In recent years, the private equity market has witnessed transformations driven by regulatory changes and shifting investor preferences. As a result, new fund structures have emerged to cater to the evolving landscape. Two such structures gaining prominence are The Sustainable Finance Disclosure Regulation (SFDR) Article 9 funds and Impact funds (the SFDR Article 9 funds refer to a category of funds which comply with certain requirements outlined by the SFDR). While these investment approaches share a common goal of aligning financial investments with sustainability considerations, they differ in their strategies and regulatory frameworks.
Understanding the nuances between a SFDR Article 9 fund and Impact fund is crucial for investors navigating the private equity market. In this article, we aim to answer the following questions:
- What are the differences between SFDR Article 9 funds and Impact funds (in terms of investment strategies, regulatory requirements, and societal/environmental impact)?
- What makes a good impact fund and a good SFDR Article 9 fund?
What is an Impact Fund?
Impact investments commonly refers to investments in companies which generate a positive impact on society and/or the environment. Several organizations have made efforts to establish norms and standards, aiming to unify definitions, such as the Global Impact Investing network (GIIN), the Impact Management Project (IMP), and France Invest. In its latest statement, France Invest states the definition of impact investment is based on 3 characteristics:
- Intentionality – desire to generate a measurable social or environmental benefit
- Additionality – contribution of the investment to the impact
- Measurability – impact ability to be measured in alignment of interest between investment team and the subscribers when performance is rewarded
However, the lack of clear definition of impact funds is a persistent challenge in the industry. Multiple definitions exist, leading to confusion and inconsistency among market participants and, to date, none of the suggested definitions has succeeded in creating consensus. The absence of a commonly shared precise definition makes the comparison of impact funds difficult, hindering the development of a cohesive industry framework.
What is a SFDR Article 9 Fund?
The Sustainable Finance Disclosure Regulation (SFDR), implemented on March 10, 2021, provided a framework to classify funds depending on their sustainability approach. Unlike impact funds, the SFDR created a classification system for sustainable financial products (commonly referred to as Article 8, 8+, or 9 funds) which imposes different transparency obligations for each type of fund.
All investments in an Article 9 fund must always meet the following 3 criteria during the fund’s lifecycle:
- They have to contribute to a social and/or environmental objective, which must be defined by the fund and linked to a clear investment methodology;
- Adhere to the “Do no significant harm” principle, which emphasizes the importance of assessing and mitigating any adverse impacts that may arise from an investment’s business activity;
- An Article 9 fund must ensure that the companies it invests in follow good governance principles.
This definition, which must be respected by all Article 9 funds, is described and shared with investors prior to investing in a new fund and enables them to better identify investments that are in line with their proprietary sustainable investment strategy.
Standardisation vs Individualisation of Impact Funds and SFDR Article 9 Funds
Impact Funds
Certain impact investment funds focus on investing in best-in-class companies or excluding potentially harmful investments. However, a clear market trend is going towards defining specific impact objectives (qualitative or quantitative) for each investee company, in order to be able to capture (and justify) the impact generated by its investments. These objectives are often linked to follow-up KPIs, which allow companies to track and quantify the impact generated. According to the GIIN Annual Survey, 89% of respondents now use external systems, tools, and frameworks for impact measurement and management, with the most common resources being the SDGs, IRIS Catalog of Metrics, IRIS+ Core Metrics Sets, and the Impact Management Project’s five dimensions of impact.
But the data collected is very specific to each investment and each fund’s investment thesis, making the consolidation and comparison of data complicated. This concern is highlighted in the GIIN Annual Survey, among others, with impact washing being the most significant concern (66%), followed by the inability to demonstrate impact results (35%) and compare them with peers (34%).
SFDR Article 9 Funds
On the contrary, the SFDR regulation streamlines reporting practices by requiring funds to complete a standardized template prior to the fund’s first investment and each year during the life of the fund.
For instance, this template requires each investor to define their sustainable investment objectives and their methodology of measuring the attainment of these objectives. This approach needs to be backed by sustainability indicators, which have to be defined prior to the investment and reported annually. While each investor has the choice to adapt the objectives and KPI to its future portfolio, imposing standardized templates harmonizes the level of information available.
In addition, all SFDR Article 8 and 9 Funds must describe their mechanisms for identifying, assessing, and managing sustainability risks. This may involve conducting comprehensive ESG due diligence, integrating environmental, social, and governance (ESG) considerations into investment decision-making processes, and establishing effective risk management frameworks that address ESG issues. In sum, unlike impact funds, this standardized reporting approach makes it easier to compare funds based on their responsible investment practices.
Quantitative vs Qualitative Data
Impact Funds
Despite the defined characteristics, there are currently neither constraints regarding adherence to a definition, a framework of impact investing, nor control mechanisms, so a degree of subjectivity is possible. Therefore, many impact investors justify their investments using causal deduction and qualitative information, rather than quantitative data. As a result, impact funds rely on qualitative narratives, case studies, and testimonials to demonstrate their commitment to creating positive social and environmental outcomes. This subjective approach may introduce a level of uncertainty which is frequently interpreted as “greenwashing” or “impact washing” – a constant risk that impact investors aim to overcome by increasingly defining quantitative impact objectives and reporting on them on an annual basis.
SFDR Article 9 Funds
The SFDR introduces the notion of adverse impact indicators, which aim to detect negative impacts generated by Investments. The 14 Principal adverse impact indicators (PAIs) prescribed by the European Commission force companies, investors, and financial institutions to streamline their reporting approach. While currently issues related to data availability exist, these indicators will indeed create transparency and comparability in the market, to an extent which didn’t exist before. These ambitions to quantify and create comparability are reinforced by suggestions by the European Commission to define sustainable investments based on minimum thresholds linked to revenue, OPEX, or CAPEX – again another example of how SFDR regulation forces investors to quantify their investment approach and thus generates increasingly quantitative data on sustainability issues.
Limitations of Impact Funds and SFDR Article 9 Funds
While the SFDR regulation implemented by the European Union provides a specific framework, certain parameters are still open to interpretation, such as the principle of “good governance.” Being classified as Article 9 requires a fund to ensure good governance within the companies in which it invests. However, the practical implications of this notion remain subject to interpretation.
To address these grey areas, Q&A documents are published by ESMA (European Securities and Markets Authority) to provide clarity and work towards harmonizing practices among investors. These documents aim to provide guidance on how to interpret the requirements of SFDR. For example, ESMA recently redefined the calculation methods of PAIs for greater clarity. Additionally, despite an obligation to collect, publish, explain, and implement actions at fund level, the SFDR does not currently impose any obligation to achieve results.
Nevertheless, the notion of PAIs which force investors to analyze the potential negative impacts of their investments and to act upon them, highlights one of the limitations of impact funds: the strong focus on generating positive impacts sometimes leads to overseeing the potential negative impacts. Very few impact funds today consider the concept of dual materiality, which makes it possible to consider not only the risks weighing on the company’s activity, but also the potential negative impacts of the company’s activity on its environment and surrounding stakeholders.
Final Thoughts
A well-defined regulatory framework and clear definition is the cornerstone of a more transparent and efficient capital market. These factors significantly contribute to the comparability of data, allowing investors to make well-informed investment decisions. With comparability at the forefront, investors can more confidently engage with their investments, knowing the true impact of their choices on sustainable development.
While impact funds have shown great potential in driving positive change, coupling them with the standardized approach of the SFDR framework makes them even more effective. By incorporating SFDR’s principles, impact funds can provide a more comparable view of their outcomes, allowing investors to view tangible environmental and societal impacts of their investments. Ultimately, a common regulatory framework, such as the SFDR, strengthens the credibility and effectiveness of sustainable investment, benefiting both investors and society.
For more information about Impact Funds and SFDR Article 9 Funds, contact us today to learn more about how Cority can help.
