ESG – Essentials for new managers

What environmental, social and governance factors hedge funds should consider.

By Lucian Firth, Partner, and Kate Tracey, Managing Associate, Simmons & Simmons LLP.

ESG, the consideration of environmental, social and governance factors, continues to make headlines. While for many start-up hedge fund managers developing ESG policies and adhering to standards such as the UN PRI (Principles for Responsible Investment) may sit on the “when we have more time and money” list and not on the critical path to launch, ESG is a theme that is increasingly recognized as beneficial to many hedge fund strategies and that allocators are often interested in as part of their due diligence. Further, regulations mandate ESG-related disclosures in some circumstances – and not just for funds with an ESG focus.

In this section we outline some of the key considerations for new managers when establishing their initial approach and also explain how ESG regulations can apply, even for non-ESG focused funds.

Investment manager-level considerations

ESG considerations are relevant to investment management firms themselves, in addition to the assets in their portfolios.

Given the very small headcount of most new hedge fund managers, “own account” ESG at firm level often receives little attention, its relevance increasing as the firm grows in size. However, demonstrating that “own account” ESG is, at least, given some thought may resonate both with investors and with new hires alike.

The most significant contributor to the environmental footprint of a new manager is usually business travel - when considering how to travel to in-person meetings, is carbon emissions a factor, alongside price and convenience?

Main takeaways

1. Start-up managers that are in scope of the SFDR need to consider which category their fund falls into.
2. With in-scope funds (including non-ESG funds) the manager must disclose how it integrates sustainability risks into investment decisions and disclose the likely impact of those risks on returns of the fund.

In many cases face-to-face meetings critical for securing investments and taking the train is not a viable alternative to flying. However, the negative effects of flying can be mitigated though purchasing carbon offsets at a relatively low cost.

As the firm grows in scale, the social considerations around hiring and nurturing a team become more relevant. Beyond being seen to be socially responsible, the diversity of the team may help achieve a broader range of perspectives to contribute to the investment process.

When thinking about social and governance factors, an increasing number of firms are considering the composition of the board of directors of the fund vehicles themselves - when selecting independent professional directors, diversity in backgrounds and experience and gender balance in particular are now receiving attention.

Investment approaches

ESG factors can be relevant to many investment approaches adopted by hedge fund managers. Sustainability risks, in particular, may be relevant to a wide range of investment strategies for financial risk/return considerations, regardless of whether such strategies have a sustainability focus.

Incorporating some basic negative screening is also a relatively straightforward approach employed by an increasing number of managers. This might involve restricting investment in issuers deriving significant revenues from solid fossil fuels or involvement in controversial weapons.

Further, the use of short positions in respect to poor ESG performers is increasingly accepted.

Some strategies, such as macro and relative value, however, do not present the same opportunities for ESG integration, although managers of these strategies can still consider their “own account” ESG at firm level.

 

Kate Tracey, Managing Associate, Simmons & Simmons LLP

 

Greenwashing

In order to be credible to allocators, any claims around the extent of ESG integration need to be authentic and proportionate. For example, claiming that a fund is “green” because it will not invest in solid fossil fuels, but where such investments are only an insignificant portion of the possible investment universe is unlikely to be well received, and may expose the manager to mis-selling claims and regulatory risk.

Further, managers would be well-advised to ensure that any claims they make are supported by documented internal processes that are consistently followed.

 

EU regulatory framework

The EU Sustainable Finance Disclosure Regulation (SFDR) applies from March 2021 and forms part of the EU’s package of measures relating to ESG issues. The SFDR applies to EU managers,

although in certain circumstances it also applies to U.K. and other non-EU managers as outlined below.

The SFDR is framed as a series of sustainability-related disclosures that must be made in the documentation for a fund or on a manager’s website, relating to:

• the integration of sustainability risks in the asset manager’s investment process; and
• the consideration of the adverse impact that investment decisions may have on sustainability factors.

 

Lucian Firth, Partner, Simmons & Simmons LLP

Key concepts under the SFDR

The SFDR introduced new concepts relating to and defining aspects of sustainability (which feed into the key rules introduced by the SFDR):

“Sustainable investment”: In summary, this is an investment in an economic activity which:

• Contributes either to an environmental or a social objective;
• Does not significantly harm any economic or social objectives; and
• The investee company follows good governance.

“Sustainability risk”: an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of an investment.

“Sustainability factors”: environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters.

In addition to their use in the SFDR, these defined concepts are beginning to be used by allocators and managers in the U.K. and elsewhere outside the EU as a common language for expressing ESG concepts.

Categorization of products under the SFDR

The SFDR provides for three specific categories of financial products, such as funds:

• products that have sustainable investment as their objective (known as “Article 9” products);
• products that promote (amongst other things) environmental or social characteristics (known as “Article 8” products); and
• other products, not falling into the above two categories (informally known as “Article 6” products).

Additional requirements apply under the EU’s Framework Regulation (Taxonomy) to products that focus on one or more of six environmental objectives.

Certain of the disclosure requirements under the SFDR apply to all funds made available by an in-scope asset manager, including those falling into the “Article 6” category, so non-ESG focused funds still have to make certain disclosures.

Most hedge fund strategies do not fall within Article 8 or 9 of SFDR, although an increasing number of managers are looking to categorize funds as Article 8 so as to take advantage of perceived investor demand for such funds.

Start-up managers that are in scope of the SFDR will therefore need to consider which category their fund will fall into and whether, in light of their potential investor base, they want to structure their fund so as to fall into a particular category.

 

 

What are the key requirements of the SFDR?

An in-scope manager must:

1. Formulate a policy on the integration of sustainability risks in its decision-making process;

2. either:

a. Implement a due diligence policy with respect to the principal adverse impacts (PAI) of its investment decisions on sustainability factors; or

b. Explain reasons why it does not consider such adverse impacts (including, where relevant, information as to whether and when it intends to consider such adverse impacts), although this option is not available to firms with more than 500 employees;

3. Include in its remuneration policy information on how the policy is consistent with the integration of sustainability risks.

For all in-scope funds (including non-ESG funds) the manager must disclose how it integrates sustainability risks into investment decisions and disclose the likely impact of those risks on returns of the fund, along with certain other information.

Additional more detailed disclosures are required for Article 8 funds that promote environmental or social characteristics and Article 9 funds that have sustainable investment as their objective.

When does the SFDR apply to U.K. (and non-EU) hedge fund managers?

As an EU regulation, the SFDR is not generally applicable to UK (or other non-EU) managers, but certain activities can bring such managers into the scope of SFDR requirements.

The SFDR can apply to non-EU investment managers in two main ways:

• Directly, where the non-EU manager markets a fund into the EU under AIFMD national private placement rules. Here, the non-EU manager will need to prepare manager-level policies and disclosures and also fund specific disclosures for the funds marked in the EU.

• Indirectly, where the non-EU managers acts as a delegate to an EU manager, such as where a non-EU firm manages a Luxembourg or Irish fund. Here, the EU manager may push down SFDR obligations, and/or as a practical matter it may be appropriate for the non-EU manager to be heavily involved in preparing the SFDR disclosures in respect to the fund.

U.K. “TCFD” climate-related disclosure obligations

As mentioned, the SFDR does not apply in the U.K. but the FCA is consulting on proposed climate-related disclosure obligations for certain U.K. regulated asset managers, which could include larger hedge fund managers. The proposed disclosure obligations are based on 

 

recommendations published by the Task Force on Climate-related Financial Disclosure (TCFD). It is proposed that there will be a phased approach to implementation, with the largest firms in scope from 2022.

However, it is proposed that these obligations will not apply to managers with less than GBP 5 billion of assets under management. Given this exception, start-up managers will not be immediately within scope. However, the regime may still be relevant if institutional investors demand disclosures from smaller firms.

About the contributors

Lucian is a hedge funds partner at Simmons & Simmons in London and focuses on structuring alternative investment funds, single investor vehicles and managed accounts. Lucian acts for a broad range of hedge fund managers and a significant part of his practice is devoted to advising start-up managers on establishing their management and fund structures, alongside providing ongoing advice to large established firms.

Lucian is also an expert on ESG and sustainability and is very experienced in helping hedge managers in the UK, US and EU develop and document their own approach to ESG which is relevant to their asset classes and strategy, and navigate the increasing regulatory requirements.

Kate is a Managing Associate at Simmons & Simmons in London and advises asset managers, from start-ups to established names, with a key focus on the establishment, structuring, restructuring and maintenance of hedge funds and managed accounts.

Kate is also an expert on ESG and sustainability requirements and advises numerous managers on their ESG approach and compliance with ESG regulations.