The speed and volume of sustainability regulation has strategic and operational consequences for alternative asset managers, says Simon Witney, Senior Consultant, Travers Smith.
Regulation is becoming an important driver of change, of course, but the dramatic shift that we have seen over the last few years towards more responsible investment in private markets has not been driven by regulation. In our view, there are two main catalysts: first, a gradual realisation, by both fund managers (GPs) and investors (LPs), that ESG – that is, integration of environmental, social and governance factors in investment decision-making and stewardship – can be a value item.
As society has changed, and as public policy has changed, many aspects of the ESG agenda now make a material difference to risk and return. That may be especially true in private markets, where investors often have longer hold periods and are focused on ultimate realisation. If something affects exit value, it matters.
Second, LPs have demanded more. They care more about a range of sustainability issues, especially climate change and diversity and inclusion, and have asked for more data – and for evidence of positive impact. As investors are a GP’s most important stakeholder, alternative asset managers have responded. So the industry is already changing, and regulation has been playing catch up.
The Sustainable Finance Disclosure Regulation
EU lawmakers have been in the vanguard of this regulatory change, but they have more work to do to make the rules work effectively – and they know that. It is perhaps not surprising – given the speed at which the European Commission and the regulators have developed their rulebooks, and the political compromises that are needed to get legislation through the Parliament and the Council – that the rules are not yet working as intended.
The biggest implementation challenge for most firms so far has been the Sustainable Finance Disclosure Regulation (SFDR). That has been hard for at least two reasons. First, the SFDR is, as the name suggests, a disclosure regime. However, because the disclosure obligations are determined by a product’s categorisation, it has inevitably become regarded as a product labelling regime.
Many European investors are now demanding that private funds categorise themselves as Article 8 or even Article 9 products. Article 8 is increasingly becoming the default for many buyout and private debt funds. Some investors are looking for an Article 9 categorisation for impact-style funds, even though the EU’s definition of those funds could restrict GP investment discretion in ways that LPs don’t yet fully understand and may not want.
Firms are, therefore, trying to work out how they accommodate that investor preference, without over-selling their ESG credentials and creating an unsustainable, and prohibitively expensive, ongoing compliance burden. These firms are acting responsibly: they need to respond to the market demand, but they do not want to over-promise and they are aware that compliance with some aspects of the rules will be hard, perhaps even impossible, at the moment.
Meanwhile, the European regulators have realised that there is a problem: that investors are at risk of being misled by these disclosure categories, believing them to signify more than they do. They are now trying to course correct.
Part of that course correction will involve the application of minimum standards to Article 8 and Article 9 funds, which turns the disclosure regime into something that is more like a labelling regime. But that will take time and, in the meantime, the authorities are focusing on other ways to limit and expose ‘greenwashing’.
Regulators already have ways to fine and sanction firms who oversell their green credentials, of course, and that will be easier to do now that firms are being forced to make ESG disclosures in regulatory filings. That means that full and fair disclosure about sustainability in fund documents is even more important.
In our view, paying close attention to what is said about ESG in marketing materials – and making sure that commitments can be, and are, delivered after closing – should be a major focus for legal and compliance teams.
The second main reason that SFDR is a headache to implement is that it is a one-size-fits-all regulation, with rules that are hard to understand and even harder to apply to closed ended, blind pool funds with illiquid underlying investments – which, of course, describes much of the private markets. Those problems are multiplied if you are a secondaries fund or fund of funds.
So, application of the rules will inevitably evolve, to some extent by additional guidance – we are expecting yet another set of clarifications in the coming months – and to some extent by the development of market positions, led by industry associations, which have become really important.
Negative externalities (PAIs) and the Taxonomy
We are seeing many firms commit to collect and report at least some so-called ‘principal adverse impact indicators’ – or PAIs – as they are somewhat rigidly defined under the SFDR and we expect that doing so will become the default for many firms. The PAIs (which are already under review by regulators, so may change next year) are essentially indicators for negative externalities and perhaps, in time, firms will also have to make a commitment to factor them into investment decision-making.
The EU’s Taxonomy – essentially a classification system for environmentally sustainable economic activities – is an incredibly ambitious (and politically charged) project, and it is far from finished. Taxonomy reporting is not easy, especially in private markets, but will increasingly be expected by European investors – who will be obliged to report under it themselves – so firms would do well to prepare for that.
These regulatory standards will have to be built into ongoing data collection and investor reporting processes, but also – to the extent that firms have made commitments in pre-contractual regulatory disclosures during fundraising – into pre-acquisition ESG due diligence.
Portfolio companies
The EU is also working on a range of significant rules that will affect portfolio companies, including, eventually, large non-EU companies that are doing business in the EU.
The Corporate Sustainability Reporting Directive (CSRD) and the Corporate Sustainability Due Diligence Directive (CS3D) are perhaps the most significant and are at different stages of development. The CSRD will be effective first and from 2025 will require a large number of private companies to assess and disclose their own Taxonomy alignment, as well as report on significant additional environmental, social and governance matters.
The CS3D is also significant and could also affect the fund itself, but is still under discussion by the EU institutions. When finalised, CS3D could require many companies (including many based outside the EU) to undertake pretty extensive value-chain due diligence to identify and, if found, mitigate environmental and human rights impacts. Its impact on investors is as yet unclear, but significant overlap with the SFDR is built into the current draft.
UK developments
The UK decided not to implement the EU’s SFDR and Taxonomy after it left the EU, choosing to develop UK-specific sustainability disclosure rules that would build on both EU and international standards.
Across the whole economy, the UK has prioritised climate change disclosures. Reports that are compliant with the internationally recognised TCFD (the Task Force on Climate-related Financial Disclosures) framework have been mandated for asset managers, along with many other financial and non-financial actors.
Private equity firms – including UK-regulated alternative investment fund managers (AIFMs), portfolio managers and adviser-arrangers – with over €5 billion of AUM (or assets under advice) will be in scope of these disclosure obligations. Those with over €50 billion will have to issue their first reports by June 2023.
Many firms are busy preparing for these mandatory disclosures – which will be at both entity and fund level – and focusing on collecting data from portfolio companies to enable them to comply, but some are preparing to report even before the rules require them to do so. TCFD is a disclosure framework that UK managers will need to get to grips with and even those currently out of scope should consider whether they want to step up. The Invest Europe and Initiative Climate International (iCI) guides will be helpful resources for private equity firms and the Alternative Investment Management Association guide is also helpful for other private funds managers.
Assuming that the new prime minister does not change tack, there is more to come in the UK. For example, an expert group is working on a UK-version of the EU Green Taxonomy. They will use the same underlying framework as the EU, but with some potentially important differences in the detailed rules that determine whether an economic activity can be labelled as “green”.
Alongside that, development of a UK version of the SFDR is continuing, although the change in government, among other things, has delayed publication of final proposals. Assuming those proposals do emerge in the autumn, it is expected that – unlike the TCFD – the UK’s sustainability disclosure regime will adopt a “double materiality” approach, requiring firms to disclose the negative adverse impacts of the activities of their portfolio companies in a way that is likely to build on the SFDR’s PAI regime. However, the UK’s Financial Conduct Authority (FCA) has learned lessons from the experience of the SFDR and will develop a standalone labelling regime, with minimum standards for green products baked-in from the outset.
The alternatives industry has urged the regulator to make sure that these work for private capital, but it remains to be seen whether they will heed that request.
The FCA is also able to use its existing rules to fine firms that are guilty of ‘greenwashing’, but so far has focused on the retail market.
US developments
The US Securities and Exchange Commission (SEC) is even further behind, but is now planning to introduce disclosure rules of its own, following some high profile SEC investigations. Although the new rules will be less demanding for private fund advisers (including non-US ‘exempt reporting advisers’) than for registered funds, they will require more ESG disclosures in a firm’s regulatory ADV filing.
As in the EU, the required disclosures will depend on a fund’s classification and the categories, although seemingly better defined than the SFDR’s Article 8 and 9, have come in for criticism for being too broad. For example, an ‘ESG-integration fund’ – the ‘entry-level’ category – could capture just about any financial product that undertakes an assessment of sustainability risk, arguably part of the fiduciary duty of all fund advisers.
Such an approach gives rise to the same ‘greenwashing’ risks as the SFDR, and the SEC may well refine its proposals before they are finalised.
How firms should respond
Regulation has the potential to drive more effective and consistent approaches to ESG in the alternative asset management universe. However, well-designed, proportionate, clear and internationally consistent regulation, if attainable at all, will take many years to emerge. In the meantime, a combination of industry initiatives – of which there are many excellent examples – and pragmatic approaches to complex and potentially duplicative rules will prevail.
First and foremost, every firm needs to be clear on its ESG positioning and get people on board with that position. That is the job of the senior leadership team. The job of ESG specialists and legal and compliance professionals is to advise the senior team on the implications of the position – including, for those firms that want to be very green, the possibility that the pay of senior staff could be impacted by whether the firm hits its green targets.
Knowing where your organisation stands is going to be essential in giving a clear message internally and externally so that your investors, your portfolio companies, your staff, your future talent, and your advisers know what to expect from your organisation – and what your organisation expects of them.
This article was co-authored by Tim Lewis, Head of Financial Services & Markets at Travers Smith.
ASSET MANAGERS, CSRD, DISCLOSURE, EUROPEAN COMMISSION, FCA, GREENWASHING, PRIVATE EQUITY, REGULATION, SEC, SFDR, TAXONOMY
The speed and volume of sustainability regulation has strategic and operational consequences for alternative asset managers, says Simon Witney, Senior Consultant, Travers Smith.
Regulation is becoming an important driver of change, of course, but the dramatic shift that we have seen over the last few years towards more responsible investment in private markets has not been driven by regulation. In our view, there are two main catalysts: first, a gradual realisation, by both fund managers (GPs) and investors (LPs), that ESG – that is, integration of environmental, social and governance factors in investment decision-making and stewardship – can be a value item.
As society has changed, and as public policy has changed, many aspects of the ESG agenda now make a material difference to risk and return. That may be especially true in private markets, where investors often have longer hold periods and are focused on ultimate realisation. If something affects exit value, it matters.
Second, LPs have demanded more. They care more about a range of sustainability issues, especially climate change and diversity and inclusion, and have asked for more data – and for evidence of positive impact. As investors are a GP’s most important stakeholder, alternative asset managers have responded. So the industry is already changing, and regulation has been playing catch up.
The Sustainable Finance Disclosure Regulation
EU lawmakers have been in the vanguard of this regulatory change, but they have more work to do to make the rules work effectively – and they know that. It is perhaps not surprising – given the speed at which the European Commission and the regulators have developed their rulebooks, and the political compromises that are needed to get legislation through the Parliament and the Council – that the rules are not yet working as intended.
The biggest implementation challenge for most firms so far has been the Sustainable Finance Disclosure Regulation (SFDR). That has been hard for at least two reasons. First, the SFDR is, as the name suggests, a disclosure regime. However, because the disclosure obligations are determined by a product’s categorisation, it has inevitably become regarded as a product labelling regime.
Many European investors are now demanding that private funds categorise themselves as Article 8 or even Article 9 products. Article 8 is increasingly becoming the default for many buyout and private debt funds. Some investors are looking for an Article 9 categorisation for impact-style funds, even though the EU’s definition of those funds could restrict GP investment discretion in ways that LPs don’t yet fully understand and may not want.
Firms are, therefore, trying to work out how they accommodate that investor preference, without over-selling their ESG credentials and creating an unsustainable, and prohibitively expensive, ongoing compliance burden. These firms are acting responsibly: they need to respond to the market demand, but they do not want to over-promise and they are aware that compliance with some aspects of the rules will be hard, perhaps even impossible, at the moment.
Meanwhile, the European regulators have realised that there is a problem: that investors are at risk of being misled by these disclosure categories, believing them to signify more than they do. They are now trying to course correct.
Part of that course correction will involve the application of minimum standards to Article 8 and Article 9 funds, which turns the disclosure regime into something that is more like a labelling regime. But that will take time and, in the meantime, the authorities are focusing on other ways to limit and expose ‘greenwashing’.
Regulators already have ways to fine and sanction firms who oversell their green credentials, of course, and that will be easier to do now that firms are being forced to make ESG disclosures in regulatory filings. That means that full and fair disclosure about sustainability in fund documents is even more important.
In our view, paying close attention to what is said about ESG in marketing materials – and making sure that commitments can be, and are, delivered after closing – should be a major focus for legal and compliance teams.
The second main reason that SFDR is a headache to implement is that it is a one-size-fits-all regulation, with rules that are hard to understand and even harder to apply to closed ended, blind pool funds with illiquid underlying investments – which, of course, describes much of the private markets. Those problems are multiplied if you are a secondaries fund or fund of funds.
So, application of the rules will inevitably evolve, to some extent by additional guidance – we are expecting yet another set of clarifications in the coming months – and to some extent by the development of market positions, led by industry associations, which have become really important.
Negative externalities (PAIs) and the Taxonomy
We are seeing many firms commit to collect and report at least some so-called ‘principal adverse impact indicators’ – or PAIs – as they are somewhat rigidly defined under the SFDR and we expect that doing so will become the default for many firms. The PAIs (which are already under review by regulators, so may change next year) are essentially indicators for negative externalities and perhaps, in time, firms will also have to make a commitment to factor them into investment decision-making.
The EU’s Taxonomy – essentially a classification system for environmentally sustainable economic activities – is an incredibly ambitious (and politically charged) project, and it is far from finished. Taxonomy reporting is not easy, especially in private markets, but will increasingly be expected by European investors – who will be obliged to report under it themselves – so firms would do well to prepare for that.
These regulatory standards will have to be built into ongoing data collection and investor reporting processes, but also – to the extent that firms have made commitments in pre-contractual regulatory disclosures during fundraising – into pre-acquisition ESG due diligence.
Portfolio companies
The EU is also working on a range of significant rules that will affect portfolio companies, including, eventually, large non-EU companies that are doing business in the EU.
The Corporate Sustainability Reporting Directive (CSRD) and the Corporate Sustainability Due Diligence Directive (CS3D) are perhaps the most significant and are at different stages of development. The CSRD will be effective first and from 2025 will require a large number of private companies to assess and disclose their own Taxonomy alignment, as well as report on significant additional environmental, social and governance matters.
The CS3D is also significant and could also affect the fund itself, but is still under discussion by the EU institutions. When finalised, CS3D could require many companies (including many based outside the EU) to undertake pretty extensive value-chain due diligence to identify and, if found, mitigate environmental and human rights impacts. Its impact on investors is as yet unclear, but significant overlap with the SFDR is built into the current draft.
UK developments
The UK decided not to implement the EU’s SFDR and Taxonomy after it left the EU, choosing to develop UK-specific sustainability disclosure rules that would build on both EU and international standards.
Across the whole economy, the UK has prioritised climate change disclosures. Reports that are compliant with the internationally recognised TCFD (the Task Force on Climate-related Financial Disclosures) framework have been mandated for asset managers, along with many other financial and non-financial actors.
Private equity firms – including UK-regulated alternative investment fund managers (AIFMs), portfolio managers and adviser-arrangers – with over €5 billion of AUM (or assets under advice) will be in scope of these disclosure obligations. Those with over €50 billion will have to issue their first reports by June 2023.
Many firms are busy preparing for these mandatory disclosures – which will be at both entity and fund level – and focusing on collecting data from portfolio companies to enable them to comply, but some are preparing to report even before the rules require them to do so. TCFD is a disclosure framework that UK managers will need to get to grips with and even those currently out of scope should consider whether they want to step up. The Invest Europe and Initiative Climate International (iCI) guides will be helpful resources for private equity firms and the Alternative Investment Management Association guide is also helpful for other private funds managers.
Assuming that the new prime minister does not change tack, there is more to come in the UK. For example, an expert group is working on a UK-version of the EU Green Taxonomy. They will use the same underlying framework as the EU, but with some potentially important differences in the detailed rules that determine whether an economic activity can be labelled as “green”.
Alongside that, development of a UK version of the SFDR is continuing, although the change in government, among other things, has delayed publication of final proposals. Assuming those proposals do emerge in the autumn, it is expected that – unlike the TCFD – the UK’s sustainability disclosure regime will adopt a “double materiality” approach, requiring firms to disclose the negative adverse impacts of the activities of their portfolio companies in a way that is likely to build on the SFDR’s PAI regime. However, the UK’s Financial Conduct Authority (FCA) has learned lessons from the experience of the SFDR and will develop a standalone labelling regime, with minimum standards for green products baked-in from the outset.
The alternatives industry has urged the regulator to make sure that these work for private capital, but it remains to be seen whether they will heed that request.
The FCA is also able to use its existing rules to fine firms that are guilty of ‘greenwashing’, but so far has focused on the retail market.
US developments
The US Securities and Exchange Commission (SEC) is even further behind, but is now planning to introduce disclosure rules of its own, following some high profile SEC investigations. Although the new rules will be less demanding for private fund advisers (including non-US ‘exempt reporting advisers’) than for registered funds, they will require more ESG disclosures in a firm’s regulatory ADV filing.
As in the EU, the required disclosures will depend on a fund’s classification and the categories, although seemingly better defined than the SFDR’s Article 8 and 9, have come in for criticism for being too broad. For example, an ‘ESG-integration fund’ – the ‘entry-level’ category – could capture just about any financial product that undertakes an assessment of sustainability risk, arguably part of the fiduciary duty of all fund advisers.
Such an approach gives rise to the same ‘greenwashing’ risks as the SFDR, and the SEC may well refine its proposals before they are finalised.
How firms should respond
Regulation has the potential to drive more effective and consistent approaches to ESG in the alternative asset management universe. However, well-designed, proportionate, clear and internationally consistent regulation, if attainable at all, will take many years to emerge. In the meantime, a combination of industry initiatives – of which there are many excellent examples – and pragmatic approaches to complex and potentially duplicative rules will prevail.
First and foremost, every firm needs to be clear on its ESG positioning and get people on board with that position. That is the job of the senior leadership team. The job of ESG specialists and legal and compliance professionals is to advise the senior team on the implications of the position – including, for those firms that want to be very green, the possibility that the pay of senior staff could be impacted by whether the firm hits its green targets.
Knowing where your organisation stands is going to be essential in giving a clear message internally and externally so that your investors, your portfolio companies, your staff, your future talent, and your advisers know what to expect from your organisation – and what your organisation expects of them.
This article was co-authored by Tim Lewis, Head of Financial Services & Markets at Travers Smith.
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