The Business of Who Owns What
In the revival of post-pandemic tourism, travellers have been packing museums, hotels, and flights. Amidst the chaos of travelling, you may spot the Sheraton or Hilton airport hotel, both of which are clients. HotelBeds is the world鈥檚 leading bedbank and , a global private equity firm that raised 鈧�10 billion in their seventh fund. If you鈥檙e scrolling through TikTok while awaiting boarding, ByteDance, the developer of the app, . The Becel margarine on your sandwich is and the aircraft maintenance crew is contracted by Atlantic Aviation, . The tourism industry is just one of many that is largely owned and operated through private financial operations鈥攐r rather, 鈥渁sset managers.鈥�
Financialization has created a disconnect between consumers and the original source of the asset, but it鈥檚 quite literally everywhere. In fact, it鈥檚 increasingly pervasive in our environment and society.
In 2023, the EU Commission updated , or the Sustainable Finance Disclosure Regulation (SFDR), in recognition of the . The SFDR is a set of requirements for disclosing environmental, social, and governance (ESG) information. This instrument who operate or engage in trading within the EU鈥攇iven the globalised nature of the industry, this impacts major players in the Americas and Asia-Pacific, too. SFDR also targets greenwashing, or rather, the marketing practice of making environmentally unfriendly business practices appear sustainable to prospective investors and the public. Asset managers must now on the environment and social justice.
Under the new EU instrument, asset managers are of their funds鈥� portfolios (Level 1) and firms鈥� policies (Level 2). However, portfolio companies that make up asset managers鈥� investments like Atlantic Aviation will effectively be indirectly impacted. In order for asset managers to provide sustainability risk assessments, portfolio companies will also have to disclose the impact of the investments they receive. All companies with private money backing them will consequently have to conduct internal reporting. And more importantly, as European asset managers want CSR badges on their funds to avoid public scrutiny.
While SFDR reinforces a norm of standardized reporting for ESG investing, the question is whether it might turn out to be an effective tool to further greenwash long-standing industry practices. Are funds still investing in the same genre of portfolio companies prior to SFDR, or have LPs changed their fundraising strategies in response to this greater scrutiny? Has this, in turn, forced more asset managers to take on better business practices to qualify for a Corporate Social Responsibility (CSR) tag that classifies them as 鈥渟ustainable鈥� products? At the heart of the issue is whether or not disclosure is an effective tool in enacting better business practices.
Are there Alternatives to 鈥渕ore and more disclosure鈥�?
Starting a business is tough, and what immediately comes to mind for financial operations and market expansions are bank loans and, for larger endeavours, bonds and public listings on various stock markets. These were some of the first capitalisation methods adopted in western countries during the 19th century and remain important to this day. However, capitalisation methods have expanded drastically since then.
For example, there were only . This number has grown to . US equity markets represent 46.2 percent of , followed by China (10.6 percent), and the EU (9.1 percent).
What explains this evolution? In the US, from the hands of few robber barons with weakly diversified portfolios and high levels of control in the 19th and early 20th centuries, to more dispersed stock ownership by the mid- to late-20th century. Though, as Tim Smart points out, stock ownership has always been . However, , like political economist , argue this is mainly due to progressive antitrust laws, higher federal taxes during wartime, the 1920s stock market boom, the rise of the middle class, and an overall postwar boost in public and private retirement benefits, which allowed pension funds to become corporate America鈥檚 most dominant shareholders with highly diversified portfolios.
However, a new dragon entered the den in the 21st century: asset managers. While pension funds gather household retirement savings, asset managers pool the holdings of a range of investors including insurers, sovereign wealth funds, and other entities. Pension funds can be LPs themselves. They鈥檙e massive.
听
Figure 1. Investment chain under asset-management capitalism ()
While pension funds invest on behalf of employee contributors for their future benefit, for-profit intermediaries : asset manager employees get a cut of the returns too. The bigger the cut, the better.
The shift towards expanding asset management chains is also rising in Europe. With the , market-based funding substituted bank-based financing to a certain extent in North and Western Europe. Since then, they鈥檝e similarly been taking . However, trends like the governmental and corporate focus in ESG-oriented performance amidst this expansion are imposing new challenges for asset managers and private equity firms: namely, managing the operative costs of compliance.
Is SFDR trailblazing a greener path for investment decisions?
The SFDR was launched as one of the key pieces of the following the . This marks the .
Asset managers must now disclose at two phases of their operations. requires general disclosure on fund portfolios such as the sector in which it鈥檚 investing. is more prescriptive, mandating detailed disclosure at both the product and entity levels. Funds can be entitled to distinction awards for sustainable practice at this level. such as investment funds, insurance-based investments, and pension plans, among others. Sustainability-related risks caused by investments at the entity level are informed by EU Taxonomy, and FMPs may also consider . These are a set of quantitative metrics that cover ESG criteria such as greenhouse gas emissions and board gender diversity.
听
Figure 2. Illustration of SFDR disclosure phases ()
Crucially, to complete these indicators, detailed information is required from individual assets that comprise fund portfolios. As , this presents a huge challenge for asset managers, both because the indicators are complex and are not all standardized metrics. Further, . This is why recent SFDR discussions have been focused on these indicators.
More importantly, the answer to the major question of whether SFDR is effectively promoting sustainable business activity depends on how we think about disclosure and its effectiveness.
presented an analysis of eight disclosure policies, or 鈥渢ransparency systems,鈥� in the US. Among the three that were effective in advancing their regulatory objectives is Los Angeles County鈥檚 1997 restaurant grading system. Under that regime, which was created to (describe aim) restaurants had to display their government hygiene score from A (good), B, or C (bad). In applying this system, it turned out that C-graded restaurants saw revenue decreases while A-graded ones saw increases. In their research, Fung et al. described 鈥榙ouble embeddedness鈥� as a feature of disclosure effectiveness: transparency systems where users can provide feedback to disclosers would result in changing discloser behaviour if they found value in those responses for their goals.
SFDR鈥檚 PAI indicators converts complex information into user-friendly menus that promote 鈥榗omparison-shopping.鈥� SFDR is changing the landscape of information asymmetry between asset managers and investors. Given that investment firms must report on the same set of core PAI indicators, a key aspect is , either across different funds or across assets within a fund.
PAI indicators show investors the sustainability objectives of the product they鈥檙e buying into for what it is鈥攖he way hungry customers can (hope to) adequately assess the restaurant鈥檚 hygiene before stepping in for their meal. While there are no official requirements to publicly share PAI performance, it is expected that investors will request this information as LPs have shown a , especially in the EU. , and likewise, it is favourable for asset managers to attain their CSR badge. , partner at Deloitte Luxembourg, observed in June 2022 that investors were expecting asset managers to have ESG products. LPs have their own ESG goals to meet and will choose where to put their money accordingly. Firms with Article 8/9 badges will thus have an easier time fundraising in Europe.
However, investors prefer high returns to food poisoning. The previously cited . Obviously, there are incentives for both investors and disclosers if profits are on the line. If sustainability is not an objective for the purpose of being ESG-oriented, perhaps investors may factor it into their financial risk assessments. Already in 2018, the legal academic and climate change expert argued that sustainability risks pose real material, and economic, risks for investors. Should this consideration be widespread, asset managers would certainly be inclined to embed investor preferences for sustainable products moving forward.
鈥r is SFDR driving up new operation costs instead of tangible sustainable practice?
What鈥檚 perhaps most interesting is SFDR鈥檚 new Level 2 mandate to classify funds. Asset managers must into Article 6 (no sustainability objectives), Article 8 (some sustainability objectives), or Article 9 (only sustainability objectives). This means funds are being classified based on where the investments are going: funds invested in green technologies would be categorized as Article 9. Most funds with investments in Big Oil, for instance, would fall under Article 6, although even this is subject to debate as the And the rest鈥� well, that鈥檚 subject to questions.
There鈥檚 been a statistical trend in classifying funds as Article 8 to veer on the side of caution. According to , the EU fund universe is mainly dominated by Article 8 (33.6%) and Article 6 (62.2%) funds by the third quarter of 2022. It's also , causing many asset managers to reclassify their Article 9 funds into Article 8.
Article 8 is a broad category and funds that have 鈥榩ositive externalities鈥� for the environment or society can be classified as such. define 鈥渟ustainable investment鈥� as an investment in an economic activity that contributes to an environmental or social objective and does not significantly harm any of those objectives. While PAI indicators will help qualify and quantify what constitutes 鈥榮ustainable鈥� economic activity, critiques the for sustainable investments. There鈥檚 just . recommends EU regulators, or (ESAs), to provide further clarification on outstanding policy gaps and provide room for industries to transition in capital reallocation towards sustainable investments.
Article 8 funds are not any more pressured or obligated to make primarily sustainable investment decisions. SFDR is a disclosure mandate, not a law that forces asset managers to act more sustainably. While investor decisions based on SFDR classifications could sway asset managers to re-strategize, they can still choose to have unsustainable investment strategies鈥攁s long as their products are classified as Article 6.
In this sense, SFDR is not mandating ESG-friendly business practices directly but relies on market forces to act as a tool through which it should become easier to assess market trends. For example, and its make it attractive for asset managers to deploy capital in that space. Conversely, , as the long term viability of as well the potential to re-sell those assets are very low. It ultimately comes down to the trade-off between and their social necessity, or potential to retain high profits.
听
A Double-Edged Sword
Ensuring compliance with SFDR poses a : it demands significant time investments, coupled with the added burden of absorbing compliance costs. While Fung et al. have found disclosure policies can work, they also warn 鈥溾�� if the time and resources put into it are ignored. A part of this also depends on investor behaviour to incentivize asset managers to make a switch to more sustainable strategies.
Several observers, such as the Financial Times鈥� , have commented on the cost implications of ESG regulations like SFDR. According to Chan, the mandate will drive up costs of operation for asset managers and portfolio companies. The amount of time that is invested into legal consultations, increasingly pervasive SFDR clarification conferences, and data collection will accumulate costs that arguably could have otherwise been put into more sustainability-oriented actions. In a 2021 article published by , it was argued that European assets managers will need to focus on controlling costs to optimize inherent operating leverage to recover from current economic shocks. SFDR has a lot of potential鈥攂ut regulators will need to effectively resolve ambiguities while keeping operating costs to a minimum.
Current Trends & Challenges
ESG enthusiasts and regulators can remain optimistic, however. So far, reveals investors are pouring money into Article 9 funds. These funds have also seen the since SFDR was introduced. Conversely, Article 8 or 6 funds have . It seems asset managers are seeing this shift and re-strategizing to switch Article 6 funds into Article 8 or 9 products. Perhaps asset managers will now think twice before developing products with no sustainability objectives. Although, SFDR regulators will have to be wary to ensure it鈥檚 not becoming the for funds to majorly be classified under Article 8.
Figure 3. Reclassifications of the top 10 largest funds from Article 6 to Article 8 ().
While publishing PAI statements is only , nearly all (95 percent) of report PAI. However, it is important to note . With the , regulators will have to monitor its tangible effects on investor and asset manager behaviour.
Undoubtedly, regulators face a daunting challenge, but this marks a significant stride towards ESG regulations, and nations worldwide can draw inspiration from it. believes SFDR has the potential to steer the global shift towards sustainable finance. The introduction of SFDR came at opportune timing, coinciding with the expansion of Western Europe鈥檚 asset management landscape. If regulators can iron out the intricacies of SFDR effectively, it will establish a strong foundation for sustainable investments in Europe and across borders.
听