Intertrust N : The private funds guide to SFDR

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The EU Sustainable Finance Disclosure Regulation represents a new frontier for the private markets industry. We explain what the rules mean and how to navigate the challenges.

The EU's Sustainable Finance Disclosure Regulation (SFDR) aims to make investment products more transparent by setting strict disclosure standards. The first set of SFDR requirements came into effect in March 2021. Part of a new wave of European regulation, the rules should make it easier for investors to compare sustainable funds and prevent greenwashing.

However, they also pose challenges for many investment firms, especially private funds.

The complexity of the legislation plus the difficulty of gathering the data required means a lot of uncertainty surrounds SFDR.

Here we explain what the rules mean, the products they affect, when they come into force - and what happens if you don't comply.

What is SFDR?

The EU Sustainable Finance Disclosure Regulation imposes mandatory environment, social and governance (ESG) disclosure obligations.

It requires disclosures from investment firms on indicators of principal adverse impacts (PAIs) on sustainability factors such as greenhouse gas emissions. It also classifies funds into three categories (see below), according to how sustainable a fund is.

The pre-contractual and periodic disclosure documents that form part of SFDR were originally planned to apply from next January; were then postponed until 1 July 2022; and have now been put back to 1 January 2023.

Which funds are affected by SFDR?

SFDR applies to all financial market participants and financial advisers in the EU, as well as those based outside the EU who market products to clients inside the EU.

Investment firms, such as asset managers and pension providers, as well as qualifying venture capital and social entrepreneurship activities, all fall within SFDR's scope. It affects products including alternative investment funds (AIFs), undertakings for the collective investment in transferable securities (UCITs) and insurance-based investments.

The PAI obligation operates on a "comply or explain" basis - unless a firm has more than 500 employees, when it becomes mandatory.

When does SFDR come into force?

The level one rules were introduced on 10 March 2021. These require financial institutions to evidence sustainability activities at an entity level.

The level two rules involve more detail and include periodic product reports. The European Commission has now stated that these - the SFDR regulatory technical standards (RTS) including the Taxonomy Articles 5 and 6 - will apply from 1 January 2023. This has been postponed from the earlier planned date of 1 July 2022.

The first disclosure of PAI reports will be due on 30 June 2023, and will cover the reference period of 1 January 2022 to 31 December 2022.

SFDR is one of ten actions of the EU's Sustainable Finance Action Plan. Others include Taxonomy Regulation, EU Benchmark Regulation, EU Ecolabel Regulation and Corporate Sustainability Reporting Directive.

How are products classified by SFDR?

Funds are put into three categories:

• Article 6 strategies either integrate ESG considerations into the investment decision-making process or explain why sustainability risks are not relevant. But they do not meet the additional criteria of article 8 or 9.
• Article 8 (light green) strategies promote environmental and/or social characteristics and may invest in sustainable investments, but do not have sustainable investing as a core objective.
• Article 9 (dark green) strategies have a sustainable investment objective.

The difference between articles 8 and 9 is causing confusion, with some firms unsure how to label their funds.

According to the Principles for Responsible Investment (PRI) initiative - a UN-backed network of international investors - some asset managers are holding off disclosing under article 8 because there's no clear definition of what "promote" means in this context.

On the other hand, some managers have classified a large proportion of their funds as meeting the article 8 threshold, leading to concerns about consistency with disclosures, and ultimately, greenwashing.

The European Securities and Markets Authority is preparing to issue further guidance on compliance with SFDR, to bring "greater clarity and coherence" to the rules.

It also proposes that two new SFDR product categories should be created for funds that have an environmental objective.

What are the challenges of SFDR for private equity and real estate funds?

The relevance of SFDR to illiquid assets such as real estate is indisputable. Buildings are responsible for about one-third of CO₂ emissions in the EU, according to the European Commission.

In the private equity sector, there is growing recognition that ESG factors can offer a competitive advantage: more than 500 private equity houses have signed up to PRI.

However, it is difficult for private equity funds to source ESG data from holdings, as this information is not publicly available. ESG data is required to make disclosures on websites, in prospectuses and in periodic reports, as stipulated by SFDR.

The data challenge - as well as uncertainty over the exact rules - is a problem for many of our clients. Intertrust Group's ESG data gathering and analytics solution, developed to collect and manage ESG data for illiquid assets, can help alleviate the problem.

As well as adhering to the general rules, managers should look out for any specific to their asset class. Fourteen of the 18 mandatory sustainability-

principal adverse impact indicators relate to investee companies including indicators on GHG emissions, water, biodiversity, waste, social and employee matters. Two of them relate to real estate: one is exposure to fossil fuels through real estate assets; the other measures exposure to energy-inefficient real estate assets. In addition, managers have to select at least one out of 22 voluntary environmental indicators and one out of 24 voluntary social and governance indicators.

Level two disclosures are more onerous than level one, and private equity and real estate funds should consider how to meet them from a framework, systems and data perspective.

What are the consequences for violating SFDR?

Complying with SFDR is vital for private funds to protect their reputation and attract investors who want to allocate their money sustainably.

Regulatory consequences of violations of EU financial markets regulations are implemented in national legislation in EU member states. There are basic fines, maximum fines, fines as percentage of net turnover and penalty payments (provisional fines). Depending on the nature and seriousness of the violation, there are fine categories (1, 2 and 3). For example, in the Netherlands category 2 fines can be up to €2.5m or 5% of net turnover. Category 3 fines can be up to €20m.

How Intertrust Group can help

• ESG data gathering and analytics is Intertrust Group's first ESG product, aimed at helping private equity and real estate fund managers take control of their portfolio ESG data.
• Our comprehensive and bespoke solution can be adapted to suit client processes and software solutions. We provide managers with the necessary knowledge and support for all ESG reporting responsibilities, including meeting SFDR requirements.
• Our presence in more than 30 jurisdictions brings excellent insight into regulatory demands.