Discussions about ESG and impact investment are ubiquitous. The prevailing trend of opinion in the industry is a renewed focus on environmental, social and governance (ESG) issues. It is about mindset and behaviour not just law and regulation. Some investors have stringent requirements and expect specifics to be in place in terms of ESG investing, ESG reporting and ESG governance. This could include reference to their own ESG strategies, benchmarks and risk ratings, as well as requirements for an ESG officer and DD team to be in place. These requirements are often documented in side letters.

Many fund managers are developing impact processes, such as an impact thesis and screening tools that are integrated into their investment processes. Fund managers are also likely to be mapping their ESG obligations and expectations, what these mean for their business (including side letter alignment) and considering internal issues that fold into their ability to deliver (eg diversity quotas and adequate internal resource and expertise). We are also seeing funds introducing independent impact reports and external audit requirements to measure their ESG credentials and in order to facilitate the evolution and improvement of ESG practices.

This briefing sets out fund managers’ legal and regulatory obligations in terms of ESG compliance, some of the key frameworks and reporting standards in the funds sector and finishes with a handful of FAQs.

Fund managers’ legal and regulatory obligations in terms of ESG compliance

The EU has introduced a package of sustainable finance reforms that affect EU firms and those wanting to do business in the EU. We have set out in the table below the broad application and key impacts of this legislative package, including proposed delegated acts that integrate sustainability requirements into other directives, namely AIFMD and MiFID II (as well as the UCITS Directive, the Insurance Distribution Directive and Solvency II), and which are currently open for public feedback. There are greater disclosure and other obligations for those firms that have sustainability focus as part of their business. We have also set out the UK’s proposals on governance of climate decision-making.

Impact of Brexit on the UK’s implementation of the EU legislative package

It is not yet clear if all of this “in-flight” legislation will apply in the UK at the end of the transitional period. However, we would expect the UK to align its rules with those of the EU, at least in order to facilitate business continuity for cross-border fund operations. Also, the FCA’s October 2019 feedback statement states that the UK government is committed to at least matching the ambition of the EU’s sustainable finance action plan initiatives in relation to green finance, irrespective of the outcome of Brexit.

Other frameworks and reporting standards being welcomed in the market

A growing number of investors and managers are signatories to the UN Principles for Responsible Investment (PRI). This involves a manager’s commitment to six voluntary and aspirational investment principles, including: considering ESG issues when making investment decisions; seeking disclosures from ESG entities in which they invest; and reporting on ESG activities.

Another framework that is gaining global recognition in the funds industry is the UN’s Sustainable Development Goals (SDG) Impact Practice Standards for Private Equity Funds, a checklist designed to integrate impact into fund design and execution.

Finally, the Impact Management Project is a forum for organisations to build consensus on how to measure, compare and report impacts on environmental and social issues. It has created a toolkit that considers impact at every stage of the investment process to aid decision-making that optimises financial and social returns. Industry voices are championing how working on this type of integrated solution has the potential to unlock investment opportunities, such as private capital partnering with local authorities/government/other investors.

ESG as an opportunity for real estate as an asset class

We expect explicit and systematic inclusion of ESG in investment analysis and decisions to become standard; measuring impact to become equally routine. Developing best practices in the mainstream financial sector, alongside full integration of processes and stakeholder engagement, may take longer. We see this as an exciting opportunity for real estate as an asset class - that can have tangible effects on economic prosperity, health and wellbeing of stakeholders. Real estate fund managers and investors can therefore take advantage of this, by propagating best practices, unlocking investment opportunities and being able to differentiate by adding value.

FAQs for fund managers

1. What is impact investing?

Impact investing involves deliberately investing capital to create measurable social or environmental benefits. Fund managers use their expertise, skill set and investment toolkit to deliver investment returns around a bespoke, viable strategy. Impact investing adds a positive impact dimension, be it health and wellbeing, sustainable growth or clean energy.

2. How is this different from ESG, or from SRI?

ESG integration involves accounting for ESG factors in risk or investment management decisions. The product, asset or service itself does not necessarily have an impact thesis. Socially responsible investing involves a particular strategy, for example green investment or choosing not to invest in arms.

3. What’s the impact of the coronavirus pandemic on ESG and impact investing?

ESG is a trend that emerged quickly, comprehensively and broadly, galvanised by the growing importance of the impact of climate change. We expect the current COVID-19 crisis to increase the urgency of issues that need to be addressed, and bring a renewed focus on social and governance issues – for instance, in terms of how businesses treat their employees, suppliers and interact with their communities, as well as recovery funding being linked to achieving social good. Also that any environmental gains resulting from the current travel restrictions and lockdown measures can be capitalised on as these measures are eased.

4. How can I measure impact/ESG factors?

Investors will want to measure how well a fund manager executes strategies, and how it can improve. To achieve this managers will need to be able to systematically collect and report on data and information on the ground for each investment, which can then be measured on a consistent basis. GRESB is private real estate's leading ESG benchmark. Real estate managers are encouraged to carry out GRESB assessments, although there are areas of concern reported on it as a substantive, transparent and consistent tool.

This is a challenging and important area and will help drive scrutiny of investment products and avoid potentially problematic commercial and regulatory consequences of greenwashing and misleading product labelling.

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