SFDR: Why private equity managers must move beyond ESG data

This article explains why private equity managers are better off to leave ESG behind. Both in general and in the context of the SFDR.

Are you trying to achieve SFDR article 9 private equity portfolios? Are you managing sustainable objectives? Don’t fall back on ESG. We explain the SFDR and the added value of real sustainability data and insights. That is, sustainability insights on portfolio company level for private equity firms.

At the moment of writing, much is still unclear regarding the Sustainable Finance Disclosure Regulation (SFDR). Creating legislation within the EU is always an intens(iv)e process. Add to that different cultural backgrounds for opinions, different benefits regarding the (speed of the) transition to a sustainable world, complexity of the financial industry, value of greenwashing and many more. All these factors lead to a challenging endeavour for consensus. 

But one thing is for sure: portfolio-company level sustainability data is the way to go for your Principal Adverse Impacts (PAI) disclosures for the SFDR. What do we mean with this data? And why is it better for you than ESG data? We answer these questions in this article. 

Introduction: What is the goal of the SFDR

The SFDR is a new EU regulation aimed at regulating sustainability reporting of all financial market participants (FMPs). It provides a framework and disclosure requirements for sustainability reporting of financial institutions on entity-, portfolio-, and financial product level. As stated on the website of the EU:

“It [the SFDR] lays down sustainability disclosure obligations for manufacturers of financial products and financial advisers toward end-investors. It does so in relation to the integration of sustainability risks by financial market participants (i.e. asset managers, institutional investors, insurance companies, pension funds, etc., all entities offering financial products where they manage clients’ money) and financial advisers in all investment processes and for financial products that pursue the objective of sustainable investment.”

With the SFDR, the ESG investing industry is improved with structured sustainability disclosures and protection against greenwashing. It promotes and structures the reporting of environmental social and governance ESG data.

The inadequacy of ESG data

Currently, investors can base their investment decisions only on financial return and perceived risk based on ESG. However, there is a large drawback in ESG criteria: ESG data is based on country-sector proxies. It does not tell you if the company you’re performing a due-diligence research on is environmentally aware. It tells you the ESG performance of this company based on the economic sector and the country it’s in, all gathered from other companies’ reports from the internet.

If you want to manage an SFDR article 8 or article 9 investment fund, you need to monitor and report the social or environmental characteristics or manage for sustainable objectives. In addition, you can ask yourself the question: what is the added financial value if I can improve the environmental performance of my portfolio company before divestment in 8 years (note: this is 2030!). 

If you, as a portfolio manager, want to manage real sustainable investment objectives in your PE portfolio, you need to go beyond ESG data. To know if a portfolio company or an acquisition target is sustainable, you want to identify three things on portfolio-company level or the asset-level:

  1. What is the current environmental, social and governance impact?
  2. Does this company have potential for improving its sustainable impact?
  3. What are the buttons to push to promote environmental, social and governance improvement.

These three questions are answered with organisational footprinting. 

Principal Adverse Impact and Do Not Significantly Harm Principle

Data from organisational footprinting is based on the actual situation and activities of your portfolio company or acquisition target. This company-level data calculates the exact impact on the climate, the community, and employees. Hence, this data discloses the sustainability risks of a (potential) investment based on reality rather than ESG’s country-sector proxies. 

With this data, you are able to disclose that the organization is doing no significant harm (DNSH). Also, all the PAI indicators are covered with this organisational assessment.

And the best part, if the environmental impact is too high, you can act immediately. This data is giving you, and the company’s management, the insights into the hotspots of sustainability impact. Hence, it supports a sustainable strategy for decreasing the impact, both for the asset – the investee company – as for the portfolio.

Added value of portfolio-company level environmental data

Most importantly: at the moment you want to divest the company in 8 years (hence when it’s 2030), the environmental performance and environmental compliance is outstanding, increasing the enterprise value for sure.

 

But, there is a list of added values of this approach for companies, portfolio managers and investors.

For companies, environmental data gives insights in hotspots within their operations and the supply chain:

 

For the private equity portfolio manager, this company-level environmental data means:

Hence, while still a lot is unclear of the SFDR and its exact Regulatory Technical Standard, don’t wait. By starting up asset-level data analysis on environment, and social and governance impact of the companies, you are already compliant with SFDR data requirements and can already reap the benefits of what this has to offer.

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Joost
Joost
Co-founder

Joost, one of our enthusiastic founders. He would rather stand on two skis than on one board. You can wake him up at night for some classic Dutch ‘stamppot’ (stew), or for lunch, too. With a small dose of humor from under the rivers, he tries to achieve the ambition he and Philip always wanted to start a company for: creating impact by doing. Pushing the transition towards a sustainable economy.

Joost’s mission is to change the world in such a way that Greta Thunberg can go to bed with peace of mind by at least 2030!

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