Taxonomy and SFDR reporting are hard.
Private equity is incredibly attractive from an impact perspective, given its ability to target assets inaccessible to other investors and actively steer companies towards more sustainable impactful business models.
However, many private equity investors are experiencing difficulties with the new SFDR reporting requirements and are thus struggling to meet increasing LP demand for ESG-focused funds. Our work with PE funds has shown us that they face considerable challenges interpreting how the regulations apply to them, what ESG metrics they should be measuring, and how to access the data needed to report.
So why do these firms face such challenges in their SFDR reporting?
Problem 1: Lack of clarity regarding the regulatory requirements
Every stakeholder affected by sustainable finance regulation is experiencing the uncertainty that exists around a novel set of new disclosure requirements. Investors face a lack of clarity around penalties or repercussions for incomplete reporting, and low levels of alignment within their portfolios.
Especially for the growing number of “mid-green” Article 8+ funds promoting environmental characteristics in their investments, there is a lack of clear guidance on how those investments should be classified. Given the significant overlap between the sustainable investment classifications under the SFDR and the EU taxonomy, at times the two are equated, yet there remains a lot of room for interpretation.
These challenges affect all investors: private equity, however, experiences industry-specific concerns we’ve heard repeatedly:
- While private companies face no reporting requirements, how are private equity funds meant to evaluate their Taxonomy alignment or PAIs? To what degree does the EU Commission expect these funds to match listed equity investors’ level of analysis?
- Article 9 funds, especially those still raising, have expressed concerns regarding their alignment commitments. Do they need to meet these commitments in advance of June 2023, or is there leeway given the long due diligence processes they must conduct before making investments?
- Can proxy data be leveraged? While liquid asset managers are currently still able to rely on taxonomy and PAI estimates in their regulatory reporting, private equity is left without any indication of if, how, and where they could employ estimates to supplement data gaps - though EU regulators have recently provided slightly more clarity on this topic.
- If yes: given the lack of data provider coverage for private assets, where does this data need to come from and how should data validity be evaluated from the perspective of the regulators?
This segues well into our second problem:
Problem 2: Lacking data availability/coverage for pre-investment screening and due diligence
Private equity firms excel in sourcing high-potential deals based on limited publicly available data - in a pre-due diligence phase, firms must rely on target company websites, word of mouth, investment memoranda where possible, and alternative asset data providers like Preqin or Pitchbook. This is changing with increased scrutiny on ESG due diligence by regulators as seen in the implementation of the SFDR.
A lack of taxonomy/PAI estimate coverage leaves private equity funds with very little to look at when evaluating target companies’ taxonomy potential or PAI values. Target companies are not conducting lengthy, expensive reporting processes of their own volition. Data providers are not able to provide accurate SFDR-relevant estimates of alternative assets (or liquid assets, to be frank).
Incorporating this analysis as early as possible in the investment process is vital for achieving the taxonomy alignment that will make LPs eyes glisten and sing your praise, but it is currently incredibly costly to do so.
Problem 3: Lacking portfolio company expertise regarding sustainability reporting and data collection
Private equity focuses on, well, private companies.
The temporal mismatch between SFDR level 2 reporting (2023) and the CSRD (2025, if the stars align) creates a vacuum where Article 8+ and 9 private equity funds must report on the taxonomy alignment of their portfolios, but have no existing portfolio company reporting that can be used.
Public companies - many of whom have a large pool of existing sustainability data and capabilities - are sacrificing blood, sweat, tears, and the social lives of Big 4 consultants to get their alignment reporting in on time.
Article 8+ and 9 funds will have to do this same reporting, but for 5, or 10, or 30 portfolio companies. The scalability issues this creates are only amplified by the fact that these companies have never conducted public financial reporting that will be audited, let alone sustainability reporting.
The silver lining: This reporting exercise is a surefire way to kickstart improved sustainability data collection and reporting within your portfolio.
Problem 4: Interrelatedness of data but difficulty connecting the dots – SDGs/PAIs/Taxonomy/other impact frameworks
ESG data availability and collection is a hot topic within sustainability-oriented private equity funds looking to measure and improve their portfolios’ impacts.
As someone smarter than me (Peter Drucker) once said: “If you can’t measure it, you can’t manage it”.
Collecting data once is hard enough. In our experience, Article 8+ and 9 private equity funds are analyzing data against at least 3-4 different frameworks: most notably, the SFDR (taxonomy + PAI), UN SDGs, UN PRI, and their own bespoke ESG frameworks.
The interrelatedness of these frameworks and the data they require is not yet fully transparent, and can often result in double work being conducted to meet multiple requests for the same data.
Since the time of writing: With COP27 came the announcement that the CDP will be incorporating ISSB’s IFRS S2 standard into its disclosure platform, which is a major step towards improved connection between standards and frameworks.
We expect to see further evolution and consolidation of these frameworks over the next few years as the market develops.
Problem 5: Increased costs for impact investors – is this penalizing the ‘best actors’?
Impact private equity firms are blazing the path in sustainable investing - given the unique access and steering advantages of PE, combined with the capability to undergo costly due diligence processes and identify the best targets, we are living in an exciting time for private equity.
It is no mystery that an increased focus on impact comes with increased costs. However, impact private equity firms will be the first to tell you that it’s worth it, and that they believe it will become a significant upside in the coming years. Historically, these increased costs have arisen from more laborious due diligence processes and increased engagement with portfolio firms on sustainability issues.
Recently, we have been seeing in the market that regulatory requirements - only affecting the most sustainability-committed - are now also driving costs for impact investors.
Private equity firms are experiencing pressure from LPs to list as Article 8+ or 9 in order to access their massive pools of green capital - while these classifications were not intended as product labels, they are being used as such. LP demand for sustainable investments is outpacing supply, and some believe it is due to increased compliance costs. Private equity firms looking to gain the ‘green competitive advantage’ when competing for LP capital will have to simultaneously accept the serious challenge of increased regulatory obligations.
These challenges might seem daunting, especially to investment professionals dealing with these rules for the first time. But they shouldn’t discourage private equity firms from setting up a sustainable fund that complies with the EU rules. With the right strategy, guidance and tools, it is perfectly possible to overcome these issues before they arise.
To this end, Briink has recently written a practical guide for investors focusing specifically on Taxonomy reporting.
Of course, the playbook doesn’t address all of the issues investors face when conducting taxonomy assessments (although our product might!) - so keep following us for more.
Feeling anxious about these challenges? Don’t: Let’s have a coffee (or tea to calm your nerves) and I can share how we’re solving these problems for our private equity clients with the help of AI.
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