The Opportunity of Rising ESG Disclosures

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The EU’s Sustainable Finance Disclosure Regulation (SFDR) signifies a new chapter for transparency in the asset management industry. From the 10th of March, investment managers will be required to disclose the “principal adverse impacts” (PAIs) of investment decisions on sustainability factors as they relate to environmental, social and anti-bribery and corruption matters. The move is part of a wider drive to redirect capital to sustainable businesses which, at this stage, is complicated by the inconsistency and largely arbitrary nature of companies’ ESG reporting.

The sustainability impact statement covers everything from investee companies’ carbon and other greenhouse gas emissions, non-renewable energy consumption, water usage, gender pay gaps, and any lack of process and compliance mechanism to monitor all of the above. It also requires firms to disclose the extent to which they adhere to responsible business conduct codes and internationally recognised standards for due diligence and reporting.

PE falls within the scope of the new regulation insofar as it applies to any GPs marketing funds to EU investors under the Alternative Investment Fund Managers Directive (AIFMD). PAI reporting will be mandatory for AIFMs with more than 500 employees from 10 June onwards. By private equity standards the 500 employee headcount threshold is pretty high. This means that the vast majority of GPs will only be expected to disclose on a “comply or explain” basis, essentially leaving the industry off the hook, in principle at least.

But not so fast.

Competitive advantage
The SFDR’s impact will almost certainly confer advantages to those GPs willing to voluntarily disclose, and in doing so make the job of LPs easier as they seek to promote transparency with their own beneficiaries. LPs have long understood that sustainability is a key driver of returns and risk mitigation and the PE industry has already made efforts to up its game, by signing up to the UN Principles for Responsible Investment for instance. However, cynics have claimed that this has been little more than a public relations exercise.

One piece of research shows that more than half (56%) of LPs believe that GPs’ focus on sustainability is inconsistent across the entire fund lifecycle, with ESG considerations appearing important during fundraising but falling off the priority list during the investment period. More striking still, only 11% of LPs believe that the level of granularity in disclosures is appropriate for them to track funds’ ESG performance against clearly measurable targets.

The granularity and consistency of investor reporting is a perennial bugbear for investors in PE. This fact has prompted repeated efforts by the Institutional Limited Partners Association, the US member association representing the interests of LPs, to standardise returns reporting so that investors can effectively benchmark GPs and make better-informed investment decisions.

Fortunately, the SFDR seeks to standardise sustainability reporting and the European Supervisory Authorities have issued a template statement for firms’ website disclosures, including the indicators that must be used to assess the PAIs of investment decisions.

Rising to the challenge
GPs have an important decision to make here. Only those firms registered as AIFMs to benefit from Europe’s national private placement and who have more than 500 employees are obliged to publish information about policies on the integration of sustainability risks in their investment decision-making processes. Since even the largest global PE houses typically establish European subsidiaries for AIFM purposes, few firms will have to report on a compulsory basis. Most can do nothing and explain to investors why. However, those taking this easy option may suffer in the long run.

For investors, the genie is already out of the bottle on ESG considerations. In the first two months of 2021 alone there have been signs of the divestment movement gathering pace. New York City’s pension funds recently voted in favour of dumping $4bn in fossil fuel assets, while an institutional investor group representing $2.4trn in assets has urged HSBC to publish a climate resolution strategy. Trinity College Cambridge has also pledged to sell all of the publicly traded fossil fuel companies owned by its endowment following pressure from its students. Meanwhile, in his 2021 letter to CEOs BlackRock’s Larry Fink laid out the asset management firm’s ambition of having its entire investment portfolio reach net zero emissions by 2050.

This is an irreversible trend.
From a political and regulatory perspective, the EU has been the first to grasp the nettle on climate change and sustainability but it certainly won’t be the last. As a pacesetter, Europe will be followed by other jurisdictions and before long investors will come to expect ESG metrics to be comparable across asset classes, including private equity.

While it is not clear precisely how the Biden administration will tackle climate issues at the policy level, the US has now officially rejoined the Paris Agreement and has set goals to achieve a carbon-neutral power sector by 2035. The recently finalised Financial Factors in Selecting Plan Investments regulation, which requires US pension schemes to invest in the “pecuniary interests” of their members, ultimately dropped its planned ESG terminology. However, this was not for a lack of political will but over concerns that there is no clear consensus of what constitutes an ESG investment. It is therefore entirely possible – likely even – that the current administration will revisit the issue. Any decision to introduce ESG fiduciary rules could have major implications for the US private equity industry’s required disclosures. Watch this space.

Ultimately becoming SFDR-compliant will mean more legwork for those EU-regulated PE managers willing to put in the hard yards. But the earlier they do so the better, and the greater the success in achieving disclosure, the more interest these managers are likely to garner from an increasingly climate-conscious LP base. Those that rest on their laurels by not taking action on ESG reporting are at risk of becoming obsolete.

The content on this article is provided for general information purposes only and does not constitute legal or other professional advice.

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