now there are very mixed messages. Some LPs are extremely demanding on their underlying funds, while others aren’t requesting any ESG data. It is not a level playing field but demands are only going one way and transparency is key. We are trying to help investment managers introduce rigorous data collection, and we can then evaluate that information and score it for them.
How is SFDR in Europe impacting the focus on ESG across global private markets?
SFDR is having a fantastic impact, for all the right reasons. The impact goes beyond Europe, which is really exciting. I had a call today with an Asian impact fund that wants to align itself with global best-in-class disclosure requirements, and they consider Article 9 to be the most rigorous standard out there. So they have no requirement to do so but they want to align with the reporting requirements of Article 9 funds under SFDR as the global benchmark.
We are seeing the same reaction from funds in the US and the Middle East. We are working with a fund in the Middle East that has asked us to do an Article 8 alignment assessment, because again they want to align with the best possible reporting framework for their type of fund.
“SFDR is having a fantastic impact, for all the right reasons. The impact goes beyond Europe, which is really exciting”
There is a reason behind that, of course, which is that a lot of these funds will be looking for investment from the EU next time they fundraise. Even if they are sitting outside the EU, if they are looking to raise capital from investors in the EU then they become liable to report in line with however they identify themselves by category. The flow of money being so global does mean that the effect of SFDR extends far beyond Europe.
Meanwhile, we also see the US and the UK implementing their own legislation, each underpinned by a set of global standards aligned with the Task Force on Climate-Related Financial Disclosures (TCFD). Our products support our clients in calculating data sets that are fully aligned to all these various regulations, and because they have a single common denominator our data sets can map to each of those regulatory frameworks as required. We focus on private markets, so everything we do is working with private funds to align more with SFDR, TCFD and other legislation as it unfolds.
What about the SEC’s proposals to facilitate transparency and standardization: how will those change the way private markets approach ESG?
The SEC is going to bring the regulatory disclosure and scrutiny into the US, and funds are not going to have a choice. We are seeing funds in the US choosing to align themselves with the categories the EU uses today because they want to get the best-in-class standards in place. Some of that is because they are aware of what the SEC is eventually going to ask them to do, so they are starting to get prepared for when they fall under this regulation.
All of this is going to make more private equity and private debt funds focus on collecting relevant ESG data on their underlying companies, and that can only be a good thing. But the number of funds that we have interacted with that are initially collecting data for a reporting purpose and are not yet thinking about how to use that data for a positive purpose is quite high.
Still, once we start to show those funds the improvement companies are making and the way companies are buying into this ever-increasing acknowledgement of the importance of ESG, then they very quickly start to get behind it and get interested and vocal about tracking how companies are improving.
A good number of funds start off saying it is up to the companies to run this, and then we work with the companies and go back to the funds with data, only for them to see how much progress is being made on carbon footprints, for example, and get engaged. It becomes almost self-fulfilling and we start to be able to show a greater impact of our goods and services, which is what it is all about.
Where do you expect GPs and LPs to be focusing their ESG attention in 2023? What should managers be making the top priority?
We are seeing much more interest from managers in SFDR Level 2 reporting. SFDR has now been in existence for nearly two years, so people have had time to think about what they want to be, how they want to be categorized, and to understand the level of scrutiny and the level of data required. We are beginning to see a set of best practices in the market, for example in relation to data convergence projects, where LPs and GPs are coming together to define what information is most important.
One use case for the methodologies that we use is that we can send data off to the Data Convergence Project, because we are supporting that consolidation effort to focus on the same KPIs. I talk to GPs that get in excess of 25 different LP ESG questionnaires and have to fill them all in differently at the moment. They are all asking for the same information in a different way, which requires a team just to answer those requests.
What we need is a consolidated approach, and my sense is we are beginning to get a little more aligned but there is still a long way to go. We also work with BlackRock’s eFront Insight, which is another LP-driven reporting solution looking to collect data on companies.
We can step in and become the GP’s outsourced data collector, and then we can work with them to extract information from underlying companies, put that data into systems so that the GP can report, and share meaningful insights from that data.
In terms of focus, we expect 2023 to see more of the same – more funds are understanding how to shift from Article 6 to Article 8 and are stepping up their capabilities. We are already seeing a huge number of funds bringing in ESG professionals, setting up sustainability committees, and launching more Article 8 and Article 9 alignment assessments before heading down those routes, and more of that will inevitably unfold through the year ahead.
What recent developments have there been in ESG across different asset classes in the private markets?
Private equity was really the first asset class out of the starting blocks in private markets. Now we are seeing a rapid catch-up from private credit funds. There was a feeling that because they were private credit, they did not have the same level of interaction with underlying entities, their facilities were revolving a bit more and therefore they could not make the same impact. But regulation has said they have to disclose in the same way as private equity if they are an Article 8 fund, or provide a very good reason why not.
Credit funds are now coming to us asking for help in collecting data on their portfolios of borrowers. That has been an interesting challenge for us. In credit portfolios it is often very exciting when they start wanting to talk about creating policies and approaches to drive change.
Similarly, in infrastructure we see quite a significant number of Article 8 and Article 9 funds already. We are doing more and more work with firms launching Article 9 funds around taxonomy eligibility pre-investment, and taxonomy alignment at pre-investment and ongoing. That is because they have to be able to report on taxonomy alignment in the portfolio going forward, so we are working with a lot of green infrastructure funds.
There is also a lot of talk about ESG in real estate, where we don’t see much activity at the moment but where there is certainly more and more pressure to be able to collect relevant ESG data. Real estate ESG relies on buildings becoming much smarter, and there is a lot of work going on around technology to address energy consumption, all of which creates data that is becoming more useful for real estate investors.