Kavitha Ramachandran, Head of Business Development and Client Management (Continental Europe), based in Luxembourg, unpacks the current and future status of the Sustainable Finance Disclosure Regulation (SFDR), stressing the need for investment managers to follow a partnership approach to interpret and implement the complexities of the regulations.

Driven by European Union regulatory change for financing sustainable growth and reorienting capital flows towards sustainable growth in the financial services sector, the Sustainable Finance Disclosure Regulation (SFDR) – promulgated in 2019 – is a bold step in the right direction to manage financial risk and improve transparency in line with ESG trends.

The SFDR has now become a reality, with EU funds and non-EU AIFs marketed within the EU being obliged, as an initial step, to have updated their prospectuses by 10 March 2021, requiring investment managers to classify their fund product into one of three categories, corresponding to the relevant level of sustainability factors incorporated into their investment decisions.

At Maitland, we witnessed an overall awareness from the industry ahead of the 10 March deadline, but what is crucial is that firms understand that the SFDR journey has only just begun. Firms cannot simply have complied by 10 March and consider the regulatory box ticked. They must prepare for the next phase and beyond in order to avoid significant business and reputational risk.

Specifically, going forward, the SFDR provides the framework within which to inform all investors on how sustainability risks are taken into account in the investment decision-making process applicable to the relevant fund. Investors in ESG funds must be provided with significant additional information both prior to investing in the fund and during the life of the investment through periodic reports and information made available on the website of the management company.

The challenge

For now, implementing the SFDR won’t all be plain sailing. It places a significant onus on fund managers to classify their own portfolios, which may involve an overhaul of many processes, including the investment strategy, risk management, reporting obligations, due diligence, and disclosures.

And whilst sustainable investment expectations will inevitably become clearer over time, many firms are still confused about what exactly they need to do to get reporting right under the complex regulation.

Contributing to existing headaches is a lack of clarity around what the SFDR means for sub-threshold AIFMs and close-ended funds. We find that general market practice is driving some of the decision- making.

And so, against a backdrop of an increasingly complex regulatory landscape and shifting customer expectations, there has never been a more crucial time for fund managers to get the product categorisation right.

It is vital that fund managers have the right expertise and people by their side to navigate the complex requirements of SFDR together.

So often we see firms underestimate the sheer task at hand and try to go it alone. This is not well-advised. They would do better to engage an expert third party not only to provide support but also to provide interpretation within the context of market practice. Such an independent third party which understands the regulation and has access to multiple channels for expert guidance, is able to relay that information to firms in a digestible format, and then formulate a strategy to apply it to their business.

What’s next?

The SFDR is just the tip of the iceberg when it comes to the wave of ESG regulation we can expect in future. The focus of institutional investors and their capital allocations is certainly slanted towards sustainable finance and may become a regulatory requirement for future fund launches. Slick marketing talk or “greenwashing” will not be tolerated and compliance with the regulations will need to be fully thought through.

Now that the regulation is in place effective 10 March 2021, firms will be expected to continue with meeting the subsequent sets of rules, starting with the Principal Adverse Impact Statement (PAIS). The PAIS is intended to show investors and prospective investors how investment decisions made by a Financial Market Participant (FMP) have or may have adverse impacts on sustainability factors relating to environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters. The requirement applies on a comply or explain basis (unless the FMP has an average of 500 employees or is the parent undertaking of a large group which has an average of 500 employees, in which case the FMP must comply by 30 June 2021).