What the UK’s SDR means for private fund managers, explained by lawyers

The UK’s Sustainability Disclosure Requirements will be published early next year, due to come into effect in June 2024. Herbert Smith Freehills’ Rebecca Perlman, head of ESG for the UK, US and EMEA, and senior associate Shantanu Naravane spoke to New Private Markets about what the regulation means for private fund managers.

What is the SDR?

The SDR, proposed by the UK’s Financial Conduct Authority, introduces labelling and disclosure rules for funds that are marketed as having sustainable characteristics. The labelling regime will apply to all funds managed by UK-based firms or marketed to UK-based investors. The disclosure requirements will vary by whether a fund is marketed to institutional or retail, consumer or non-professional investors.

Although the regulation “is geared towards enhancing trust within the consumer or retail investor base”, says Perlman, “the regulatory proposals are far more wide-ranging and impact the entire product range and all distribution channels.”

Current status

The SDR is in consultation phase: industry members are invited to provide guidance on the proposal until 25 January 2023. In October 2022, the FCA released a consultation paper covering the proposed rules and questions for industry members to shape the SDR’s details.

The FCA expects to release the finalised requirements by June 2023, and they will come into effect a year later in June 2024.

Co-existing with the SFDR and TCFD

The FCA is making efforts to reduce incompatibilities with the EU’s Sustainability Financial Disclosure Regime, but SDR-compliant labels for ‘sustainable’ funds will not be interchangeable with Articles 8 or 9 of the SFDR.

“A lot of Article 8 products won’t be eligible for the FCA’s labels,” says Naravane. “It’s possible to be designated Article 8 through a negative exclusionary strategy, whereas for the FCA’s labels you need to have some positive contribution to environment or society. Just screening out the bad actors is not enough.”

Asset managers must also provide climate-related disclosures in separate regulation aligned with the Taskforce on Climate-Related Disclosures. The TCFD regulation, which came into effect on 1 January 2022, will remain in place alongside the SDR – although the FCA plans to replace it with International Sustainability Standards Board-aligned reporting standards once these are released.

The labels

There are three categories (“fund labels”) that allow fund managers to use certain terms in their marketing and will require particular sustainability-related disclosures. “Products that don’t align with any of those labels will be label-less,” says Perlman.

• Sustainable focus: At least 70 percent of the fund must be invested in assets that “maintain a high standard of sustainability”. Fund managers can meet this requirement by aligning the fund with a specified sustainability theme such as climate or by “meet[ing] a credible standard of environmental or social sustainability”, according to the latest consultation document. The FCA does not specify a standard, but stipulates that it must be “robust, independently assessed, evidence-based and transparent”. The FCA may mandate the use of the UK’s Green Taxonomy, which is currently under development, at a later date.

• Sustainable improvers: A fund investing in assets that are “not currently environmentally or socially sustainable” at the time of investment, “with an objective to deliver measurable improvements in the sustainability profile of assets over time”, according to the latest consultation document. Fund managers must set and disclose KPIs for improving the sustainability profiles of a fund’s assets. Managers must also outline investment processes, stewardship activities and scenarios of non-improvement that could trigger divestment.

• Sustainable impact: The fund must have an explicit goal to “achieve a positive, measurable contribution” to sustainable social or environmental outcomes. The FCA emphasises additionality: the fund must have “a clearly-articulated theory of change” that its capital delivers. Fund managers will need to use “industry standard approaches” and “rigorous, evidence-based KPIs” to report on impact performance.

“We would expect UK-authorised private fund managers to comply with these requirements, even if the naming and marketing rules and the distribution rules do not strictly apply to any products they manage which are not marketed to retail,” says Naravane.