- within Government and Public Sector topic(s)
KEY INSIGHTS
Private capital vital: Europe needs significant private investment in defence, but unlocking this funding is complex due to structural obstacles and varied investor policies.
SFDR need not be a blocker: The SFDR itself does not prevent defence investment, yet its lack of clarity – especially regarding human rights due diligence – creates real compliance challenges for some European funds.
Urgent need for guidance: Asset managers would benefit from clear, consensus-based standards on human rights due diligence in defence, as current European Commission advice and industry practice remain insufficient.
Overview
A regular briefing for the alternative asset management industry.
Everyone now knows that Europe will spend more on its defence in the coming decade. What is less clear, though, is where the money will come from. While there is general agreement that public sector funding will not be enough, unlocking private sector capital is not straightforward – including for private equity, credit and infrastructure funds. As we have said before, governments will have to clear several obstacles to ensure appropriate investment opportunities meet risk and return expectations. They can also help to ensure those opportunities conform to the legitimate sustainability concerns they have encouraged in recent years.
The European Commission has recognised the problem and is keen to fix it. Its Defence Readiness Omnibus, published earlier this year, includes a number of worthwhile initiatives to tackle issues like procurement, licensing and import duties. In fact, many of these are issues that need to be addressed at member state level, but the political will is clear, and the Commission's leadership is helpful. On sustainability regulation specifically, the Commission also published a Notice, explaining why the EU's sustainable finance regulations, including the cornerstone Sustainable Finance Disclosure Regulation (SFDR), are "fully consistent" with facilitating defence investment. A report issued last month by RUSI concludes that ESG regulation has "little impact on the defence industry's access to capital".
That's true – as we pointed out in April, most of the obstacles to investing in defence assets are actually more deep-rooted and structural. And, for alternative asset managers, LPs' own internal policies, and the resulting side letter demands, can be problematic – especially given that they all vary. Some industry-standard wording (like this, proposed by EDIN) would undoubtedly help, but won't be a panacea – in particular, because of the geographically diverse investor base of many private capital funds.
"Human rights due diligence is intended to identify and mitigate – although not to eliminate – risks that the products of the investee company will be used to infringe fundamental rights. This is both important and difficult."
It would be wrong, though, to conclude that the SFDR is irrelevant for alternative investment fund managers that want to make a defence-related investment. The notorious lack of clarity in the SFDR means that navigating it is harder that it should be. In particular – as we explain in a note issued this week – the SFDR's (sensible) requirement for an explanation of how a "sustainable investment" satisfies human rights requirements needs careful thought. The European Commission's analysis on this point is superficial and its suggested solution is not a complete answer.
Sponsors of private funds that are categorised as "Article 8" do not have much to worry about. As long as they have not made minimum commitments to make "sustainable investments", or to align with the EU Taxonomy – and the vast majority have not – the SFDR's requirements are relatively straightforward. The manager must ensure the investee follows good governance practices, and that the investment is otherwise consistent with the environmental or social characteristics that have been advertised to investors.
However, for an "Article 9" fund – which can only make "sustainable investments" – the process is more involved. If a manager wants to classify an investment as "sustainable", it must first identify an environmental or (more likely) social objective to which the investee contributes and, secondly, perform a "do no significant harm" test. This second step requires a broad assessment of sustainability factors, including confirmation that the investee is not involved in the manufacture of certain "controversial weapons". Finally, the asset manager will need to be able to explain, among other things, how it has carried out human rights due diligence. No investment can be qualified as "sustainable" under the SFDR without such an explanation.
Human rights due diligence is intended to identify and mitigate – although not to eliminate – risks that the products of the investee company will be used to infringe fundamental rights, including the right to life, liberty and freedom from torture. This is both important and difficult. Supply chains are complex and can be opaque. Products often end up in conflict zones. These issues make responsible precautions all the more important. As this UN report highlights, human rights due diligence is possible – and necessary – for defence investments but rarely done well.
The European Commission addresses this issue in its Notice; it recommends reliance on national export licensing rules. That is helpful, as far as it goes, but the UN report argues that it is not enough on its own, and many asset managers (and their investors) will want to do more. For them, clearer guidance on how to conduct meaningful human rights due diligence in the defence sector would be welcome – and is currently lacking. The industry should support and develop consensus-based, practical standards for defence reviews, perhaps using this ABA guidance as a basis. These should facilitate rather than preclude responsible investments in defence.
Europe needs private capital to fund its security, and the message from Brussels is clear: we will work to dismantle the barriers – but the SFDR is not one of them. However, given that the stakes are so high, more concrete help would be useful, especially if international standards on human rights are to be taken seriously and not side-lined. SFDR reform proposals are expected in mid-November and the Commission should make good on its commitment to address this head-on, rather than swat the problem away.
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