3 tips for new impact investors to address SFDR requirements

The world of impact investing is growing. The promise of financial returns with positive environmental and societal outcomes has driven significant growth in the sector. Organisations like the Global Impact Investing Network (GIIN) are now sizing the impact investing market at over $1trillion

But with the introduction of the EU’s Sustainable Finance Disclosure Regulation (SFDR), impact investors are hitting a roadblock due to the strict and uniform reporting requirements it brings. Pitchbook’s sustainable investment survey of 2023 shows that, especially in Europe, investors experience difficulty in collecting data on ESG factors and find regulation unclear and burdensome.

The investor struggle

Because of inconsistent reporting standards and a lack of comprehensive data, investors are struggling to assess the true impact of their investments. The introduction of SFDR and Article 9 aimed to address this by creating a common ‘impact investing’ language, but so far it is showing little signs of success.

To be clear, we agree that managing impact and adhering to regulatory requirements is crucial to avoid greenwashing and build transparency. But a uniform, standardised approach may be an Achilles heel for impact investing and reporting. The multitude of reports designed to guide VCs and startups on how to report their impact only underscores this difficulty.

Although frameworks such as the Global Reporting Initiative (GRI ), Project Frame and the Impact Reporting and Investment Standards (IRIS ) offer valuable guidance for transparent impact reporting, we wanted to highlight some issues we have encountered since these regulations were implemented and provide advice on how to overcome them.

Here are our top 3 learnings for any aspiring impact fund addressing SFDR requirements:

1. Set impact and sustainability KPIs from the start

To ensure investments are more than just financially motivated, your due diligence process should incorporate impact and sustainability from the beginning.

Defining, measuring and quantifying the potential impact of a startup is a key task for any impact fund (and a requirement under SFDR Article 9). While goals at the fund level are not mandatory, individual company targets and KPIs to track them are expected.

At SET, we establish impact KPIs with the startup before investing. We often prioritise operational or outcome KPIs that the companies can integrate into their core operations and business reporting. This approach ensures that impact reporting regularly steers the company and that its strategy is inherently aligned with achieving impact.

Note, that individual targets and KPIs are typically stage-specific and may change as the company scales its growth strategy. Still, creating these environmental investment objectives is doable, even though you may invest in a diverse set of companies and business models.

Besides the focus on impact, sustainability assessments should be integrated early into a VC’s due diligence process. VCs need to look beyond financial performance and evaluate the environmental, social and governance (ESG) practices of deals.

The fact that a startup itself is focused on “doing good’ may seem sufficient for an impact investor, but engaging in good sustainability practices early will benefit both the startup as it scales, and the VC in SFDR compliance.

2. Set environmental investment objectives – by applying the Theory of Change framework

Complying (as well as one can) with SFDR and other regulatory frameworks takes a robust structure for defining and measuring sustainable investments. By adhering to these standards, VCs ensure investments are aligned with best practices and benefit from regulatory incentives aimed at promoting sustainability – e.g. avoiding greenwashing.

SFDR Article 9 requires the definition of an environmental impact objective for each investment undertaken. This can be quite challenging, especially when dealing with different types of impact and different stages of growth.

We’ve found that regulation can accommodate different aspects of environmental impact investment and that applying a “Theory of Change ” framework is a good starting point to bring out the “additionality” of each investment.

This strategy supports the start-ups’ need for a pragmatic approach to measure impact and it supports the different reporting needs that LPs require from an impact fund. Aligning your investments to a well-defined, company-specific Theory of Change ensures that you agree with the startup on its impact journey. It also shows that you can align investments to your impact goals, your stakeholders and regulatory requirements under SFDR.

3. Minimize Principal Adverse Impact (PAI) reporting – ditch the one-size-fits-all approach

Another requirement under SFDR regulation is assessing the potential Principal Adverse Impact (PAI) of a company’s activities. In general, large companies are already required to engage in sustainability reporting. This is to meet regulatory demands under the new EU Corporate Social Responsibility Directive (CSRD) and to satisfy investor expectations. Usually, this includes reporting on scope 1 - 3 emissions but also includes labour, ethical and governance practices. However, under SFDR regulations, startups are required to also report on similar parameters no matter their size.

This has proven to be challenging. A startup’s limited resources makes it difficult to allocate sufficient time and expertise for such comprehensive reporting. Moreover, collecting this data is complex, particularly without established data management systems. Ensuring consistency, and transparency and obtaining third-party verification for sustainability reports can also be resource-intensive. All of which add to the overall burden on startups to report on the potential PAI.

The key is to keep PAI reporting to a minimum. Where data is not available, explain why no answer can be given and move on. Where data is available, guide startups through PAI requirements and methodologies to help them with calculations. Digital reporting tools allow fast and efficient processing and verification of such inputs. Integrating Impact and PAI reporting into business operations while investing in supportive technology will benefit the startup and its stakeholders in the long run.

The way forward: standardise metrics for each growth stage

The SFDR aims to create standardised metrics that allow for consistent measurement and comparison of the impact as well as sustainability outcomes of investments. What has become obvious, is that standardising your metrics does not equal a “one size fits all” approach. This is because standardised metrics don’t work for the various growth stages a startup faces. A startup in its seed stage will work with different metrics than one that is seeking Series C funding.

In our portfolio, we see the mature companies deploying a more robust impact and sustainability strategy, whereas the early-stage startups are more unique in their impact model and (rightly) focused on executing their go-to-market strategy.

As startups scale to mature companies, they should work with dynamic metrics that can scale and grow with them. It’s important to look at unique measurements while at the same time finding common ground to report on, and maintaining the flexibility to change the metrics as the company grows.

Conclusion: stay positive

Impact investing has great potential to drive positive change. But its success relies on transparency and the genuine commitment of VCs to their sustainability goals. While steps have been taken to enhance transparency in impact investing, challenges remain. With efforts often being fragmented among governments, limited partners (LPs), VCs and startups.

At the same time, strict PAI reporting requirements can sometimes hinder sustainability-focused startups, even though their positive impacts often outweigh their adverse ones. By adopting standardised (yet flexible per growth stage) metrics and maintaining clear communication, VCs can improve their impact reporting. These efforts will help the impact investing sector grow, delivering both financial returns and meaningful societal benefits.

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Join Us in Crafting Transparency

As an Article 9 VC fund, we are committed to enhancing transparency and accountability in impact investing.

We invite you to read our latest impact report to learn more about our methodology and the positive impacts of our portfolio companies.

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This article was written by Simone de Bruin , Head of Insights at SET Ventures . With input from Dr. Till Stenzel and Hayden Young .