Private Equity & SFDR: a new frontier for the industry?
15 January 2021
Appetite among private equity (PE) firms for integrating ESG considerations is not a new phenomenon. Over 500 PE houses are signatories to the Principles for Responsible Investment (PRI), and there is growing recognition that ESG factors can offer a competitive advantage in the market.
Increasingly, regulatory drivers are also front of mind. In particular, firms are focused on the imminent implementation of the EU’s Sustainable Financial Disclosure Regulation (SFDR), which takes effect from 10 March 2021.1
While the regulation hasn’t been included as part of the Brexit onshoring process by the UK Government, many UK-based firms are likely to remain in scope of the requirements in their capacity as Alternative Investment Fund Managers (e.g. when marketing funds into the EU or managing EU-based funds). Greater scrutiny of the ESG credentials of funds by Limited Partners (LPs) is pushing many in the market towards voluntary adoption.
Navigating PAI(n) points
PE firms are grappling with a number of challenges when implementing SFDR, notably the requirement to disclose the principal adverse impacts (PAIs) of investment decisions on sustainability factors. While most PE houses will not be required to adhere to the rules on a mandatory basis2, a number of firms are taking the strategic decision to comply voluntarily.
The key issue here will be data. Although PE firms are well versed in obtaining data from portfolio companies directly, the type and breadth of information needed to report against PAIs are likely to present challenges. PE houses will need to rely on bespoke information requests and bilateral engagement to collate data, which are time consuming and costly. Even once the relevant data is obtained, inconsistencies in approaches to data collection, data quality and disclosure between portfolio companies may create further hurdles when it comes to ensuring the data is comparable.
From challenges to solutions - what should PE firms be thinking about now?
ESG regulation will remain a priority for PE houses over 2021, and firms will need to invest in finding solutions for implementing new requirements and overcoming challenges, including those related to SFDR. Here are some key areas that firms should be focussing on in order to get on the front foot:
- Know your place: PE houses should get comfortable with where they fall in scope of SFDR obligations at entity and fund level, especially if they retain a presence in the EU or have EU-based LPs.
- Consider a phased approach to PAIs: As this requirement is likely to be voluntary for most PE houses, firms may look to take a staged approach whereby they initially publish a statement in March 2021 explaining that they aren’t required to disclose against the rules, but then introducing the reporting at a later date. This approach can provide firms with additional time to establish effective processes for data collection and calculating the impact of PAIs on sustainability factors.
- Reflect on your product ambitions: Finally, PE houses will need to assess which of SFDR’s product categories will apply to which funds, including any future fund raises and legacy funds. Although the regulation is unclear on how the product-level requirements will apply to legacy funds, firms are of the view that they will be relevant in the context of ongoing reporting, on the basis that LPs are likely to want clarity on these funds’ ESG performance over time.
SFDR represents a new and potentially daunting frontier for PE houses, but the clock is ticking, and many firms are already making headway with their implementation plans. Those that aren’t will need to act fast, not only to ensure regulatory compliance, but to keep up with the competition.
1 While the majority of provisions under SFDR will enter into force on 10 March 2021, there are some exceptions, mainly in relation to ongoing reporting requirements. The mandatory requirement for larger firms to disclose against the PAIs commences from 30 June 2021, while product-level disclosures against PAIs will need to be made by 30 December 2022. Periodic reporting requirements for Article 8 and Article 9 products apply from 1 January 2022.
2 The PAI obligation operates on a ‘comply or explain’ basis from March 2021, unless a PE firm has more than 500 employees or is a so-called ‘qualifying parent undertaking’ (per Article 3(7) of Directive 2013/34/EU), in which case it will become mandatory from 30 June 2021.