The growing importance of ESG in fund launches

Environmental, social and governance (ESG) factors are increasingly important when launching new funds. Ocorian surveyed fund managers interested in launching funds in Europe and almost all (97%) think it will become harder to do so unless they have a strong ESG focus.

In this article, we examine the findings of Ocorian’s research, specifically the rules around fund names, marketing and launches.

Once you have the measure of ESG relevance to your audience, how do you go to market?

Funds are able to label their products as ‘green’, ‘sustainable’ or ‘environmental’ via a range of schemes in different jurisdictions as long as these terms can be fully justified.

Within the process of integrating a strategy, businesses must now routinely look at sustainability in the same way as previously they analysed EBITDA, they will need to mine data from underlying assets, and reassure regulators and authorities that they’ll have continued access to data to be given an ESG label.

It’s not enough to do a snapshot at the point of investment; if the fund wants to gain a coveted sustainable label, 70% of the fund’s investments need to pursue a sustainable objective over the lifetime of the fund.

Despite the rise in prominence of fund labelling, there are still some grey areas around how best to quantify ESG elements. For example, many standards adopt the concept of ‘do no significant harm’, which is quite subjective and requires significant due diligence to check that in order to provide for good a company does not unwittingly create another problem, for example building solar energy units at the expense of local wildlife.

Why managers should look at sustainability in the round

“Integration really is key because ESG factors should not stand alone, completely outside the investment process,” says Abi Reilly, Funds Practice Lead, Bovill Newgate. “It’s becoming more common now, but in the next five years I think it’ll be a fundamental part of investing; looking at companies’ performance as well as how they are tackling gender equality will absolutely be the norm.”

Due diligence teams looking at portfolio companies will often have a sustainability check list, where they use a numeric system to score environmental, social and governance strategies that businesses have; if they don’t score highly, they risk being rejected as suitable investment opportunities, especially for funds seeking to apply for an ESG label. 

The Financial Conduct Authority (FCA) finalised its Sustainability Disclosure Requirements (SDR) and investment labels regime for funds based in the UK in November 2023 – with businesses able to use labels from 31 July 2024, forcing them to ensure a 70% fulfilment of a sustainability objective. If funds aren’t going for a label, they still must be careful around how they market their products.

If a manager uses the terms ‘sustainable’ or ‘impact’ in the title of funds that are to be marketed to retail then they are then subject to the same disclosure requirements as if they had formally labelled their fund. Even using marketing terms such as ‘green ‘or ‘Paris aligned’ in financial promotions designed for professional investors, fund managers need to be careful as they can fall foul of the anti-green washing rules applicable to all regulated firms.

What are the litigation risks?

There are numerous litigation risks which have recently become more likely to emerge with the increase in ESG focus, such as:

• Companies that make exaggerated or false claims about their ESG practices may face lawsuits for misrepresentation or fraud
• As governments introduce more regulations around ESG, companies that fail to comply may face fines, sanctions, or litigation
• Failing to disclose ESG risks and practices accurately in financial reports can lead to regulatory fines and/or litigation
• Board members and executives might be individually sued by shareholders for not adequately managing ESG risks, which can be seen as a breach of their fiduciary duty and in the case of regulated firms’ executives in breach of the senior manager conduct rules
• Companies can face litigation for environmental damage caused by their operations, including pollution, deforestation, and harm to biodiversity

To address these risks, businesses will need to ensure accurate and transparent reporting of ESG practices, as well integrating ESG considerations into their corporate governance frameworks.

Ocorian’s research investigated whether European regulation was seen as complex and whether ESG was viewed as a priority. Only 1% of North American managers thought that the European regulation was not complex and almost all (97%) those survey agreed it would be harder to launch new funds in Europe without a strong ESG focus.

Bovill Newgate’s Ed O’Bree picks up the thread: “What's interesting is that 83% of those who answered our survey were already marketing and raising capital in Europe. Of the remaining 17%, 76% planned to raise capital in Europe in the next two to three years.

“So, what does that mean? Yes, we have complex regulation across Europe, and yes, it is becoming more complex with upcoming regulations like DORA, increased ESG rules, and AIFMD 2. However, these complexities don't seem to be putting people off. With the right advisers, planning, and looking out at the horizon, firms can deal with these challenges and hopefully find some kind of advantage, as many have with the new ESG rules."

What ESG rules are changing and how to navigate the changes?

Upcoming changes to SFDR include specific provisions on product labelling: the existing SFDR labels (Article 8 and 9) might be revised or supplemented with new categories to offer more clarity and comparability between different products. EU and UK regulators are consulting with each other, so it’s likely they will try to harmonise an approach to labelling across both regions, to help address the challenges faced by retail investors when trying to understand a financial product’s focus on sustainability.

While there’s no indication of any significant change in scope in terms of who the regulation applies to, we do expect many of the reporting requirements to be made broader. This means that regulation might even apply to financial market participants who don’t promote themselves as ‘sustainable’.

When launching a fund, it is vital to carefully label it by aligning the name with the applicable rules and regulations to prevent any misleading claims or to avoid any potential legal issues. By adhering to the strict legal and financial guidelines, this will minimise the risk of litigation.

Using legal and financial experts early in the fund launching process will ensure that all aspects of the fund are handled properly from the get-go, and they are able to provide the relevant guidance and help navigate complex regulatory requirements.

About Ocorian Fund Services

Ocorian’s fund services team delivers operational excellence across fund administration, AIFM, depositary and accounting services to the world’s largest financial institutions along with dynamic start-up fund managers and boutique houses. It’s team of over 300 funds specialists work across all major asset classes of alternative investment funds such as private equity, real estate, infrastructure, debt, and venture capital, whilst its specialist Islamic Finance team is a leading provider of Sharia-compliant investment structures.

About Bovill Newgate, an Ocorian company 

Bovill Newgate is an Ocorian company and specialist financial services regulatory consultancy with a global offering across the UK, the Channel Islands, Singapore, Hong Kong, Mauritius, and the Americas. The firm helps its clients meet complex and evolving regulatory obligations, providing certainty and peace of mind. Its clients are firms of every size across the financial services sector. Bovill Newgate supports its clients in managing regulatory change and dealing with regulatory scrutiny. Providing advice on regulatory change and preventing financial crime, applications to regulators, building or enhancing regulatory frameworks, conducting compliance investigations or diagnostics, training and fulfilling prescribed roles Bovill Newgate have experts based across all the world’s key financial centres who operate globally, acting as one team.