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28 July 202125 minute read

Integration of sustainability factors under the UCITS, AIFMD, IDD II and MIFID II regulations

Sustainability risks and factors to be taken into account by Alternative Investment Fund Managers
Sustainability risks and factors – new traction post 2008 for Alternative Investment Managers

Responsible investment is largely seen as the inclusion of environmental, social and governance (ESG) factors in investment and decision-making processes. This concept has developed over time, and more specifically post 2008.

Following the financial crisis of 2008, ESG progressively became a risk and performance management topic for management companies at large and AIFMs investing in private equity in particular. As a result, ESG dimensions were increasingly formalized and included into the investment policies, as part of the investment (ESG due diligence) and divestment (ESG vendor due diligence) processes. Typically, focus has been placed on the contribution of, for example, best practice governance policies. More recently, however, the broader environmental and societal impacts of investee company activities during the holding period has become an important factor for AIFM attention under the combined pressure of investors and the regulation. Specifically, fund managers have been tackling ESG risks at the level of their investee companies by drafting ESG action plans focusing on the most material priorities identified during the due diligence process or immediately post-closing. Progressively, ESG has become an operational component in its own right.

As a result of such increased traction, the process of ESG analysis has moved from an extra-economic analysis process to a full-fledged investment policy and it is now common to find investment fund managers promoting construction of a fund's portfolio with integrated ESG criteria. Investor demand for these products and broad alignment of such strategies with multiple national and supra-national political goals is fuelling the trend.

However, under the umbrella term of ESG, a broad range of environmental, social and governance factors and risks coexist. In recent years the multiplication of funds promoting an investment strategy deemed to be in line with ESG principles has raised a number of questions from investors and regulators as to the veracity of the relevant characteristics promoted by such funds and there has been mounting pressure for establishment of international standards to enable effective comparisons.

These issues have prompted the European legislator to adopt a normative framework for ESG funds. Through the new rules introduced by the EU regulation 2019/2088 on sustainability‐related disclosures in the financial services sector (SFDR), the European legislator intends to harmonise the rules for the disclosure of ESG information by fund managers. This will enable investors to be in a position to compare products and thus to make informed investment decisions. From a fund manager’s perspective, the legislative package makes clear that AIFMs need to account for sustainability risks and factors as part of their ordinary course duties and reporting obligations toward investors, both at their management company level and at the level of the investment funds they are manufacturing or selling (product level).

In this article, we will start by analysing the paradigmatic shift introduced by the new EU sustainability-related regulatory framework in relation to sustainability risks and factors, before reviewing how AIFMs should consider such sustainability risks in the conduct of their duties, and the extent to which negative impacts on sustainability factors need to be taken into account.

Sustainability risks and factors and the double materiality concept, a new paradigm

While the integration of sustainability risks into the fund? management process does not come as a completely new concept, the complexity of the new SFDR provisions and underlying concepts will oblige fund managers to drastically enhance their investment management processes and investor disclosures to be compliant.

One of the first challenges for fund managers is to clearly understand the double materiality concept so here, we will examine what this means. In SFDR, sustainability has a two-tier meaning and covers (i) integration of sustainability risks and the impact of such risks on the returns of the fund (Art. 6 of SFDR) and (ii) adverse sustainability impacts of investment decisions on sustainability factors (Art 4 and Art 7 of SFDR). These aspects are relevant both (i) at the management company level (i.e. the AIFM) and (ii) at the product level (i.e. the AIF).

What are the differences between these concepts?

  • A “sustainability risk” is defined by SFDR as “an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.” Sustainability risks are therefore risks encompassing short-term or long-term environmental, social or governance risks that AIFMs should assess as part of their investment decision-making processes – including within their due diligence. It also encompasses financial risks which may result from the material negative impact of such identified risks on the value of the investment, and indirectly on the value of the investment fund managed as a whole.
  • “Sustainability factors” are defined by SFDR as “any environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters” whereas adverse sustainability impacts (also called principal adverse impacts and referred as PAI) are the overall impacts that the investments have on ESG factors. As a result, AIFMs should assess, as part of their investment decision process, whether and how the economic activities to which they will be exposed as a consequence of the investment could have negative impacts on the environment, employees, communities, individuals or on the governance of entities.

As a result of SFDR, AIFMs must consider (and integrate in their investment decisions and management processes) these two additional concepts: relevant sustainability risks and the relevant principal adverse impacts of their investments on sustainability factors, with equal importance granted to the two concepts.

A good example to clearly distinguish between both concepts is that of a fund investing in coal plants producing electricity. Here the fund manager would need to be mindful of sustainability risks while investing (such as water management, any use of child labour, appropriate health and safety policies and governance in the plants, etc.). However, it would also need to be cognisant of the sustainability factors – investment in such a business could also cause principal adverse impacts on ESG factors (mainly on the environmental ones) which the manager will need to consider and assess as well.

As a result, the new sustainability regulatory framework introduced by SFDR is intended to produce holistic integration of these sustainability concepts across the entire value chain of asset management, with profound impacts on asset managers and AIFMs. From an operational perspective, the main challenge for AIFMs is to identify, assess the materiality, manage and monitor both sustainability risks and adverse impacts on sustainability factors, in order to be able to meet the new transparency requirements provided by SFDR.

In practice how are AIFMs dealing with sustainability risks and factors?

Sustainability risks

The applicable requirements in relation to sustainability risks operate at two levels: (i) AIFMs need to disclose how their risk management process accounts for sustainability risks (via information on how sustainability risks are taken into consideration as part of the investment decision process, which must be published on the AIFM website); and (ii) AIFMs must procure that fund offering documents (or any other pre-contractual obligation document issued to comply with Art. 23 of the AIFMD), includes a description on how the AIFM manages sustainability risks of the fund. This description must encompass how the potential impacts that an external ESG event could have on the fund’s financial returns are accounted for and the outcome of such an assessment or, as applicable, a clear and concise explanation that such sustainability risks at product level are not relevant.

While the notion of risk is simple to grasp, its implications are subtle. In relation to sustainability risks, the process generally starts with sustainability risk mapping, generally carried out across several teams having relevant expertise within the AIFM (the most obvious being the risk team and the portfolio management team). Then, the most relevant ESG risks arising in relation to a particular investment or a fund investment policy will be shortlisted, by adopting a classical risk management approach.

A classical risk management approach consists in documenting the materiality and relevance of a risk for a particular investment/fund. This often proves to be a complex process requiring a significant amount of data over an extensive historical period. Ideally, managers should be in a position to document the occurrence of likely events, impacts, existence and effectiveness of mitigating factors. In the event that internally defined risk acceptability thresholds are exceeded, managers must implement corrective actions developed in advance to limit the risks. For sustainability risks, the issue is clearly rendered even more complex by the simple lack of existing data in relation to some sustainability risks, and by data quality issues arising from incomplete, inaccurate, irrelevant, or out of date data.

At some point, it is therefore fair to say that sustainability risk assessment for AIFMs becomes a data management issue, which means that in order to substantiate their assessment of material sustainability risks, AIFMs need to have thorough processes in place to figure out what type of data and information (quantitative and qualitative) they need, how to collect that data and what to do with it once obtained. For real assets, the quality of data gathering heavily relies on the quality of data gathered from portfolio companies, which is why implementation of robust ESG policies and data collection processes at investee company levels are also crucial to ensure quality and meaningfulness of the data gathered. The materiality concept comes into play again here - it is essential to concentrate ESG themes on material issues in order to obtain the support of managers and internal teams.

AIFMs need to clarify how they identify, assess and quantify as relevant the impacts that an external environmental, social or governance-related event might have on the financial return of the funds managed (and discretionary mandates as applicable), as well as how their risk management process accounts for sustainability risks. As discussed below, this cannot be a one-off exercise but will need to be carried out alongside the investment process and on an ongoing basis during the holding period for real assets.

We have set out below a few examples of focus questions used by AIFMs to refine their risk management process around material sustainability-related risks and factors.

Investment phase          Typical question/ topic
  • Does the AIFM identify main ESG challenges and carry out a
    risks and opportunities analysis (resulting from climate change for instance)?
  •  Is ESG analysis systematically included in investment memos?
  • Are specific methodologies/ framework used e.g. EU taxonomy?
  • Are there ESG clauses included in the portfolio company
    related documentation (such as investment documents,
    reporting…), for instance?
  • What is the business model of the target company and what part
    of a more sustainable system does it contribute to?
Holding period
  • Are there specific processes in place to regularly collect and
    analyse ESG data and KPIs (such as using impact dashboard)?
  •  If a portfolio company is exposed to significant ESG related
    risks, how is the manager going to engage with the investee
    company to make sure these are identified and managed
    (financial, operational, commercial, reputational risks)?
  •  Is measurement of the financial contribution of ESG initiatives
    carried out at the level of the underlying assets?
  •  Are ESG improvement plans in place?
  •  Are ESG challenges monitored at board level or executive
    committee / how frequently (at least once a year)?
Exit/ divestment
  • Is ESG information systematically part of divestment memos?
  • How are potential buyers informed by the management company
    / AIFM on ESG performance of the investment?
Source: France Invest

An additional challenge for AIFMs is to adapt their risk management policy to the asset classes of the funds they manage. Indeed, the AIFM Directive did not intend to provide for regulations at product level and therefore managers of alternative investment funds are allowed to invest in a wide range of assets, including real assets. While the opportunity to invest in a variety of asset classes is one of the attractive features of alternative investment funds for investors, it also brings additional challenges in identifying, assessing and monitoring specific sustainability risks and negative impacts on sustainability factors which often require a high degree of tailored expertise.

We have set out a few examples of sustainability risks by asset class to illustrate these challenges.

Type of funds

Sustainability risks





Equity, private equity and debt funds.

  • Environmental risks: risks linked to climate change, access to and scarcity of natural resources and non-compliance with measures introduced by governments to foster a low-carbon economy and more broadly to reduce pollution and waste.
  • Social risks: such risks materialise internally or externally and may affect the company's subsidiaries, its suppliers, local communities, as well as the company's customers. The internal risks can correspond to a lack of diversity, incidents of discrimination and non-respect of fundamental employee rights such as human rights violations, modern slavery, workforce health and safety. External social factors can consist in cybersecurity threats and consumer data privacy violations, local community engagement, fines and other regulation sanctions and/or investigations and litigation.
  • Governance risks: companies are governed by a set of rules that structure the way companies are controlled and managed and the lack of institutional governance structure, as well as the lack of appropriate policies and processes ensuring the highest standards of governance may potentially negatively affect the performance of the investee companies and therefore the performance of the fund.





Venture Capital

Risks linked to the size of the investee companies which are at an early stage:

  • Environmental risks: small-sized companies mostly outsource their energy-intensive clouding activities and therefore have a low positive impact on the environment. In addition, technologies such as blockchain are increasingly adopted by startups and present environmental risks due to their significant energy requirements.
  • Social risks: insufficient social protections such as workplace accident prevention policies for employees or lack of whistleblower protection.
  • Governance risks: partial or total lack of clear separation of certain management functions in the investee companies. These companies face challenge in term of sufficient management, compliance and board oversight.



Real Estate

Real estate investments are inextricably linked to a specific geographic location:

  • Environmental risks: risks are linked to natural disasters and the potential additional costs they can generate (repairs, reconstruction, increased insurance costs). Climate changes risks (such as in temperature and precipitation) may increase the operating costs of a real estate assets and therefore its performance.

On top of this, Article 6 of SFDR provides that “the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available” need to be disclosed. The aim is for fund managers to assess the potential negative consequences of sustainability risks arising from one or more investments on the return of the fund. This assessment of the likely impacts of sustainability risks is carried out both quantitatively and qualitatively by AIFMs. In practice, the following risks are frequently spotted in these assessments:

  • Illiquidity Risk: the liquidity of the investments made by the fund may be negatively affected by the occurrence of an ESG or sustainability risk. The illiquidity of an investment may result in a negative impact of the return of the fund on such an investment if it results in extending the holding period, for instance, or in limiting exit opportunities.
  • Loss in value: to the extent that a sustainability risk occurs in a manner that has not been anticipated by the Partnership, it may negatively affect the value of an investment, and result in a material loss in value. The loss in value of an investment may result in a negative impact on the net asset value of the portfolio of the fund.
  • Reputational Risk: the occurrence of an ESG or sustainability risk at the level of a portfolio company may result in reputational damages and consequently a lack of business opportunities, enhanced personnel turnover and hiring difficulties, increased costs and expenses which will negatively affect the value of the investment and ultimately the return of the fund.

Sustainability factors

When an AIFM decides to consider principal adverse impacts of its investment decisions on sustainability factors, it will need to publish information in that respect on its website. In practice this means that the AIFM is expected to describe how it identifies and assesses the potential negative impacts of the investments on sustainability factors; to prepare and issue an annual impact report, including a number of indicators and their evolution from one year to the next (Art. 4 of SFDR) and to make disclosures at fund level (Art. 7 of SFDR).

Sustainability factors are typically taken into account by AIFMs through ESG integration policies and more specifically at the due diligence stage before an investment by the fund. In practice, ESG due diligence starts with a standard list of issues that need to be considered for every investment. The major issues are categorized within the three subdivisions of ESG criteria.

Regarding environment, the analysis will incorporate consideration of factors such as energy consumption (and source), biodiversity and habitat impact, resilience to catastrophe and disaster, land and water consumption and waste management. A holistic assessment is required to cover the investee company's internal management arrangements and its management of external negative factors. By extension, this analysis aims to highlight the impact of the investee company on sustainability factors both internally (eg implementation of an internal sustainability policy) and externally (eg positive or negative impacts of the products and services offered).

However, as we know, ESG does not only refer to environmental factors. Thus, AIFMs will have to analyse the impact of investee companies on social and governance factors as well. Social factors cover those relating to the fundamental rights of the actors in the company's economic chain: labour standards and working conditions, low-income communities access to education and resources, human rights and more broadly health and safety. The analysis typically goes further and takes into account factors relating to inclusion and diversity, stakeholder relations or controversial tenants whose data is more difficult to capture. Although governance factors are intuitively perceived as relating to factors related to the management and direction of the company, the scope of these governance factors is broader: they should also include, for instance, issues of data protection and privacy, cybersecurity and anti-bribery and money laundering.

In the past, the ESG analysis carried out by the dedicated teams on investments often resulted in a list of positive and negative impacts altogether. logically, asset managers were keener to disclose to their investors the positive impacts of the investments made by the fund. SFDR has brought about a paradigmatic shift in that respect as AIFMs are now required to disclose at least whether or not they are taking into account the negative impacts of their investments on sustainability factors. The investor should therefore receive information not only on sustainability risks but also on their negative impacts.

In accordance with the Joint Committee draft Regulatory Technical Standards (RTS) on ESG disclosures developed by the three European Supervisory Authorities (EBA, EIOPA and ESMA) under the SFDR, AIFMs that consider the main adverse impacts on sustainability factors must disclose negative sustainability indicators – together with their evolution from one year to the next – that allow for qualitative and quantitative measurement of the adverse impacts. In environmental terms, these are greenhouse gas emissions, biodiversity, water and waste management issues. Social and governance matters indicators are linked to social, employee, respect for human right, anti-corruption and anti-bribery issues. All these indicators, while the list provided by ESA in Table 1 of the draft RTS does not intend to be exhaustive, provide clues as to the sustainability factors that should be taken into account by AIFMs.


In light of the elements brought forward in this paper, it is clear that the consideration of sustainability risks and factors can no longer remain a selling argument put forward by so-called ESG funds and their managers for mainly commercial and marketing purposes. Times have changed and such changes are here to stay.

While the new regulatory wave introduced by SFDR, complementary RTS and the upcoming Taxonomy regulation can understandably frighten fund managers, in particular considering its complexity, the lack of data and track records, this additional layer of regulation also introduces a clarified and consistent framework that should give additional comfort to asset managers, investee companies and investors alike on their duties and obligations but also opportunities to contribute to a more sustainable future and to create long-lasting impact and value.