How the SFDR is changing the dynamics in Private Equity

How the SFDR is changing the dynamics in General Partners and Limited Partners in Private Equity

It’s been one year since the Sustainable Finance Disclosure Regulation (SFDR) requirements came into effect. And yet, EU regulators and financial market participants (FMPs), including private equity firms, still face significant challenges to implement the SFDR.

What’s the purpose of the SFDR?

The new regulation aims to foster the integration of ESG factors into the investment and advisory processes and to make investment products more transparent. The rules shall enable investors to compare sustainable funds more easily and prevent greenwashing. The SFDR is the disclosure tool in the EU’s broader sustainable finance framework, along with the EU Taxonomy Regulation and the Corporate Sustainability Reporting Directive (CSRD). The entity-level disclosure obligations in the SFDR are divided into three main areas: 

1. Integration of sustainability risks in the investment decision-making and advisory process 
2. Principle Adverse Impacts (PAIs) of investment decisions on sustainability factors
3. Transparency of information for products that either advertise their ESG characteristics (Article 8) or describe themselves as sustainable investments (Article 9) 

The challenges one year on

Since 10 March 2021, the Sustainable Finance Disclosure Regulation (without the Regulatory Technical Standard) leaves significant room for interpretation and therefore often led to generic and qualitative disclosures, and ample room for interpretation. Implementation of the Regulatory Technical Standard (RTS), which includes more detailed quantitative disclosures, has also been postponed several times and will now start to apply on 1 January 2023. In order to comply with the SFDR, we are still lacking accessible, definitive guidance and industry agreement on what comprehensive quality data related to environmental, social and governance (ESG) investments. The complexity of the legislation, as well as the difficulty of gathering the data required means private equity firms are facing a lot of uncertainty and resulting in challenges with regards to SFDR reporting requirements of their Limited Partner (LP) firms.

ESG data struggles

Regardless of the lack of alignment and the changing timeline, extensive ESG reporting is already essential for many LPs. SFDR’s quantitative PAI disclosures require LPs to report on 18 mandatory PAIs (including 9 environmental, 5 social, 2 sovereign and 2 real estate indicators) for direct and indirect investments for the year 2022. The reporting is based on the four quarter ends and has to be published by June 30, 2023, requiring PAI data to be already gathered from private equity funds for FY 2022. Without the funds integrating PAI considerations in their investment approach, as well as collecting and managing standardized data from a diverse range of portfolio companies, LPs face significant challenges when trying to comply with the data demands of the SFRD.

With the exception of FMPs with fewer than 500 employees, the SFDR allows an FMP to choose between a “comply” or “explain” basis to publish a PAI statement on the due diligence policies outlining the principal adverse impacts of their investment decisions on sustainability factors. Given most private equity companies have fewer than 500 employees, a significant proportion of the sector can opt out of the regime and disregard principal adverse impact issues altogether. Based on Deloitte’s analysis, the majority of private equity companies have issued a negative PAI statement i.e. “no consideration of PAI”, which suggests sustainability is still relatively low on their agenda, or they do not have the processes in place to gather the relevant data to consider these impacts. Complying with the SFDR is vital for private funds to protect their reputation, attract investors who want to allocate their money sustainably, as well as meeting the data demands of their LPs. 

Most institutional investors (i.e., LPs), by contrast, employ more than 500 people and are therefore obliged to issue information on adverse impacts, leading to a positive PAI statement i.e. “consideration of PAIs”. In the case of insufficient data, LPs must conduct “best efforts” to ensure that the data is made available, using sources such as engagement with investee companies themselves, own research, third-party data providers or reasonable assumptions. One common misunderstanding that we have observed is that PAI data only apply to sustainable funds. However, as the PAI reporting applies on entity levels it aggregates all sustainable as well as non-sustainable products. Private equity companies will, as a result, face multiple requests for fund PAI data from LPs who are obliged to collect and aggregate the information. ESG has become an integral part of the investment decision-making process for LPs, and it is unsurprising that General Partner (GPs) routinely receive extensive questions focusing on various ESG-related themes. Adding to the complexity, GPs are actually attempting to answer these questions while many LPs are still trying to work out what exactly they are looking for, and why it is important to them. 

There is an additional challenge in that entities often use different approaches to source the data, causing significant discrepancies in the PAI indicators reported by similar funds. Without easily available and comparable data, as well as appropriate guidance from regulators, private equity firms may be using different information based on unrelated criteria, making it difficult for investors to rely on and compare the data disclosed.  

The CSRD for the sustainability reporting of companies could serve as a potential data source for the PAI reporting of investors under the SFDR. The new directive (first draft published in April 2021) will amend and enhance the existing sustainability reporting requirements stipulated by the Non-Financial Reporting Directive (NFRD). It will not only significantly increase the companies in scope but also introduce harmonized reporting standards developed by EFRAG. However, the timelines of the SFDR and the CSRD are not aligned: ESG reporting for the latter is not required until 2025 (for FY 2024) for the majority of portfolio companies. 

Regulation complexity and uncertainty

Private equity firms’ challenge in sourcing ESG data from private holdings is further exacerbated by a lack of clarity in the regulation’s language. Ambiguities and uncertainties remain, whether it is how thresholds are labelled (using Articles 6, 8 and 9) or the way the regulation applies to some firms and products. 

While the SFDR is a disclosure regulation and shall provide greater transparency about the integration of ESG factors, there are ongoing discussions about potential minimum requirements for sustainable products (i.e. for Article 8). This lack of clear definition results in a wide range of interpretations and further confusion among investors. While the SFDR requirements are complemented by reporting requirements from the EU Taxonomy, neither provide clear criteria, definitions for eligible investments or minimum strategies for so-called ‘light green’ financial products. Even the regulator pointed out that the effectiveness of the strategies varies significantly among ‘light green’ financial products. 

It is essential for private equity firms to implement sufficient processes that will allow them to determine where they can access all necessary ESG data, navigate data costs and how to integrate scoring into their portfolio systems. That said, non-financial portfolio companies must also embrace a more professionalised approach to ESG data management in order to satisfy investor demand for the data they need to comply with the SFDR. Including comprehensive ESG data in the due diligence work has gone from being a ‘nice-to-have’ to being increasingly a ‘must-have’ for both GPs and LPs. Now it is up to them to implement the necessary processes to meet these requirements and implement the necessary frameworks, systems and data. This is especially vital, as investors will hold the private equity sector has a pivotal role in the transition to more environmentally and sociably sustainable economy. 

Here at Deloitte, we understand the current challenges private equity firms face at the entity, fund and portfolio company level as the regulations governing sustainable finance continue to evolve. With the support of Deloitte’s combination of experts, a variety of services are offered such as sustainable product design, structural sustainability integration, reporting workflows as well as ESG due diligence.