Explainer: Why the SFDR impacts US investments and how to leverage its business opportunities

Article 6 funds must disclose how sustainability risks are integrated into their investment decisions and the results of an assessment of the likely impacts of sustainability risks on the returns of the financial product.

Article 8 funds, by contrast, must disclose how the environmental and social characteristics it promotes are met and if an index has been designated as a reference benchmark, as well as the information on how this index is consistent with those characteristics.

Finally, for Article 9 funds, where an index has been designated as a reference benchmark, the fund must provide information on how the index is aligned with the fund’s objective and an explanation as to why that index differs from a broad market index.

While SFDR brings another layer of complexity, it allows funds to build trust and drives more significant differentiation in investing.

SFDR has made raising funds in the EU more challenging for US investors. Because European limited partners are obliged to report under SFDR, they set the bar high for their general partners and funds willing to access their capital. If US investors wish to access EU capital, they are left with no choice but to align with the EU requirements.

If they haven’t already, US-based fund managers marketing their funds to EU investors must classify them under SFDR. By designating funds as Article 8, which promotes environmental and/or social characteristics, or Article 9, which has sustainable investment as its objective, US fund managers must strictly follow complex SFDR rules.

The disclosure regime covers five core components that need to be included in the very early stage of setting up a fund.

1. Website disclosures: SFDR requires financial market participants (FMPs) to publish specific disclosures to increase transparency on the entity and/or fund (financial product) level. Disclosures include integrating sustainability risk policies, adverse sustainability impact statements, and remuneration policies integrating sustainability risks.
2. Pre-contractual and periodic disclosures: FMPs are required to report on two layers for each fund. First, they must provide pre-contractual disclosures in their funds’ prospectus to disclose fund objectives, targets, planned benchmarks, asset allocation, and investment strategy. Next, FMPs must report periodic disclosures showing the fund’s quarterly performance. Funds willing to be classified as Article 9 require a robust strategy with a specific choice of technologies considered in the deal phase to demonstrate the sustainable investment objective.
3. Principal Adverse Impact indicators: SFDR requires FMPs to explain if and how the entity and the fund consider principal adverse indicators (PAIs) in the investment decision process. PAIs bring additional complexity, requiring FMPs to report the climate and other environment-related indicators, as well as social and employee matter indicators calculated on the portfolio company level and aggregated for reporting purposes. FMPs with 500 and or more employees are obliged to report PAIs, while FMPs with less than 500 employees have the “comply or explain” option.
4. Minimum safeguards: FMPs must follow good governance practices and provide evidence of considering four critical aspects of their investments: human rights (including labor rights), anti-corruption, taxation, and fair competition. Additionally, FMPs must disclose the Reference to the UNGP and OECD Guidelines.
5. EU Taxonomy: As a classification system, EU Taxonomy provides specific detail for sustainable economic activities and guides investors’ informed financial decisions. While reporting the Taxonomy alignment is voluntary, pre-contractual disclosure for Article 9 requires the expected ratio of Taxonomy-aligned investments. Moreover, investors use Taxonomy as evidence-based proof of demonstrating sustainable investment objectives, e.g., for Article 9 funds.

SFDR brings another level of complexity, imposing on fund managers requirements to ensure funds’ compliance with SFDR disclosures throughout the entire investment lifecycle and until the exit phase.

Accordingly, we have identified vital reasons why SFDR must be considered by the US financial sector, particularly private equity firms:

1. Access to finance: The SFDR creates visibility and transparency for investors, providing more precise insight into which investments will make a positive environmental impact. As shareholders increasingly seek high-ESG-rated funds, market data demonstrates that Article 9 funds even with the latest wave of downgrades, still secure the highest flow of capital per fund. SFDR disclosure is thus an obvious avenue for attracting capital from EU-based investors.
2. Compliance: Compliance: Financial markets have seen the growing impact of ESG disclosures globally. Since the SFDR is currently the most mature and comprehensive reporting scheme, upcoming disclosure regulations are very likely to be influenced by it. Notable examples include the UK’s Sustainable Disclosure Regulation and Green Taxonomy, which mirrors elements of the EU Taxonomy, and the US Securities and Exchange Commission’s proposed rules regarding climate-related disclosures in fund registration statements and annual reports.
3. Higher brand recognition: SFDR disclosures are intended to, among other things, build trust with investors. They require a demonstration of clear, positive climate impacts with specific evidence that must be shown immediately at the pre-contractual level. The general SFDR disclosure framework is expected to expand globally, thus allowing private equity players to gain higher ESG brand value and positive global recognition by classifying their funds as” light green” or “dark green.”
4. Better competitive position: Keeping in mind that SFDR disclosures are binding as of January 1, 2023, financial market participants already aligning with SFDR could prove to lead the way in attracting European capital. Moreover, classifying funds as Article 8 or Article 9 gives a competitive advantage in the race for European inflows. Additionally, Article 9 funds show robustness and tangible science-based evidence of sustainable objectives, thus attracting EU-based investors.
5. Unified risk management: The SFDR is shaping the basis of future investing based on transparency. Since financial market participants disclosing SFDR compliance will provide detailed information on their actual environmental and social performance, it is expected that SFDR will be primarily used globally as a risk management framework.

The message from the financial market is loud and clear – regardless of the upcoming SEC climate disclosures, US investors can’t be indifferent to EU rules. SFDR is now essentially the price of admissions to operate in the EU market and fundamentally increases US-based funds’ chances to attract EU capital.

US financial institutions should see SFDR not only through the compliance lens but also as an opportunity to create a portfolio of more resilient investments that align with the greener future that we must achieve.

Consequently, we encourage US financial institutions to be proactive regarding SFDR alignment and compliance and use the SFDR to assist them in the transformation to more sustainable business practices. SFDR compliance contributes to being recognized as a global sustainability leader and facilitates the green transition.

Finally, we strongly believe that it makes business sense to leverage the opportunity the SFDR presents to build resilience, enhance reputation, inspire employees, and at the same time, increase potential market value.

¹⁾ Sustainable Finance Disclosure Regulation: Click here for the website link