Product categorisation changes

The most significant proposal in SFDR 2.0 relates to the deletion and replacement of the existing Article 6, 8 and 9 requirements, with three new product categories known as:

• Transition (Article 7): For funds that invest in companies and projects that are on a credible transition path, or investments that contribute towards such transition;
• ESG Basics (Article 8): For funds that integrate sustainability factors into their investment strategy beyond consideration of sustainability risks that form part of risk management considerations; and
• Sustainable (Article 9): For funds that invest in sustainable undertakings, sustainable economic activities, or other sustainable assets or contributes to sustainability.

The qualifying criteria for the new product categories consist of a) a mandatory 70% binding commitment minimum investment threshold, subject to a ramp up period (the Mandatory Threshold); b) mandatory exclusions (e.g., for tobacco, prohibited weapons and fossil fuels above certain limits); and c) certain permitted investments. The European Commission has been empowered to develop criteria and provide additional colour on both the methodology for calculating the Mandatory Threshold and the assets that will qualify as permitted investments.

Interestingly, the Draft SFDR 2.0 provides a shortcut of sorts, as funds that hold 15% or more investments in economic activities aligned with the EU Taxonomy will be deemed to have met the 70% investment threshold.

In addition, Articles 7 and 9 must identify and disclose the principal adverse impacts (PAI) of their investments on sustainability factors and explain how these will be mitigated.

Whilst the removal of the ‘do no significant harm’ principal and the ‘good governance’ concept from the product category criteria may be welcomed by some managers, the inclusion of certain assets and sectors in the ‘mandatory exclusions’ list may pose significant challenges for managers and sponsors seeking to target both EU and US investors or investors with conflicting and competing sustainability expectations.  This issue will need to be discussed and addressed as part of the initial fund design and marketing process. Early engagement with investors may assist in this regard.

There is a new combination category, Article 9a, which appears to be designed for fund of funds and other indirect investment vehicles that hold investments in products that qualify as Article 7, 8 or 9, subject to compliance with certain requirements. Such funds will be allowed to rely on disclosures produced by the provider of the underlying fund or product that qualifies under the new product categorisation regime. That said, the criteria in the combination category may be difficult to comply with in practice if funds of funds are unable to obtain guarantees from the underlying fund or product provider that they will comply with the exclusion criteria in SFDR 2.0.

Finally, the Draft SFDR 2.0 also introduces an ‘impact’ category as a sub-category of Article 7 and 9 funds that have ‘an objective of making a pre-defined positive and measurable social or environmental impact.’  In this regard, the use of the term ‘impact’ will generally be limited to such products and funds.

Article 6a

Funds other than those categorised as Articles 7, 8, 9 and 9a funds will still be able to disclose whether and how they consider sustainability factors in the Article 23 pre-contractual disclosures (similar to the current Article 6 requirements under SFDR 1.0), subject to compliance with certain requirements (Article 6a funds) including:

• Compliance with the ‘fair, clear and not misleading rule’;
• Ensuring that sustainability references do not feature in the fund’s name or marketing material; and
• Ensuring that sustainability references are not a prominent part of disclosure (meaning it should account for less than 10% of the space taken up in describing the investment strategy of the fund).

In addition, Draft SFDR 2.0 warns managers that care must also be taken to ensure that any sustainability references in marketing or other external facing materials do not include a claim that would result in or suggest that the fund is an Article 7, 8, 9, or 9a fund. In the absence of more prescriptive guidance, managers and sponsors may find these requirements difficult to navigate in practice. This perhaps represents a real ‘greenwashing risk’ for funds.

No professional investors AIF opt out, but relief for portfolio managers and advisers

Whilst the leaked version of SFDR 2.0 teased the possibility of an opt out of SFDR 2.0 for funds that only market to professional investors (almost akin to the UK approach under SDR), this has not been carried forward in the Draft SFDR 2.0. That said, there is still time for market participants and industry bodies to engage with relevant stakeholders at the EU legislative-level in a bid to have this provision reinstated in the final version.

In better news, portfolio managers and financial advisers will be taken outside the scope of SFDR 2.0, which is a sensible approach as they do not manufacture or manage the underlying assets or products and thus have limited impact on the design of such products. This means that unless they qualify as an AIF, it should be possible for funds of one and separately managed accounts structures to fall outside the scope of SFDR 2.0.

Disclosures

The SFDR 2.0 has proposed significant changes to the product and entity disclosure requirements as follows:

• Managers will no longer be required to publish and maintain information on: (a) the principal adverse impacts (PAI) of their investments decisions on sustainability factors; or (b) how their remuneration policies are consistent with the integration of sustainability risks. However, transition (Article 7) and sustainable (Article 9) funds will still have to make PAI disclosures.
• Taxonomy eligibility and alignment disclosure will no longer be mandatory for all managers although this will still be required for transition (Article 7) and sustainable (Article 9) funds that pursue an environmental objective.
• Fund disclosures will be significantly shortened and simplified with pre-contractual ESG disclosures capped at two pages, and periodic ESG disclosures capped at one page – although transition (Article 7) and sustainable (Article 9) funds will be required to publish an additional page which should include details of the intended impact and metrics data. It is important to note that the specific content requirements will be developed further by the European Commission at Level 2.

Finally, managers will still be required to publish and maintain information on their websites, but this can take the form of a web link to the pre-contractual and periodic ESG disclosures.

Data analytics

The Draft SFDR 2.0 includes new requirements on the use of data and estimates. This will require managers to ensure that such data is based on formalised and documented arrangements and methodologies. In addition, information on sources of data and methodologies used will have to be made available to clients upon request.

Grandfathering

Unhelpfully, there is no transitional relief for compliance with SFDR 2.0 for open ended funds or closed ended funds that are still raising capital from investors when SFDR 2.0 enters into force.

Whilst SFDR 2.0 will not apply until 18 months after it is published in the official journal, it is currently unclear when the Level 2 technical standards will be published by the European Commission. It is hoped that they will be published in a timely manner before the requirements in SFDR 2.0 apply to avoid any unpleasant surprises for managers and funds, which has been an unhelpful feature of SFDR 1.0.

Commentary

SFDR 2.0 is certainly a step in the right direction with the current vague and imprecise product disclosure tests being replaced with more prescriptive category specific criteria. The introduction of the transition category is expected to be welcomed by managers who have struggled to categorise their transition funds under the current regime. In this regard, transition funds’ strategies that focus on making an impact at the asset level are more likely to qualify for Article 7 categorisation than those with a strategy, which focuses on supporting the transition. That said, based on the nature of existing funds’ strategies, the expectation is that Article 7 funds will be a relatively niche segment of the overall fund market in the EU.

The changes to the disclosure regime should help alleviate some of the challenges faced by funds and managers in obtaining the necessary data to support their ESG disclosures, and the removal of certain entity level disclosure requirements may further assist in reducing the overall administrative burden of compliance.

Further, the deletion of the ‘do no significant harm’ and ‘good governance’ concepts are likely to be welcomed in particular by private credit funds and managers, who have struggled to disclose under Articles 8 and 9 due to the limited governance control and influence that they have over borrowers and the associated difficulties in plugging data gaps.

Notwithstanding the many improvements in SFDR 2.0 text, some challenges remain, including that existing (light green) Article 8 funds may find it harder to qualify for the new product category without making material changes to their investment processes and asset selection to reflect the narrowing of the qualifying criteria. The explicit exclusion of investments in companies that derive 1% or more of their income from fossil fuels activities may also make it difficult for funds that market to US and EU investors. Additionally, the costs associated with compliance under the new regime may still be viewed as prohibitive for some funds and managers who have a limited footprint or investor base in the EU.

Next steps

Given the extent of the proposed changes, managers may need to start planning for implementation well ahead of the go-live date. Actions that managers may wish to consider include:

• Assessing how existing fund strategies map across to the new product categories;
• Identifying which changes, if any, are required to be made to existing fund documents, and whether this will require investor consent;
• Deciding how to position, categorise, and market any new funds including in relation to Article 6a funds;
• Engaging with investors and stakeholders to ensure that funds continue to meet expectations in relation to their sustainability features and assessing how to address any competing and conflicting investor expectations; and
• Identifying data sources and requirements, which will now focus on exclusions, transition plans of underlying products, projects and portfolio companies, taxonomy alignments (in certain respects), and engagement data. Managers will need to take steps to ensure that data gaps and challenges are adequately plugged and accounted for prior to launching the fund.

Feel free to reach out to our team if you would like to discuss SFDR 2.0 or understand how the proposed changes may affect your fund structures and disclosure obligations.

Our team includes Karen Butler, Josh Dambacher and Christopher Hilditch.