In the absence of further guidance from the European Commission, the current understanding across the industry is that non-EU alternative investment fund managers (AIFMs) that market their funds into the EU under the national private placement regime need only comply with the SFDR product/fund-level requirements (Articles 6 to 11) and not the entity-level obligations (Articles 3 to 5).
In this Insight we look at what UK AIFMs should be focussing on now and in advance of the draft regulatory technical standards (RTS) coming into force next year. Subject to individual EU Member State rules which may require a different analysis (for example in relation to Luxembourg AIFMs), this will also be relevant to other non-EU fund managers intending to market their funds into the EU.
- Draft your Article 6 PPM disclosure
To comply with Article 6 of SFDR, fund managers need to disclose in their fund private placement memorandum (PMM): (i) the material sustainability risks relevant to the fund; (ii) how these risks are considered in the fund's investment process; and (iii) if sustainability risks can have an impact on the fund’s returns, the likely impact.
There are no accompanying RTS and the regulation does not prescribe a particular form of template for this disclosure. General market practice seems to be to keep the disclosure on the investment process generic. If sustainability risks can have an impact on the fund’s returns, a logical approach (and one which mirrors the way that fund managers generally disclose financial risks) would be to describe the impact specifically by reference to the relevant category of sustainability risk ("environmental," "social" or "governance") as per the Article 2 definition. Ultimately, fund managers will need to be mindful of their obligation to ensure that the disclosures are "fair, clear and not misleading”.
If the fund manager determines sustainability risks not to be relevant, it will need to include a clear and concise explanation of its reasoning in the fund PPM.
- Decide whether you will disclose principal adverse impacts
Article 7 of SFDR requires fund managers to include in the fund PPM a clear and reasoned explanation of whether, and - if so - how the fund considers principal adverse impacts (PAI) on sustainability factors. This is a product-level requirement but its application is limited to those fund managers that disclose PAI at the level of the entity, as per Article 4.
Article 4 is undoubtedly one of the more challenging aspects of the regulation as it requires fund managers who consider the PAI of their investment decisions on sustainability factors to publish a website statement on their due diligence policies with respect to those impacts. The European Commission has confirmed that such PAI disclosure can be carried out generically (including, for example, descriptions of the internal processes and relevant standards at the fund manager level) as from 10 March 2021 , and that the first detailed PAI Statement will only become due by 30 June 2022, followed by the first PAI Statement including reference period reporting on 30 June 2023. Further information on timings for this statement is set out in the European Supervisory Authorities' (ESA) supervisory statement (25 February 2021).
The application of Article 7 to funds marketed in the EU by UK fund managers will therefore depend on whether the manager discloses PAI as per Article 4.
Fund managers will need to think carefully about whether Article 4 is an obligation that they can comply with. The draft RTS (2 February 2021), which prescribes the content and form of the detailed PAI statement, will require the manager to expend considerable effort obtaining the required data, not only for the first investment level, but also for the underlying investments. Managers who intend to comply should start thinking now about how they will collect the data, which internal/external sources they will use and how the cost of doing so will be allocated under the limited partnership agreement. Managers may also wish to include an appropriate risk factor in the fund PPM addressing the risk of additional cost for the fund as a result of SFDR compliance.
According to the draft RTS, the data should be obtained through "all reasonable means available", and refers to a non-exhaustive list of potential sources including external research providers, internal financial analysts/specialists, specifically commissioned studies, publicly available information or shared information from peer networks or collaborative initiatives. However, the ESAs acknowledge that in the case of insufficient data, direct engagement with the investee companies will become necessary. Now is the time for managers to be setting up that dialogue and educating investee companies on what information they may be asked to provide. A lot of portfolio companies are really excited about ESG, and many are ahead of the game in certain sectors, but for others this is likely to be unchartered territory.
Ultimately, if the fund manager cannot obtain this information, it may find that it needs to choose the “explain” option (to the extent this is available) and include the necessary negative statement in the PPM (as per Article 7(2)) (as from 10 March 2021).
- Classify your funds
One of the first steps fund managers need to take is to analyse whether any of their funds that are marketed into the EU promote environmental or social characteristics (under Article 8) or have sustainable investment or a reduction in carbon emissions as their objective (Article 9). Falling into either of those buckets will give rise to additional disclosure obligations.
It may not always be immediately obvious whether a fund is "normal" (Article 6), "light green" (Article 8) or "dark green" (Article 9) and the fact that the ESAs have called for clarity from the European Commission on the scope of Articles 8 and 9 goes to show that the lines are blurred. Matters are further complicated by the fact that we are likely to see diverging practices and interpretations across EU Member States.
Despite the uncertainty, this is an exercise that fund managers need to be conducting now. Broadly speaking, if the manager promotes a product as having a sustainability focus or applies fund-specific exclusions (and which form a key feature of that product), then it is likely an Article 8 product (assuming the environmental or social characteristic being promoted can be identified). If the fund has a “sustainable investment” objective (those that pursue an environmental or social objective alongside a financial return), then it is likely to be an Article 9 product. These products often have an index aligned to its objective in order to benchmark the product’s progress in achieving its stated objectives.
There is some (limited) guidance in Recitals 18 to 25 of the draft RTS which may assist fund managers with this classification exercise – together, with industry Q&As (such as those published by the Investment Association). Ultimately, firms need to be able to back up their classification with reasoned justification as the regulatory and reputational risks of miscategorising a fund may expose the manager to accusations of greenwashing. Equally, firms need to be mindful of the wording in the PPM to ensure it does not include any reference to environmental or social aspects that may cause regulators to consider that a fund has been incorrectly classified as a "normal" (Article 6) fund.
- Draft Article 8/9 PPM disclosures and prepare for periodic reporting
Where the fund manager concludes that a fund is an Article 8 or 9 product, it will need to include the relevant product disclosures in the fund PPM as prescribed under those Articles of the SFDR, and prepare for the periodic reporting obligation which comes into effect on 1 January 2022 under Article 11.
When making any changes to the PPM, the manager should also think about whether that change will trigger any investor consent/notification requirements.
While fund managers are not obliged to comply with the relevant draft RTS until they become effective (expected to be 1 January 2022), we are seeing varying approaches in the market. The majority are opting to take a "wait and see" approach with respect to the RTS, with a view to revisiting their disclosures once the rules become effective. They are adopting the "principles-based" approach to compliance with the Level 1 obligations, as advocated by the European Commission (including the suggestion that firms could refer to international environmental, social and corporate governance (ESG) and sustainable investment standards to comply with the rules). Others (largely those who are much further along in their ESG journey, such as managers of impact investment funds and those who have whole teams dedicated to looking at sustainability issues) are deciding to comply with the draft RTS now in the expectation that there will not be significant changes. One cautionary word of warning is to avoid selective compliance – if you pick only those RTS disclosures which complement the fund or firm, you run the risk of inadvertently greenwashing.
The draft RTS published by the ESAs in February 2021 are currently subject to proposals for further amendment as set out in the ESAs' Joint Consultation Paper published on 15 March 2021. Additional RTS have been incorporated to address the content and presentation of sustainability disclosures under Article 8, 9 and 11 of SFDR in relation to taxonomy – the idea being that we have one "single rule book" covering both the SFDR and the Taxonomy Regulation. The amendments are particularly targeted at Article 9 funds but are also relevant for Article 8 funds that intend to make sustainable investments in environmental objectives in compliance with the Taxonomy Regulation. The templates for pre-contractual and periodic information have also been amended to take account of taxonomy-specific elements (as set out in Annexes II, III, IV, and V).
The deadlines for the taxonomy-related product disclosures RTS range from 1 June 2021 to 1 June 2022, hence the ESAs are seeking responses to the consultation by 12 May 2021.
With respect to the periodic reporting obligation under Article 11, fund managers should refer to the ESAs' Supervisory Statement for details on the applicable timeline.
- Check your marketing materials and Key Information Document
Fund managers should engage with their marketing teams to ensure that the fund's marketing communications (and Key Information Document, as relevant) do not contradict the information disclosed under the SFDR. This obligation applies to all fund managers whether they are promoting an ESG fund or not. Preparing an inventory of all marketing materials currently in use is a good starting point, and then conducting a review of those materials against the SFDR website and PPM disclosures to make sure they are consistent.
- Consider any local requirements
Firms should consider any local requirements imposed by the regulators for each Member State’s specific national private placement regime. Since Member States are entitled to adopt more stringent provisions than that under the SFDR (indeed a number have already done so), UK fund managers should consider the specific requirements applicable to firms in the countries where they are distributing their funds.