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
2. Investors must choose between article 6, 8 or 9
3. Main elements for SFDR reporting
4. The relevant deadlines
5. Funds can turn SFDR into an opportunity

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:

1. On the website, a fund has to publish its sustainability approach
2. In pre-contractual disclosure documents,  a fund must specify its sustainability approach
3. 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

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”

Article 9 funds have a sustainable investment objective for 100% of their investments. So they go one step further than “medium green” article 8+. For all their sustainable investments they have to show how they contribute to their sustainable investment objective and they have to explain how they assess that a company Does No Significant Harm (DNSH).

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 more free in their approach. The most relevant elements to understand are:

3.1. Principle adverse impact (PAI) indicators

3.2. PAI indicator reporting

3.3. Sustainable investment objectives

3.4. Environmental and social characteristics (E/S characteristics)

3.5. Do no significant harm (DNSH)

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.

About ImpactNexus

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.

FAQ

Could you provide a good example of a venture capital fund successfully navigating SFDR compliance, particularly regarding their choice between article 6, 8, or 9 classifications?

One notable example of a venture capital firm effectively navigating SFDR compliance is GreenTec Capital Partners. GreenTec is known for its focus on investing in African startups with high impact potential. In response to the SFDR regulation, GreenTec evaluated its investment approach and aligned its strategies with the principles outlined in the regulation.

After careful consideration, GreenTec opted to classify its funds under Article 9 of SFDR, indicating a strong commitment to sustainable investment objectives. By doing so, GreenTec demonstrated its dedication to promoting environmental and social sustainability through its investment portfolio.

To ensure compliance with SFDR reporting requirements, GreenTec implemented robust data collection processes across its portfolio companies. This involved working closely with investees to gather relevant sustainability metrics and performance indicators. By fostering transparent communication and collaboration with portfolio companies, GreenTec was able to effectively collect the necessary data for reporting purposes.

Moreover, GreenTec utilized the flexibility provided within Article 9 to tailor its sustainable investment objectives to align with the specific needs and opportunities within the African startup ecosystem. This allowed GreenTec to focus on areas such as renewable energy, agriculture, and healthcare, where investments could generate significant social and environmental impact.

Overall, GreenTec's proactive approach to SFDR compliance not only ensured adherence to regulatory requirements but also reinforced its commitment to sustainable investing. By strategically leveraging the SFDR framework, GreenTec positioned itself as a leader in the impact investing space, driving positive change across the African continent while delivering financial returns to its investors.

How do venture capital and private equity investors ensure consistency and accuracy in the data collection process from their portfolio companies to comply with SFDR reporting requirements?

Venture capital and private equity investors employ various strategies to ensure consistency and accuracy in the data collection process from their portfolio companies for SFDR reporting compliance. One key approach is establishing clear communication channels and guidelines for data collection. Investors often provide portfolio companies with detailed instructions on the specific sustainability metrics and performance indicators required for SFDR reporting.

Additionally, investors may offer training or resources to assist portfolio companies in understanding the importance of sustainability data collection and reporting. This may include workshops, webinars, or access to educational materials that help portfolio companies align their reporting practices with SFDR requirements.

To enhance consistency, investors may implement standardized reporting templates or frameworks that streamline the data collection process. These templates often outline the specific data points and metrics needed for SFDR reporting, reducing ambiguity and ensuring uniformity across portfolio companies.

Investors also prioritize regular monitoring and validation of sustainability data collected from portfolio companies. This involves conducting periodic audits or reviews to verify the accuracy and completeness of the data. By proactively identifying and addressing discrepancies or gaps in the data, investors can maintain the integrity of their SFDR reporting.

Furthermore, investors leverage technology solutions and data management platforms to facilitate efficient data collection and analysis. These tools enable portfolio companies to input, track, and report sustainability data in a centralized and standardized manner, enhancing accuracy and minimizing errors.

Are there any foreseeable changes or updates to the SFDR regulation in the near future that could impact how venture capital and private equity investors approach sustainability reporting and compliance efforts?

As of the current knowledge available up to January 2022, while there haven't been any specific updates or changes announced to the SFDR regulation in the near future, it's essential for venture capital and private equity investors to remain vigilant about potential developments. Regulatory frameworks, particularly in the realm of sustainability and finance, are subject to ongoing evolution as policymakers respond to emerging challenges and stakeholder feedback.

One potential area for future changes or updates to the SFDR regulation could involve clarification or refinement of reporting requirements. As stakeholders gain more experience with SFDR compliance and implementation, policymakers may seek to address any ambiguities or challenges that arise in practice. This could include providing additional guidance on specific aspects of reporting, refining definitions or classifications, or introducing new metrics or standards to enhance transparency and comparability.

Additionally, there may be efforts to align SFDR with other sustainability reporting frameworks or initiatives at the international level. Harmonizing reporting requirements across jurisdictions could simplify compliance for investors operating in multiple markets and promote consistency in sustainability disclosures. This alignment could also support the broader goal of advancing global sustainability objectives and facilitating cross-border investment flows.

Moreover, changes in political landscapes or shifts in public sentiment towards sustainability issues could influence the trajectory of SFDR and related regulations. As awareness of environmental, social, and governance (ESG) factors continues to grow, policymakers may face pressure to strengthen regulatory frameworks and raise the bar for sustainable finance practices.

In summary, while there are no specific foreseeable changes or updates to the SFDR regulation at present, venture capital and private equity investors should stay informed about potential developments and remain adaptable to evolving regulatory requirements in the realm of sustainability reporting and compliance efforts.