The EU’s sustainable finance framework is widely recognised as immensely complex. For private equity firms, it’s even more so, especially now that more and more investors demand that their investments are made in funds with sustainable assets.
With reliable ESG data being sparse, fully understanding the people who manage the business that you invest in as a fund manager has become critically important. PE firms have always kept close and tight contacts with managements, but now that ESG has entered the scene, managers also need to be questioned about their sustainability approach, Especially by PE funds who want to be sustainable themselves.
Wednesday’s panel discussion at the LuxFlag Sustainable Investment Week conference made clear that private equity actors also struggle with the new requirements as defined in the increasingly stringent Sustainable Finance Disclosure Regulation, or SFDR, as the main body of the EU framework, which also includes the EU taxonomy, is known.
Stronger engagement policy
“A stronger engagement policy is expected under the SFDR,” said Julie Pelcé, ESG specialist at law firm CMS Luxembourg, adding that the EU framework is primarily tailored to investment funds, not private equity. “It is a subjective assessment. You need to have a strong policy in place to ensure that the companies you are investing in are complying with the requirements. Check the composition of the board, whistleblowing policies, but you also need to report on the engagement policy.”
Teresa Gonzalez, head of sustainability and ESG at Arcano Partners, a Spanish private equity firm active in infrastructure and corporate credit, underlined the importance of having a proper methodology in place. Arcano does not run its own ESG funds but does have fund-of-funds that aspire to have a “light green” Article 8 or “dark green” Article 9 status.
“Most important is to have a solid methodology behind the product in terms of ESG. Once you have this you will have a good product,” Gonzalez said, adding that Arcano’s approach diligently checks a range of ESG KPIs for the funds that it invests in and their managers, which are then kept in a database.
‘Very basic’
She explained that they check for ESG standards at the level of the general manager of the funds, and not at a portfolio company level. The internal tool at Arcano rates each general partner in the fund, and gives them a score in terms of ESG commitment. “It’s very basic for us,” Gonzalez said. “Do they do their ESG due diligence? Do they give ESG training to their employees? Are they an active actor in terms of ESG? Is there a ESG close in their transactions? We try to understand their monitoring and control processes.”
“We all should keep in mind that SFDR and taxonomy are transparency regulations, and not classification tools,” CMS’ Pelcé added. “Being as transparent as you can is the best you can do.”
Investors demanding sustainable funds
For Alternative Investment Fund Managers, the AIFMs, the legally responsible firms as a third party for alternative investment funds, ESG presents its own challenges. Tomos Tobolka, conducting officer at Vista Fund Management, a Luxembourg-regulated AIFM, advises funds against setting their ESG ambitions too high, even at a time when investors are demanding green SFDR funds.
Tobolka said “lots” of alternative funds have opted to classify their alternative private funds as Article 6 under the SFDR, the category for “brown” investments where no additional reporting requirements are demanded. “Lots of clients have opted for Article 6 just to be on the safe side. Few are going for Article 8 or 9, even though there is pressure from investors demanding to be ‘at least article 8’.”
“It’s done on a best effort basis, which can be quite challenging,” he said.
Tobolko outlined a range of additional requirements that are coming in the next half year, referring to a number of other SFDR articles that require specific disclosures and declarations via websites and annual reports, and the EU’s new ESG reporting templates that are required from January 2023.
AIFMs are in the middle
“It’s definitely complex,” Tobolka said. “As AIFM we are kind of in the middle, we need to file templates by a certain deadline, but others need to collect the data.”
The industry in recent months has seen a number of regular investment funds being reclassified from Article 9 to 8, as Investment Officer as reporter. Asked about such reclassifications among alternative funds, panellists noted that this is not a trend in this part of the market, although, according to Vista, one specific real estate in Luxembourg recently did decide to switch its classification to Article 8 from Article 9.
“You really need to think it through before you decide to become Article 8 or Article 9. The last thing you want is to be blamed for greenwashing,” said Tobolka.
As moderator of the panel, Stephane Pesch, CEO of the Luxembourg Private Equity Association, nevertheless was upbeat about the prospects of sustainable finance among alternatives. “It’s not as rosy or as lovely as you could imagine. There are also obstacles on the road: data collection, legal certainty, also how to implement it in your business model and for your clients,” Pesch said. “But it’s a long-term effort. See AIFMD in 2013, but look at where it brought us. That’s exactly the parallel that I would like to draw.”