The arrival of the SFDR is front of mind for operational leaders of private capital funds. Thanks to several delays to implementation coupled with conflicting advice and interpretations, the industry’s head is in a spin when it comes to what the new rules actually mean and the specific actions they require from managers.
The SFDR is importantly a regulation; it is uniform across European member states (unlike a directive). However, individual jurisdictions have been taking their own stances on the rules, creating more confusion, and that increasingly dreaded thing – divergence. Add to that the separate ESG rules coming from the UK and the US, and fund managers are in a tangle when it comes to ESG compliance.
Says Jan Gruter, funds structuring partner in Addleshaw Goddard's Private Funds Group: “SFDR is a regulation, so in theory, it applies in the same manner across all member states. But its enforcement rests primarily with national regulators and some have been putting out their own guidance, and that’s creating an additional overlay, whether that's guidance on SFDR itself or around national fund marketing rules which indirectly touch on aspects of the SFDR. And on top of that we have an ever-expanding list of Q&As and other guidance from the Commission and the ESAs.”
The underlying cause of this confusion comes from the European regulators themselves. Questions continue to flow between the European Commission and ESAs, creating uncertainty before the rules pass to the local regulators to apply.
This has left many private capital funds looking to peers with similar profiles for guidance. However, many are finding that their counterparts – however similar – might be classed as an Article 9 in one jurisdiction, but as an Article 8 in another. This has the very real potential of causing an unlevel playing field.
In response, the natural urge for fund managers is to play it safe. Without sufficient clarity and reassurance, many sponsors are opting for lighter green classifications in the fears that one regulator might object to, say, an Article 9 classification.
This is a real concern for PE houses, as very few operate solely in one jurisdiction. While a fund might be domiciled in the UK and invest in UK companies, investors will likely hail from across Europe and the US, meaning that house is caught by all three ESG-related rules. “There is certainly a level of geographical confusion,” says Anne Sheedy, ESG Advisor to Bowmark Capital.
As local regulators publish their own guidelines and clarifications on SFDR, the differences between member states are coming to the fore. Gruter highlights one example: “In the property space, take a transition fund focused on a retro-fit investment strategy like brown to green, which can play an important part in greening the office stock and help get us to net zero. Some managers want to wrap this into an Article 9 fund, but that can run into difficulties because you start with brown investments and hence don't necessarily have a portfolio that is completely invested in sustainable investments at the outset. We hear that some national regulators have approved those funds as Article 9 but others have not, as their stance is that they can only be Article 9 once the portfolio has been truly greened; i.e. once the properties have been retro-fitted.”
Gruter points out that the same can apply to some energy transition funds. For example, some of the processes that enable green hydrogen energy production may entail at least an element of environmentally harmful activity in the early stages. “Like in the property space, you can see there could be divergent approaches by national regulators as to whether some energy transition strategies can sit within Article 9 funds.”
Against this confused backdrop, what would actually help fund managers in the short term? Sheedy believes consensus is needed. “If there was one broader group where we could discuss these issues and find consensus, that would be really helpful. As a fund manager, you can’t do this in isolation, nor can the LPs. And it’s even less feasible for
midsized and smaller managers to do this on their own because you have to be at market, both in terms of cost and what you issue to investors.”
Richard Small, funds regulatory partner in Addleshaw Goddard's Private Funds Group, agrees and also points out how the UK’s departure from the EU has impacted the situation. “There needs to be a stronger voice in the industry on this, and it’s not helpful that the UK is no longer in the EU. In reality, a large proportion of the industry is in London, so those who would have previously been vocal in shaping these rules haven’t had as much of a voice as they may have had in the past. It's more important than ever that managers make their views known through the various industry bodies.”
Gruter argues that industry associations have been good at bringing people in a given industry sector together, but more is needed. “Where the industry is most effective is where we see collaboration across asset classes and industry bodies – so the private equity side of the asset management industry collaborating with real estate and so on. More of that is needed; we need to be talking across asset classes and not just focusing on our own patch.”
He adds that the regulators themselves are more often than not open to dialogue on this. “But at the end of the day, they have certain restrictions too, so untangling what’s already been set out is challenging. Early engagement at the policy development stage is key and continues to be the hard lesson learned from all sea-change regulations – from AIFMD to SFDR.”
Regardless of open lines of communication, with the SFDR now in play, managers need to take a view. “You need to draw a line in the sand but it’s not easy when you haven’t got any one jurisdiction, adviser, or anyone confident on one line. If you push back to a lawyer or anyone, things tweak, and then they push back to the regulator, it tweaks again. It’s not so much drawing a line in the sand, it’s more drawing a line in the quicksand,” says Sheedy.
Luxembourg Swift and supportive
With the vast majority of European fund managers running their vehicles through Luxembourg, the local regulator – the CSSF – has been one of the more helpful when it comes to SFDR
The CSSF asked fund managers to update their prospectuses (for those funds requiring a so-called visa stamp on their prospectus) with the right disclosures under the new rules, and send those to the regulator for consensus under a fast-track regime. According to Addleshaw Goddard’s Gruter, the fast-track approval process helped managers get up to speed in terms of having robust disclosures in place – with helpful guidance from the CSSF that the mere updating of prospectuses with required RTS disclosures would not in itself be considered a material change and hence not require investor approvals or offering redemption rights. “In that sense, Luxembourg has really facilitated compliance,” he says.
Furthermore, unlike other jurisdictions including France, Germany and Spain, where additional rules related to marketing have been lumped together with SFDR, Luxembourg hasn’t goldplated the new regulation. “They have resisted the temptation to add in more rules and focused on clarifications that I suspect are welcomed by the industry,” says Gruter. “They are conscious of being the largest fund domicile in the EU and making SFDR work in practice.”
A neat example of the CSSF’s supportive stance when it comes to SFDR adoption is a recent FAQ, published in December 2022.
Material change: It clarified that when pre-contractual SFDR RTS annexes are included in the prospectus, any changes made are to be treated as any other changes to prospectuses, and are subject to the regulator’s approval.
Exclusion strategies: This strategy may be considered as promoting ESG characteristics for Article 8 funds. But in these cases, the CSSF expects a detailed description of the exclusion criteria, which links to evidence that it promotes ESG characteristics. For Article 9 funds, the CSSF has clarified that exclusion is not enough to evidence ESG characteristics, as all assets must qualify as sustainable investments under Article 2.
Qualifying sustainable investment for Article 9 funds: The Lux watchdog said sustainable investments need to meet the investment criteria (as defined by Article 2), from the date of the actual investment, as well as throughout the lifecycle of the fund. Industry commentators have noted that this would prevent funds from investing in transition assets – an important strategy for reaching net zero. As it stands, the confusion lies at the root of the rules, with important clarifications of the qualification of a sustainable investment yet to be provided by the European Commission. Industry commentators say the industry needs more guidance and granularity to apply that definition in a uniform manner. The CSSF believes an inclusion strategy to set out the positive investment selection process is mandatory for Article 9 funds, to demonstrate how all underlying investments meet the conditions of Article 2.
Website disclosures: The CSSF also made it clear that the Luxembourg ManCo is responsible for Article 10 website disclosures, regardless of portfolio management delegation.
While any sense of clarity is welcome at this point, the very publication of these FAQ highlights by the CSSF demonstrates the complexity of the SFDR and how much is open to interpretation.