Introduction
Interest of the financial services industry in environmental, social and governance (ESG) matters has surged in recent years driven mainly by rapid regulatory developments and the rising investors’ awareness about the climate change and sustainability aspects of their investments. The EU Commission was particularly eager to become a trend setter in this field by creating the first comprehensive regulatory framework on sustainable finance that will apply to the majority of financial institutions operating within the EU Single Market. In the centre of the scope of application of this new framework are asset managers that are seen as one of the most suitable financial intermediaries able to ensure channelling of additional investments towards financing of sustainable economic activities.
Impact of the ESG Regulation on private equity and venture capital funds
Private equity and venture capital schemes operating in the EU, that constitute collective investment schemes under the applicable law of their home Member State, generally fall under the definition of alternative investment funds (AIF) under the Alternative Investment Funds Management Directive (AIFMD). The same applies for investment funds investing predominantly in venture capital businesses that, where certain criteria are met, can constitute qualifying venture capital funds under the EU Regulation on venture capital funds (EuVECA).
Both alternative investment fund managers (AIFMs) as well as managers of EuVECA funds are subject to new sustainability related disclosure requirements introduced by the Regulation (EU) 2019/2088, better known as the Sustainable Finance Disclosure Regulation (SFDR). Under SFDR, fund managers are obliged to disclose certain information on how they integrate sustainability risks (ESG events or conditions that cause a negative impact on the value of investment) into their investment decisions and their remuneration policies. Further, fund managers are required to prepare a due diligence policy on how they take into account principal adverse impacts that their investee companies have on sustainability indicators when making their investment decisions.
In order to ensure compliance with the new requirements, besides updating fund prospectuses, websites, annual reports and marketing documentation, fund managers also need to overcome one significant obstacle which promises to become essential of their day-to-day business: they will have to obtain credible ESG data about their investment assets that would form a basis for their disclosures under SFDR.
Challenges for the private equity and venture capital industry
Despite being experienced in obtaining financial data, private equity and venture capital fund managers can experience some new challenges when finding their way to obtain ESG data about smaller and non-publicly listed companies that are usually their investment targets.
Whereas a significant number of large companies is already now subject to mandatory corporate sustainability reporting requirements in accordance with the Non-Financial Reporting Directive (NFRD), there is no similar framework that applies to smaller and medium companies in the EU. This puts private equity and venture capital fund managers in a tough position in comparison to UCITS fund managers that can generally rely on corporate sustainability reports or ESG ratings of their targets, larger companies that are able to gather and prepare more detailed information about the ESG aspects of their business.
In April 2021, the EU Commission has proposed a new Directive (Corporate Sustainability Reporting Directive “CSRD”) which aims to bridge this gap by expanding the scope of entities that are subject to mandatory corporate sustainability reporting. Nevertheless, even once the new regime becomes operational, many companies especially in the venture capital space will remain outside of its scope of application and “the data challenge” will still remain for many private equity and venture capital fund managers.
Obtaining relevant ESG data about target companies
In the light of the above-mentioned challenges, the question remains how private equity and venture capital fund managers can obtain relevant ESG data about their investee companies that are not subject to existing or the forthcoming corporate sustainability reporting requirements? For this purpose, fund managers can generally use one or more of different methods, some of which can be summarized as follows:
Voluntary disclosures made by investee companies
Companies keen to get financing from ESG oriented investors that are not subject to mandatory corporate sustainability reporting can still decide to prepare voluntary disclosures with relevant ESG data about their business. These can be developed in accordance with recognised international standards (like OECD Responsible Business Conduct Guidelines for Multinational Enterprises, ISO26000 etc.). For private equity and venture capital fund managers, the reliance on voluntary disclosures may be seen as the easiest method which can be especially helpful during the screening phase when potential targets are being pre-selected.
However, fund managers willing to invest in a particular company can hardly rely solely on voluntary disclosures prepared by investee companies themselves since they may well not contain all relevant ESG data that they need for the purposes of compliance with the applicable disclosure requirements. To that end, a certain degree of effort on the fund manager’s end will still be needed when it comes to verification of ESG data contained in voluntary disclosures that can be done in one of the below described ways.
Self-performed ESG due diligence
In recent years, more and more investors are taking ESG aspects of their prospective investee companies under consideration as part of the due diligence process. Generally ESG due diligence includes a review of investee company’s compliance with applicable environmental, bribery and corruption as well as human rights, supply chain and labour laws and regulations. However, the extent of ESG data that is necessary for fund managers’ compliance with ESG regulations usually goes beyond the scope of the review of investee company’s compliance with statutory law. For this purpose, fund managers usually need to develop internal policies on ESG due diligence accompanied by adequate key performance indicators (KPIs) based on which relevant ESG aspects of investee company’s business can be properly assessed. In order to do this, fund managers need to closely engage with their investee companies and to obtain credible information about the ESG aspects of their business.
Third party reports
The rising interest of companies across all industries in climate change and sustainable development has resulted in rapid increase in the number of environmental and technical consultants that provide ESG due diligence external verification services. External consultants of this kind usually need to engage more closely with the investee company in order to obtain relevant information based on which they can produce external ESG due diligence report or ESG verification of company’s business. Therefore, this method can be quite time and cost consuming. However, unlike results of the self-performed ESG due diligence or information contained in voluntary disclosures prepared by investee companies, reports prepared by external consultants and verifiers can bring a greater degree of certainty for fund managers willing to rather rely on third party’s professional expertise in this peculiar field.
It is important to mention that ESG standards vary widely from sector to sector and that there is no “one-size-fits-all” solution that can be used in every case. For example, certain renewable energy or green finance oriented start-up companies may possess more relevant data about the environmental impact of their business whereas some other companies may put more accent on social or governance aspects of their business in their disclosures. Therefore, it is important to approach to assessment of ESG aspects of the business of each prospective investee company under due consideration of relevant factors related to its industry, size, location
ESG considerations in transactional documentation
When structuring transactional documentation, ESG focused fund managers may be incentivised to include additional contractual provisions that would ensure that the ESG profiles of their investee companies have in the past been and remain in line with their needs and expectations over the period of investment.
To ensure the respective compliance of an investee company in the past are contractual warranties that can be expanded to cover specific ESG related warranties in a particular case. For this purpose, investee companies can provide warranties that they have in the past complied and/or currently comply with specific internationally recognised environmental, social and governance standards that go beyond usual warranties on compliance with the statutory law (like environmental, employment, anti-bribery, anti-money laundering law).
Poor alignment of investee company’s business with the ESG standards that is identified at an early stage, can also be remediated through implementation of certain post-closing undertakings into transactional documentation. For instance, investee company may agree to commit to develop internal frameworks and documentation (like anti-bribery, gender equality or environmental friendly office policy) or to enter into agreements with third parties (like the power purchase agreement with the supplier of electricity from renewable energy sources) that would improve its ESG profile. However, this can be done solely in cases where the relevant fund manager is not limited by the applicable fund agreement(s) to invest the fund’s assets solely in companies that already meet relevant ESG standards before the conclusion of an investment.
Additionally, the transactional documentation can specifically provide for obligations of the investee company to provide certain information to the fund managers in order for them to be able to fulfil their ESG related reporting requirements.
Conclusion
Rising investors’ interest in sustainability oriented investment assets together with rapid developing regulations on sustainable finance promise to keep ESG on the top of the list of priorities of European fund managers in the years to come. In the process of ensuring compliance with new ESG regulations in the EU, private equity and venture capital fund managers will be facing some obvious aforementioned obstacles the greatest of which will definitely remain the data challenge that can hardly be resolved solely by greater engagement of the fund management industry. Nevertheless, given that the entire financial services industry will be looking for a way to comply with rising expectations of European regulators in this field, private equity and venture capital fund managers will at least by no means be alone in this process. This “joint effort” may also result in the emergence of some common best practices that private equity and venture capital fund managers may be able to use to navigate complex regulatory environment and rising investors’ expectations when it comes to ESG more easily in the future.