Updates on Regulation, Trading, and Market Reforms for the Alternative Investment Community

New ESG-Related Regulatory Obligations for Private Funds

The consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process are increasingly popular ways for investors to evaluate companies and funds in which they may choose to invest.  According to the most recent report from US SIF Foundation, investors held $11.6 trillion in assets chosen according to ESG criteria at the beginning of 2018, up from $8.1 trillion just two years earlier.  While ESG investing is a newer concept with U.S.-based private funds, in Europe, ESG-factors have been part of investor due diligence, side letters, and fund manager considerations for more than a decade.  However, no legal requirement existed in Europe for fund sponsors to factor in ESG into aspects of their business.

The commercial scramble to capture market share in the ever-growing ESG investment segment has led to the issuance of myriad non-governmental, voluntary standards in the absence of regulation and an ESG data and analytics industry to support the ESG-investment community. These expectations have often been linked with the UN Principles for Responsible Investment or other similar benchmarks.  Many fund sponsors have also gone to great lengths to advertise their ESG credentials, recognizing the prominence of private capital in the global economy and the accompanying responsibilities.  Thus, ESG standards and policies vary profoundly.

Recently, the European Union adopted two new regulations (i) the Sustainability-Related Disclosure Regulation and (ii) the Taxonomy Regulation.  These regulations will be relevant to all private fund sponsors that are managing or marketing funds in Europe.

Sustainability-Related Disclosure Regulation.  The Sustainability-Related Disclosure Regulation (Disclosure Regulation) will apply commencing March 10, 2021 to “financial market participants” that includes alternative investment fund managers (AIFMs) that are authorized in an EU member state (EU AIFMs) and AIFMs from outside the EU that market or offer funds to investors in the EU (non-EU AIFMs).  The Disclosure Regulation will require certain asset and fund managers, as well as certain advisers, to comply with the rules on ESG disclosures.  The Disclosure Regulation will require entities to implement policies and make certain periodic and pre-contractual disclosures as to how ESG factors are being integrated into investment decisions and internal processes, and to ensure marketing communications are consistent with such disclosures.

Effective March 10, 2021, Disclosure Regulation will require EU AIFMs and non-EU AIFMs to make pre-contractual disclosures to prospective investors describing the manner in which sustainability risks are integrated into the AIFM’s investment decision-making process.  Disclosure Regulation will require an equivalent disclosure will be required on the AIFM’s website.  By December 30, 2020, the European authorities will release technical standards regarding the content and presentation of disclosed information.

Taxonomy Regulation.  The Taxonomy Regulation became effective July 12, 2020 to create a benchmark for green products to alleviate the need for investors to conduct their own due diligence with regard to a financial product’s environmental sustainability. The scope of the Disclosure Regulation matches the Taxonomy so all in-scope AIFM will need to use the Taxonomy Regulation to sponsor and promote a fund as having ESG credentials.  To classify a fund’s investment as having ESG activity, the investment must make a “substantial contribution” to at least one of these six environmental objectives detailed in the Taxonomy Regulation:

1. climate change mitigation;
2. climate change adaptation;
3. sustainable use and protection of water and marine resources;
4. transition to a circular economy;
5. pollution prevention and control; and
6. protection and restoration of biodiversity and ecosystems.

Moreover, a fund shall comply with screening criteria and minimum safeguards to be set forth in future legislation.  The AIFM must also demonstrate that the fund does not cause harm to any of the named environmental objectives.

Further Action Steps

EU AIFMs and non-EU AIFMs intending to commence fundraising in 2021 should pay particular attention their disclosures and investment processes and policies to determine whether refinements are required to their website, operating and investment policies, and pre-contractual disclosures.  Pre-contractual disclosures should explain how sustainability risks will be integrated into investment decisions and the likely impacts of sustainability risks on the returns of financial products.  Moreover, where sustainability risks are not relevant, it should be explained.  In addition, private fund sponsors that have funds that invest in shares traded on an EU regulated market should comply with the revised Shareholder Rights Directive.

Further steps may be necessary for products which promote ESG factors or have sustainable investment objectives.  For certain financial products, additional disclosure on the AIFM’s website may be required along with pre-contractual disclosures may be required if such products promote ESG characteristics such as how the ESG characteristics or investment objectives promoted are met.  The companies in which the investments are made must comply with sound governance practices.

About the author

Debbie Klis represents private investment funds and investment advisers in connection with fund structuring, advertising, private placement procedures, compliance policies and procedures, side letters, placement contracts, related agreements and issues.  Debbie assists clients on a range of issues relating to sustainability, including advice on ESG financing, drafting ESG policies and advising on principles governing responsible investment.  Debbie’s experience includes private equity funds, venture capital funds complex partnership reorganizations, domestic and offshore hedge funds, Opportunity Zone Funds, real estate investment funds and trusts, EB-5 funds, and large master-feeder structures.  Debbie has extensive experience with private securities offerings and financial products, including through crowdfunding, domestic and international joint ventures, global equity offerings, where she represents placement agents, issuers, broker-dealers, public and private companies, investment banks, financial institutions, private funds, and investment advisers.

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Updates on Regulation, Trading, and Market Reforms for the Alternative Investment Community