European LPs continue to struggle with ESG investments despite SFDR

November 5, 2024 (Preqin News) – The EU’s Sustainable Finance Disclosure Regime (SFDR) has been of little benefit to European investors in private markets. This is despite a majority wanting to take environmental, sustainability, and governance (ESG) criteria into account when making investments, according to a survey of LPs by Preqin researchers.

Preqin questioned 44 LPs in Europe that invest in private capital funds, with the single largest response, cited by 41% of respondents, being that they ‘invest in ESG but have no requirements’. This compares with 14% who allocate to impact funds, 20% who plan to invest in Article 8 or Article 9 funds, and 18% who said they do not consider ESG issues.

The responses imply that SFDR, and other labels applied to funds under the ESG umbrella such as climate, ESG Integration, and Sustainable Development Goals (SDGs), are not meeting LPs’ needs.

This mirrors the broader investment world. In the EU’s consultation on SFDR, conducted from September to December 2023, while 89% of respondents said ‘the objective to strengthen transparency through sustainability-related disclosures in the financial services sector is still relevant today’, 77% highlighted key limitations of the framework, including a lack of legal clarity regarding key concepts, limited relevance of certain disclosure requirements, and issues linked to data availability.

‘Different investors have different views on the SFDR,’ Simon Witney, Senior Consultant at law firm Travers Smith told Preqin News. ‘Many institutional investors recognize that – as a disclosure regime – it has limited value when assessing an investment opportunity. Others value the discipline that it brings to the design of sustainability characteristics for a fund and the ongoing disclosure requirements.’

SFDR was established in 2019 to help investors put money into companies and projects supporting sustainability objectives and allow them to assess how sustainability risks are integrated into the investment process. It came into force in 2021, and the specific fund regulations became effective in 2023.

Early indications from the first funds to launch are that Article 8 funds deliver returns in a narrower range, with less likelihood of large losses than the average private equity fund, as reported in Preqin First Close. For example, a pool of 15 2020-vintage SFDR Article 8 vehicles reports a median net IRR of 16.3%, with the lower quartile boundary at 8.4% and the upper boundary at 26.6%. The comparable pool of 517 private equity funds has lower returns at all quartile boundaries, standing at 7.9%, 14.9%, and 25.1%, a pattern repeated by 2021 funds.

However, it is too early to fully assess the performance of SFDR funds. The first SFDR funds were launched in 2020 and Preqin does not publish vintage year performance from the first three years of a fund’s life because of uncertainty about how accurately it would reflect actual performance.

Preqin surveys show that ESG remains an important criteria for many investors, with 60% of LPs surveyed for Preqin’s ESG in Alternatives 2024 report saying they had turned down an investment due to ESG concerns.

Article 8 and 9 funds only make up a small percentage of the capital in private market funds in Europe (3.8% and 4.0% of AUM respectively as of September 2024), though capital in Article 9 funds has increased significantly over the last few years, from 1.7% in 2022 to 4.0% in September 2024.

Mark Zünd, Head of Private Equity as Unigestion, says there are other factors at play when comparing SFDR funds with the wider universe. ‘Most Article 9 funds are first time funds. This makes fundraising more challenging, particularly in the current market.’

The presence of an SFDR label has little impact on fundraising success. Article 9 funds have been marginally more likely to hit their fundraising goals than Article 8 funds, with 84% of funds closed since the beginning of 2022 achieving target compared with 81% of Article 8 funds. Both types of fund have been slightly less likely to hit targets than the private capital funds in Europe, where 87% achieved target size.

Zünd said: ‘Our Article 9 fund has proven to be an excellent door opener for attracting new investors. For LPs who are still on the learning curve and not yet ready to commit to an Article 9 fund, we have been able to build deep relationships —with some of them investing in, or actively considering, our other programs, including those that meet Article 8.’

Regardless of any future changes to detail of the regime, the momentum is likely to be maintained. ‘SFDR set out to tackle one of the industry's biggest challenges: greenwashing. This is no easy feat, especially when one organization must consider all of the intricacies of different asset classes, region-specific investment trends, and, when it comes to how it affects private markets in particular, the opaque nature of our market,’ Soojin Kim, Head of ESG Research at Preqin, said.

‘One of the largest questions that remains in our industry is: What makes a fund sustainable?’ said Kim. ‘Labelling based on intent may lead to disappointment while sustainability reporting is still largely fragmented and insufficient to satisfy investor demands. Continued focus on fund reporting is required for better data analysis.’

Changes to the SFDR regime look increasingly likely. In a joint opinion published in June, the three European Supervisory Authorities (EBA, EIOPA, and ESMA) called for a ‘coherent sustainable finance framework that caters for both the green transition and enhanced consumer protection, taking into account the lessons learned from the functioning of the SFDR.’ As well as improvements to definitions, the ESAs suggested a grading system for both the ‘sustainability’ and ‘transition’ categories.

In a detailed response to the SFDR consultation Invest Europe, the trade association for European private equity and venture capital firms, proposed an evolution of the green investment scheme. ‘We do not support a radical departure from the existing SFDR framework,’ it wrote. ‘Our members have invested considerable time, money, effort, and resources in understanding, operationalizing, and building reporting systems in line with the existing concepts used in Articles 8 and 9. These concepts, while not perfect, are now reasonably well-understood by FMPs and investors alike. Creating a product categorization system based on new concepts would impose a significant burden on both fund managers and investors.’

Additional reporting by Grant Murgatroyd.

This article was updated to include quotes by Mark Zünd.

_{The opinions and facts included within the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin providing the information in this content accepts no liability for any decisions taken in relation to the above.}