The SFDR on the horizon: What venture capital and private equity investors need to know
The EU Sustainable Finance Disclosure Regulation (SFDR) is one of the key topics investors talk about these days. As we come closer to the mandatory reporting deadlines, there is still a considerable amount of unclarity on the best approach for private investors. We collected our current knowledge and recommendations in this article with the aim to help investors understand what they can do. We discuss:
1. What the SFDR is and how it affects investors
The EU Sustainable Finance Disclosure Regulation (SFDR) aims to increase the transparency about the sustainability performance of financial market participants in Europe. It requires EU-regulated asset managers and financial advisors to disclose how they consider sustainability in their portfolios and to explain to investors and clients how they do so. The overarching aim behind the regulation is to redirect capital flows towards sustainable objectives. With this goal, it is one important element of the larger EU Green Deal program that aims to make the EU economies more sustainable.
The SFDR affects all private investors that are active in the EU, including those investing directly in startups (Venture Capital) and SMEs (Private Equity). They have to define their sustainability approach, ranging from not considering sustainability (so-called Art. 6 funds) to having clear sustainability investment objectives (so-called Art. 9 funds), and they have to report in line with their sustainability approach. If a fund decides to consider sustainability, it has to assess the sustainability performance of its assets, report on its performance in line with the SFDR regulation, and make sure that the portfolio companies deliver on the set sustainability objectives.
2. Investors must choose between article 6,8 or 9
There are three main disclosures that a fund has to do according to the SFDR regulation:
- On the website, a fund has to publish its sustainability approach
- In pre-contractual disclosure documents, a fund must specify its sustainability approach
- In annual reports, a fund must report on its sustainability performance
In addition to these three different types of disclosures, the required information has to be gathered from three different layers.
- On the highest layer, the SFDR requires some information about the investment company launching a fund. Investors have to report if and how Principle Adverse Impact (PAI) indicators are used for them as a company and how their remuneration policies incentivize sustainability.
- At the layer of a fund, the sustainability orientation of the fund has to be defined and which activities a fund does to translate this orientation into action. For a fund, it can be chosen between articles 6, 8, or 9 of the SFDR which come along with different reporting requirements.
- This leads to the layer of portfolio companies. To comply with the reporting requirements of SFDR, VCs and PEs must collect data from the companies they invest in. In practice, the data collection quickly creates a lot of effort for investors and their portfolio companies; especially, if the information is collected for the first time.
Much of the effort around SFDR reporting is linked to the data collection from portfolio companies in line with the three articles 6, 8 and 9. The European Commission provides some guidance on the way these disclosures should be done in the regulation and the ANNEX documents on its website. Based on this information, we prepared the below overview of the three sustainability orientations and added some comments on the way the three articles are currently discussed by experts and investors in the field.
The sustainability orientation of funds is becoming an important differentiator
SFDR Article 6 "grey"
Funds without sustainable characteristics
Explain if and how sustainability risks are considered
SFDR Article 8 "light green" and "medium green"
Funds that promote environmental & social characteristics
For all portfolio companies show how they contribute to the promoted environmental & social characteristics.
Optional: A share of portfolio companies can, but it does not have to contribute to a sustainable investment objective (unofficially called article 8+ “medium green” funds)
SFDR Article 9 "dark green"
Funds that have a sustainable investment objective
For 100% of investments they must show how they contribute to the sustainable investment objective
Article 6 “grey”
Classifying a fund as article 6 comes along with the smallest disclosure requirements. Funds in this category are free to choose if they deem sustainability risks to be relevant for their investment decisions. If they do consider sustainability risks, they are required to explain how sustainability risks are integrated into their investment decisions and disclose how the sustainability risks affect their financial performance. If they do not consider sustainability risks, they are required to explain why they don’t integrate these into their investment decisions.
Due to the low sustainability reporting requirements, an “article 6 product” has often been described as a fund that is not sustainable or does not promote sustainable development. While this is probably an exaggeration for many funds, we see that many investors move towards article 8 or 9 to avoid reputational damages and to assure they can attract sufficient investments in the future.
Article 8 “Light green and medium green”
Article 8 funds promote environmental and/or social characteristics. Funds in this classification must collect quantitative and qualitative data on the environmental and/or social characteristics of their portfolio companies. The regulation provides some flexibility regarding the exact reporting. Therefore, many practitioners differentiate between “light green” article 8 and “medium green” article 8+ funds. We use this differentiation in our article to clarify the different requirements, but readers should keep in mind that it is not an official sub-classification of the regulation.
“Light green” article 8 funds advertise some environmental and social characteristics, but their investments explicitly do not contribute to any sustainable development objective. For these funds, it is mandatory to assess the promoted environmental and social characteristics. For this, they can, but they do not have to use the official Principal Adverse Impact (PAI) indicators (see an explanation of PAI below). Funds can also choose to use their own indicators as long as they explain their approach and clarify why they chose not to consider the official PAI indicators.
“Medium green” article 8+ funds promote environmental and/or social characteristics and parts of their investments target a sustainable investment objective. For instance, such a fund could allocate 30% of its volume towards climate change mitigation or 40% to fight poverty. For all companies that contribute to the sustainable investment objective of the fund, additional reporting requirements apply. The fund must show how these companies contribute to their sustainable investment objective and they have to explain how they assess that a company Does No Significant Harm (DNSH) (see an explanation of DNSH below).
Building on our discussions with investors and experts, we see that article 8 will become the minimum standard in the near future. For funds “light green” article 8 is appealing, as they can promote environmental and social characteristics, but they do not have to achieve specific targets like saving a certain amount of CO2 emissions. However, we must also emphasize that “light green” funds that only aim for the minimum required by the regulation should be aware of the risk of greenwashing allegations. Accordingly, we would strongly recommend that funds conduct robust assessments for the environmental and social attributes they promote and consider the official PAI indicators.
Article 9 “Dark green”
The current momentum around sustainable development suggests that article 9 funds will become more and more attractive. They obtain more regulatory support, investee companies are less likely to face material ESG risks and many LPs favor investments with a clear positive impact. Classifying as an article 9 fund today represents an important differentiation and puts investments on a future-proof path. Therefore, we see that particularly many new funds aim for article 9.
3. Main elements for SFDR reporting
The SFDR regulation uses a lot of cryptic terms, like E/S characteristics, DNSH or PAI, which make it hard to understand what this means for the practice of investors. Therefore, we want to explain the most relevant elements of proper SFDR reporting. With these explanations, we focus on the requirements for article 8 and 9 funds, as article 6 funds are freer in their approach. The most relevant elements to understand are:
Overview of the main reporting elements
3.1. Principle adverse impact (PAI) indicators
The PAI indicators are a list of indicators the EU selected to assess the sustainability performance of financial products (see detailed list in Annex I ). The PAI indicators are used in different contexts which leads to a lot of confusion around them. We see three main roles for the PAI:
- PAI indicator reporting: For all investments that contribute to a sustainable investment objective (so “medium and dark green” funds), funds should collect data on 14 mandatory indicators in table 1 and at least one additional environmental indicator and one social indicator from table 2 and 3 of Annex I. For more details see 3.2.
- PAI to show progress on the promoted environmental & social characteristics and/or objective: To explain how an 8 or 9 fund contributes to the sustainable characteristic (article 8) and/or objective (article 8+ and article 9) it promotes, the fund can use PAI indicators, but it can also use other indicators. For more details see 3.3. and 3.4.
- PAI to assess Do No Significant Harm (DNSH): For investments with sustainable objectives (i..e article 8+ and 9) investors must report if their business activities pose any harm to the 14 mandatory indicators in table 1 and any other relevant indicator in Annex I as part of the DNSH assessment. See 3.5. for details
3.2. PAI indicator reporting
In their annual report funds that have sustainable investment objectives (so article 8+ and 9 funds), should report indicators from Annex I for all investments that contribute to their sustainable investment objective. For these investments, the regulation expects investors to collect data on the 14 mandatory indicators in table 1 and at least one additional environmental indicator and one social indicator from table 2 and 3 of Annex I. Many metrics require data from the portfolio companies that must be aggregated on the portfolio level. Indicators range from greenhouse gas emissions to hazardous waste, biodiversity, and diversity. Even though the regulation strongly encourages investors to use PAI indicators, they can also choose not to use PAI indicators as long as they provide a clear explanation of why these are not suitable.
3.3. Sustainable investment objectives (mandatory for article 9 and 8+)
Each fund that classifies itself as article 9 must formulate a sustainable investment objective and they have to show how their portfolio companies contribute to this objective. For article 8 funds the SFDR provides the option to report their proportion of sustainable investments. If they partially aim for sustainable investments (article 8+), they must also follow the rules explained below to report on the sustainability of these investments.
The contribution to sustainable development can be shown in different ways. One clearly defined way is to invest in companies that contribute to one of the six EU taxonomy objectives. These objectives concentrate on environmental impacts around climate change, circular economy, biodiversity, pollution, water, and marine resources (see more details here). But a fund can also pursue a sustainable investment objective if it contributes to other environmental or social objectives. Here it is crucial to show convincingly how companies make a contribution to relevant social or environmental objectives. A good solution here can be to assess contributions to the 17 UN Sustainable Development Goals or focus on the IRIS+ impact themes of the GIIN. If the sustainable investment objective is the reduction in carbon emissions, funds are further required to display how much their reduction target contributes to the global warming objectives of the Paris Agreement.
3.4. Environmental and social characteristics (E/S characteristics)
For all investments for which E/S characteristics are promoted without a clear sustainable objective, the regulation wants investors to explain how these E/S characteristics were considered. The regulation does not provide a mandatory assessment approach, but it encourages investors to consider the PAI indicators. So the most important thing about the E/S characteristics is that investors explain the methodologies they use to assess, measure, and monitor the environmental or social characteristics they promote. This provides a lot of flexibility, but it also leaves investors alone with the challenge to design a robust assessment, measurement, and monitoring methodology.
3.5. Do no significant harm (DNSH)
The principle of DNSH has two main components: First, investors must assess if companies have significant adverse impacts on the 14 PAI mentioned in table 1 of Annex I as well as on any other relevant indicator from tables 2 and 3. This includes a wide range of topics from climate change, to biodiversity or diversity. In the SFDR there are no clear thresholds when harm to the PAI topics is considered “significant”, but regulators expect investors to explain DNSH compliance and where applicable to use benchmarks (due to the lack of data, the latter seems unrealistic for VCs and PEs investing in startups & SMEs). Second, investors should check if their portfolio companies comply with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights. The link to these international guidelines has been integrated to link the SFDR regulation to the so-called “minimum safeguards” of the EU Taxonomy.
4. The relevant deadlines
The implementation of the SFDR is happening in phases over a period of several years. It began with the technical implementation of phase 1 in 2021. Key events and deadlines are as follows:
- Implementation began on March 10, 2021, with Level 1 of the SFDR, forcing financial market participants to define whether they comply with the regulation.
- In April 2022, the Delegated Regulation specifying reporting details was adopted. This included the publication of the final Regulatory Technical Standards (RTS) including the final list of PAI indicators. Important guidance is given in the Regulatory Technical Standard (RTS) on how to comply with the SFDR with terms, deadlines, templates, and indicators to be used in periodic reviews.
- In January 2023, Level 2 of the SFDR will go into effect, specifying the reporting details funds have to consider.
- Latest by June 30, 2023, the first annual report must be published. It must cover the reporting period from 01.01.2022 – 31.12.2022.
- Latest by June 30, 2024, the second annual report must be published. It must cover the reporting period from 01.01.2023 – 31.12.2023.
The official deadlines set the frame for all relevant reporting activities that investors have to conduct. In practice, this leads to a series of internal timelines for collecting and preparing data by investors. The following are some suggestions based on experience and feedback from industry leaders:
- From January to September 2022 we suggest finalizing the choice of an applicable article and investment objective for all funds in the investment portfolio
- From September to December 2022 funds should prepare the necessary data collection for all their portfolio companies
- Between January and April 2023 will be a reasonable time to collect data from portfolio companies on PAI indicators and sustainability objectives
- This leaves time in May and June 2023 to prepare the collected data for the first reporting deadline on June 30th.
5. Funds can turn SFDR into an opportunity
The SFDR helps to increase the transparency about sustainability and it will help to get more data to compare funds across the promoted PAI indicators. This can help to reduce greenwashing and make it easier for investors to invest in funds that are truly sustainable. But of course, the SFDR is far from perfect. It provides a lot of “flexibility” – especially, around article 8 and 8+ – that can be abused. It also puts a strong focus on environmental impacts along the EU taxonomy, while social issues are less central. Nevertheless, it is definitely a step in the right direction and we are convinced that more steps will follow (e.g. an EU Social Taxonomy is already on the horizon).
- It helps to standardize a rapidly growing market around sustainable investments. For instance, VC investments into impact startups experienced strong growth from 9.5 billion USD in 2016 to 66.2 billion USD in 2021. For now, the “impact” and “sustainability” claims in this domain are very hard to compare, something that will stepwise become better.
- The focus on sustainability will help to mitigate sustainability-related risks for portfolios. There are many studies that show that sustainable businesses are more resilient, which translates into economic value for investors and society.
VCs and PEs should not try to abuse the loopholes of the regulation (which will be closed step by step). Instead, they should use the momentum around the SFDR and develop robust sustainability strategies that will be beneficial for investors, portfolio companies, and society. This might be a challenge in the beginning, but it will pay off in the long run.
ImpactNexus understands the difficulties that funds face in implementing the different aspects of the SFDR. We have focused on developing SFDR solutions that make it easy for both funds and portfolio companies to report relevant data. In close cooperation with important actors in the field, we have developed solutions to assist funds in the reporting challenges that SFDR is bringing, to increase transparency, understanding, and adaptation of your investment approach to the SFDR.
Interested to learn more about our solutions?
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The above has been researched by the ImpactNexus team and constitutes our understanding of the SFDR regulation and its implications for investors. Please feel free to reach out to us if you find some of the explanations are not accurate enough or if there are things we should clarify further. We must emphasize that this article does not constitute legal advice. In doubt, you should approach a knowledgeable attorney.