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.
The close relations between the EU regulations: CSRD, SFDR and EU Taxonomy
ESG data struggles
Extensive ESG reporting is already essential for many LPs, despite the changing timeline and lack of alignment. SFDR’s quantitative PAI disclosures require larger 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 quarter ends and must be published by 30 June 2023, requiring PAI data to be already gathered from private equity funds for FY 2022. If funds do not integrate PAI considerations in their investment approach, and while collecting and managing standardized data from a diverse range of portfolio companies, LPs face significant challenges with SFDR data compliance.
For FMPs with fewer than 500 employees, the SFDR allows them to choose between a “comply” or “explain” basis to publish a PAI statement on the due-diligence policies outlining the PAIs 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 PAI issues altogether. Based on Deloitte’s analysis, most 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 SFDR is vital for private funds to protect their reputation, attract investors who want to allocate their money sustainably, and meet the data demands of their LPs.
By contrast, most institutional investors (like LPs) 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, their own research, third-party data providers or reasonable assumptions. One common misunderstanding that we observe is that PAI data only apply to sustainable funds. However, as the PAI reporting applies on entity levels, it aggregates all sustainable and non-sustainable products. As a result, private equity companies will 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 actually attempt to answer these questions while many LPs are still working out what exactly they are looking for and why it is important to them.
Entities use different approaches to sourcing the data, causing significant discrepancies in the PAI indicators reported by similar funds. Without easily available and comparable data and 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.
Companies’ sustainability reporting under CSRD could serve as a potential data source for investor PAI reporting 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 expand the companies in scope but also introduce harmonized reporting standards developed by European Financial Reporting Advisory Group (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 most portfolio companies.