Shantanu Naravene (top left), Stephen Newby (top right), Rebecca Perlman (bottom left) and Heike Schmitz (bottom right): Hebert Smith Freehills

The costs associated with ESG monitoring and reporting are the subject of continued industry debate, according to fund lawyers.

“One thing I am seeing in terms of fund terms is a debate between GPs and LPs about who bears that cost,” said Stephen Newby, a partner at law firm Herbert Smith Freehills. Newby was participating in a webinar on compliance with EU SFDR.

It is unclear if the cost of monitoring investments and reporting is part of the GP’s overhead – borne out of its management fee – or a fund expense passed on to the LPs over and above the management fee, Newby continued.

“I don’t think there is an answer to that in the market yet… We are certainly seeing ESG reporting costs being expressly identified as fund expenses, with some pushback from LPs, who say ‘well actually this is all now part of the ordinary course of business and the GP should be staffed up to bear that'”.

For managers considering Article 9 status – the most stringent sustainability standard under the EU SFDR – for their new fund, one of the first questions they ask is “Are investors willing to bear higher fees?”, said Heike Schmitz, a Herbert Smith Freehills partner based in Düsseldorf. “There is no clear answer to it, but there is a general feeling that if you are an Article 9 fund, that comes with a cost,” she said.

The question becomes even more challenging where you have a fund marketed to a global investor audience; the requirements of the European investors will effectively increase the operating costs for all LPs, noted Shantanu Naravane, a London-based partner. “It’s an interesting conversation,” he said.

Impact-linked carry

The conversation also took in the topic of impact-linked carried interest: a mechanism that means a portion of the GP’s carried interest can only be accessed if certain impact or ESG targets are met. This is an emerging trend, “so the mechanisms are still being refined”, said partner Rebecca Perlman, who noted:

  • Penalty-based structures – where a “reverse ratchet” is deployed to potentially withhold some carry – are “definitely the most common” way of linking impact KPIs to carried interest. This is as opposed to bonus-based system, where additional carry is accessed on the upside.
  • “Managers can sacrifice anything from 10-100 percent of the carry. Most examples we have seen are in the region of 15-50 percent sacrifice”, said Perlman, who also noted that sliding scales are more common than a simple, binary “pass/fail” approach.

Tax complication

One reason why penalty-based structures are more prevalent than bonus-based ones relates to tax treatment. Carried interest is taxed as a capital gain; if part of if it is awarded as a bonus, it could call its status as a capital gain into question. “The tax point needs to be considered very carefully,” said Newby. “The concern is the extent you are paying a bonus based on a non-financial metric; does that change that analysis?”