Private equity sponsors have become more accepting of the EU Sustainable Finance Disclosure Regulation (SFDR), largely driven by increasing demand from investors for ESG-related products.
Since the implementation of SFDR in March 2021, private equity sponsors have recognized that complying with it can lead to value creation by uncovering weaknesses in portfolio company operations, and help with fundraising, since many investors consider ESG factors when making allocation decisions.
To help evaluate portfolio companies and better comply with SFDR, more private equity managers are creating ESG committees or advisory boards.
Ruth Knox, a partner at Kirkland & Ellis, says the committees also enable data compilation and investment analysis.
“I think it’s more prevalent amongst the larger private capital managers compared to the mid-market and the smaller players. But it’s very much a trend,” she notes.
Michael Newell, a partner at Cadwalader Wickersham & Taft, notes that ESG advisory boards or committees provide insight to the investment and risk committees to make sure the investment decisions they’re making comply with a firm’s sustainability objectives, as well as enabling ongoing review of the portfolio.
“Having people with significant backgrounds in ESG is quite a sensible way to build oversight and compliance with the sustainability objectives into the investment process, not just to ensure compliance with the letter of the regulation but also with the spirit of it,” he says.
Hari Bhambra, global head of compliance solutions at Apex, predicts that ESG advisory boards or committees will become more common once a strategy becomes more defined or more sophisticated with key investors.
Getting ahead of regulation proliferation
SFDR requires specific firm-level disclosures from asset managers and investment advisers regarding how they address sustainability risks and “principal adverse impacts.”
Asset managers are also required to disclose remuneration policies related to the integration of sustainability risks. Sustainability risks refer to environmental, social or governance events, or conditions, such as climate change, which could cause an actual or a potential material negative impact on the value of an investment.
Principal adverse impacts are any negative effects that investment decisions or advice could have on sustainability factors, such as a business that significantly contributes to carbon dioxide emissions, has poor water, waste or land management practices, or lacks board diversity.
Since its implementation, SFDR has become the mainstay of European fundraising for both EU and non-EU fund managers as every fund manager marketing into Europe has to account for it in their compliance processes.
Additionally, companies outside the EU that wish to attract capital from EU investors will have to report the respective data and key performance indicators to the fund management companies, since SFDR also applies to investments outside the EU.
Knox adds that as the benefits of compliance are understood, and more investors are demanding ESG data and products, private equity firms are taking a more nuanced approach to and greater willingness to manage compliance with SFDR regulation.
And ESG regulation is only proliferating, Knox notes.
“Now we’re seeing equivalent regimes emerging in other major jurisdictions. So yes, more firms are accepting of SFDR and getting used to its requirements, and in light of the emergence of applicable regimes in other jurisdictions,” she adds.
SFDR doesn’t have to be a burden
SFDR does create a significant administrative burden for fund sponsors.
As Newell explains, it is particularly difficult for non-EU managers to decide how much they have to embed relevant sustainability criteria in their processes and procedures to the same degree as an EU-based manager.
“You have to comply with the pre-investment disclosure requirements, include a certain amount of reporting annually to your investors in the EU, and you have to make separate regulatory filings to the EU regulators to whom [Nation Private Placement Regime] applications have been made (a similar pattern to current AIFMD disclosure),” Newell notes.
According to Alex Di Santo, group head of private equity at Crestbridge, with the right processes in place, SFDR compliance doesn’t have to be burdensome: the regime allows fund managers to effectively opt out of reporting on principle adverse impacts if they have less than 500 employees. Most private equity firms globally qualify by that description.
A significant proportion of the sector has actually opted to do so, especially those that do not yet have the processes in place to gather relevant data to consider such impacts, Di Santo says.
Michael James, a partner at Cleary Gottlieb, states that when SFDR came into effect, some parts of the industry were approaching it as a tick-the-box exercise and were concerned SFDR was very much an administrative burden.
“That has developed a little bit and the industry is significantly more nuanced now in their views and approach to SFDR,” James says. “Clients are taking SFDR very seriously at the outset of a fund and thinking very deeply about what they want to project for their fund.”