Private fund investors struggle with EU SFDR’s ‘moving goalposts’

There is confusion around the role of European sustainable finance regulations, say investors and advisers.

The EU Sustainable Finance Disclosure Regulation, which came into effect early last year, requires investment managers to make certain disclosures about their approach to environmental, social and governance matters. Managers decide whether they want to classify themselves as: Article 6, the least stringent set of requirements; Article 8, which requires a greater degree of disclosure and reporting; or Article 9, the ‘greenest’ classification, which requires detailed disclosures and an investment strategy with sustainable objectives.

While the regime is technically in effect, confusion reigns.

“We are still in a state of flux,” said Alison Hampton, the founder of sustainability consultancy Alma Verde Advisors. “Everyone is proceeding towards implementation, while we are still waiting for final sign off for key parts and planks of the regulation,” she told delegates at the Impact Investor Global Summit in May 2022.

Michael Johnson, a regulatory expert with consulting firm KPMG, said at the same event: “One year on from implementation day and we are still seeing a huge amount of inconsistency across the market in terms of how firms have implemented… particularly on fund classification.”

“Even at this late stage, the European authorities are moving the goalposts,” continued Johnson, noting that there is “still no final-final” version.

One longtime European general partner, speaking privately on the sidelines of the conference, said they were currently pre-marketing an energy transition fund but were unsure whether to commit the fund to being Article 8 or Article 9. They are not alone in this uncertainty.

To upgrade or not to upgrade?

EQT is marketing a €4 billion long-hold private equity fund that it describes as “impact-driven”. The fund has a number of sustainable characteristics, including carried interest linked to various sustainability targets. Having started marketing as an Article 8 fund, the firm is now considering upgrading its classification. “The assessment initially was that it was not difficult to become an Article 9 fund,” said Rikke Kjær Nielsen, partner at the firm, “[but] it is probably more difficult to remain an Article 9 fund and live up to the reporting requirements that you don’t know.”

Schroders Capital, an asset manager with multiple private markets strategies, is committing any impact-focused products it is currently raising to be Article 9. For fund of fund products – where capital is committed to third party managers – this means finding partners prepared to align themselves with Article 9 disclosure levels. “As such,” said Amara Goeree, private equity sustainability director at Schroders Capital, “we are looking for fund managers that – if it is a fund investment – also have Article 9 or very nearly equivalent reporting of the framework and the target KPIs. That is still something that is quite complex; there really has to be a lot of alignment in the strategy.”

Why “very nearly equivalent”? Because, said Goeree, “there are some managers we are talking to that are still hesitant to become Article 9 funds, but they are set up in such a way that they could at least market it to investors in that manner.” It is “just the risk averse” approach to SFDR, added Goeree: firms not wanting to over-commit.

The European authorities are creating “tramlines” around different sustainability strategies, said Ruth Knox, an ESG and impact partner at law firm Kirkland & Ellis, “but it is not standardized” and the understanding of what constitutes Article 8 and Article 9 “is still evolving.”

“We have a baseline understanding,” said Knox, “but it’s still coming through the works. It is going to take at least another 18 months to two years before there is a relatively settled understanding.”

Tied to the issue of hazy definitions is another point of contention: will a fund’s status under the regime be used by investors as a label to help them decide which funds are sustainable and which are not?

EU SFDR is not intended as a labeling regime; it is all about disclosure, say experts.
“It is meant to provide investors with as much information as possible to be able to make informed decisions: to have a good idea about what the manager and the product is doing,” said Silva Deželan, ESG director at private markets firm Stafford Capital Partners. “These are not labels – it is self-assessment.”

A ‘labelling’ system

However, what started out as a disclosure-focused regime is – as certain minimum requirements are introduced – starting to look a little more like a labeling system, said KPMG’s Johnson.

“Whether deliberately or not, these classifications are actually operating as ‘labels’, and of course firms are keen to attract the capital that comes with having the right label,” wrote Simon Witney, a senior consultant with law firm Travers Smith, on affiliate title New Private Markets in November.

And this, according to Alma Verde’s Hampton, is what the market wants. “I feel many people desperately want it to be a label, a ‘Kitemark’, to be able to put a badge on what they are doing,” she said.

Indeed, even if the intention for the regime is all about disclosure and reporting, there is a sense that it will start to be used in investor decision-making – a sustainability or impact investing label in everything but name.

“It is not a firm and fast rule right now that to have an impact investment fund or GP you must be Article 9,” said Matt Christensen, global head of sustainable and impact investing at Allianz Global Investors, “[but] I think it could go that way.”

Indeed, fund of fund investors such as Schroders who chose to designate their products as Article 9 will, by virtue of their data reporting needs, seek out Article 9 GPs to back.
GPs seem to be anticipating this; they have shifted their mindset, according to KPMG’s Johnson, from one of “baseline compliance” to product design and strategy. Previously, KPMG was being asked to “figure out what’s in scope, produce the disclosures, job done,” said Johnson. “More recently, we have had firms come to us ahead of new fundraises and say: ‘We really want [our fund] to attain Article 8 or Article 9 status; help us make that happen.’”

Article 9 may well become an unintended labeling regime, something which many market participants will welcome. For the moment, however, confusion reigns.