How sustainable investment rules have impacted funds documentation

Regulators have been grappling with how to ensure that investors in sustainability-related financial products have an appropriate level of protection, by setting certain minimum requirements for firms who offer such products, while also seeking to avoid imposing so stringent a regime as to restrict the traditional flexibility and freedoms associated with the private funds market.

As investors and fund managers look to embrace sustainable investing opportunities, they need to develop a compliance strategy to ensure fund documentation complies with the new regulation emerging in this area.

An emerging issue

For funds established in the EU, the Sustainable Finance Disclosure Regulation (SFDR) has so far had a significant, albeit compartmentalised, impact on the way private fund documentation is drafted. The regulatory requirements to provide pre-contractual disclosures give additional comfort to investors and an enhanced level of accountability for fund managers, and so managers are having to more carefully consider and describe the nature of the fund’s strategy when in the process of establishing the fund.

While SFDR has had significant implications for the fund industry, it has not itself had a major impact on the way the fund documentation is negotiated and prepared. In our experience, most fund documents already incorporated ESG considerations to some extent, either as part of the fund's investment strategy, objectives, or restrictions, or as part of the manager's own ESG policy and practices. The introduction of SFDR itself has not resulted in substantially different contractual obligations or rights for the parties.

Instead, investors are driving the more significant changes to fund document negotiations as a result of developing ever more sophisticated ESG-related targets and fund performance expectations. These not only influence the content and format of certain disclosures and reporting that the manager must provide to the investors and regulators, but are also driving changes to how such targets and performance are measured, incentivised, remunerated and documented.

Investor-instigated changes

Despite SFDR being in its infancy, sustainability is becoming a more prominent feature within investors’ own investment strategies. We have observed various degrees of sophistication over the ways in which investors seek to take advantage of sustainable investment opportunities in the private funds market.

At the more developed end of the spectrum, where a sustainability investment strategy has been more thoroughly considered, investors are seeking very specific sustainable outcomes from their investments, and such outcomes are already integrated within broader long-term investment and business plans. As a result, differences in the way the terms of conventional fund documentation are negotiated is very much dictated by individual investor policy and can contain very prescriptive and bespoke metrics by which fund manager performance is to be assessed.

The nature of these negotiated terms vary depending on the size and strategy of the fund, as well as the jurisdiction and sector of the investor, but can include:

• specific ESG investment restrictions;
• reporting obligations of the fund manager;
• enhanced oversight of proposed investments by the investor advisory committee in relation to sustainability-related factors;
• sustainability/impact-linked carried interest mechanics, whether on a positive or negative assessment basis;
• a requirement of the fund to appoint a third party sustainability adviser, for instance, to create the metrics against which the fund manager will be assessed and/or being responsible for making such assessment, and indeed avenues for resolution of any disputes in relation to whether sustainability targets have been met;
• establishment of various committees by way a forum for the manager and representatives of the investors to discuss prospective investments or existing investments with respect to meeting any sustainability targets.

As may be expected, where investors seek more unusual or bespoke terms, the managers have typically been more accommodating for cornerstone investors or where relatively few investors with aligned concepts of sustainable targets are being admitted to the fund. Therefore, it is important for investors and managers to have a clear understanding of their respective sustainability and ESG expectations and obligations during the establishment phase, and to communicate these effectively during the fund formation process to avoid potential disputes or misunderstandings during the life of the fund.

Examples of investors driving fund documentation changes

In our work at Pinsent Masons, we have advised institutional investor clients with developing fund terms in relatively novel ways to align with sustainability factors.

Consumer goods company

In this example, we advised a global consumer goods company, which participated in a joint venture fund arrangement, to be structured as an SFDR Article 9 fund, in relation to a regenerative agriculture investment strategy. The investor negotiated terms to align the manager’s performance with the investor’s sustainable investment targets through an incentivisation mechanism. The mechanism included:

• a bespoke sustainability-linked carry arrangement on a weighted basis such that if 75% or more of sustainability-related KPIs were achieved for each portfolio company then 100% of the available carried interest would be distributable to the fund manager, but with a sliding-scale adjustment to the applicable percentage of distributable carried interest for any failure to achieve the 75% threshold;
• an arrangement so that 50% of all available carried interest would be held in escrow until an assessment of performance had been carried out;
• additionally, as part of the negotiations, a third party adviser be appointed by the fund upon establishment and engaged to assist with, and be consulted on by the manager in, setting the various KPIs for portfolio companies and metrics by which the manager would be assessed, as well as the framework for the process to be followed in making an assessment of performance – which included regular consultations with certain committees with investor representation.

These fund governance measures underpinned our client’s efforts to achieve key sustainability targets in relation to its investment portfolio, and those of other parties to the arrangement.

Development finance institution

For another fund with an investment strategy focusing on sustainability in Africa, a similar sustainability-linked carry mechanic was negotiated by a development finance institution (DFI) investor. This arrangement provided that:

• an 80% threshold of achieving agreed sustainability objectives was required before the manager was entitled to 100% of the available carried interest;
• for any shortfall in performance to achieve this threshold, the percentage of carried interest not distributable to the manager would instead be donated to associations’ whose activities aligned with the sustainable performance targets set by the investor;
• the methodology for calculating the achievement of the sustainable objectives of the manager be set by the investor advisory committee;
• an independent adviser would be appointed to audit such calculations on an annual basis.

Despite a growing trend in more bespoke arrangements for aligning sustainability targets between investors and the fund manager, there are still funds – for example, focusing on regenerative agriculture or improving climate and biodiversity impact – which are being established where the entire investor contingent is satisfied that alignment with the manager in relation to sustainability targets is achieved through more conventional governance arrangements, such as through clearly defined investment objectives, investment restrictions, excuse rights in relation to particular types of investments, and regular impact reporting obligations of the manager.

Compliance strategies and best practices for meeting SFDR requirements

To ensure compliance with SFDR requirements, including around fund documentation, firms should consider:

• conducting a gap analysis to assess the current state of ESG integration and disclosure across the organisation, and identifying the actions needed to comply with SFDR;
• developing an ESG policy and strategy that aligns with SFDR principles and standards, and communicating it clearly to all stakeholders, including investors, employees, and regulators;
• implementing appropriate processes and systems to collect, monitor, and report ESG data and indicators, and ensuring their reliability, consistency, and comparability;
• applying a proportionate and risk-based approach to ESG disclosure, taking into account the size, nature, and complexity of the organisation and its products, and the expectations and preferences of the target market;
• reviewing and updating the ESG disclosure regularly and providing feedback and guidance to the relevant teams and functions on how to improve their ESG performance and reporting;
• engaging with external experts and industry bodies to keep abreast of the latest developments and best practices in ESG disclosure, and to benchmark the organisation's ESG practices against its peers and competitors;
• implementing suitable controls to manage and document compliance with SFDR requirements and commitments set out in fund documentation.