It is imperative for HR professionals, in-house counsel, compliance officers and others with responsibility for remuneration-related issues within firms who will be covered by the Alternative Investment Fund Managers Directive ("AIFMD") to be aware of the impact of the AIFMD on the structure and form of remuneration.
The AIFMD was published in the Official Journal of the EU on 1 July 2011. It enters into force today and member states are required to implement its provisions by 22 July 2013. On 13 July 2011 the European Securities and Markets Authority ("ESMA") published a consultation paper setting out its proposals for the level 2 implementing measures which are subsequently to be adopted at the EU level by the Commission. Those wishing to provide comments on the proposals have two months in which to give their feedback to ESMA. ESMA will then finalise its advice to the Commission by the stated deadline of 16 November 2011.
As far as the UK is concerned, the FSA (or its successor) will work to implement the AIFMD by the 22 July 2013 deadline and, we would expect, will consult on such implementation in 2012.
Who is covered by the AIFMD?
The AIFMD applies to Alternative Investment Fund Managers ("AIFMs") established in the EU which manage one or more alternative investment funds ("AIFs") irrespective of where the AIFs themselves are located, whether or not they are listed and what legal form the AIF takes. The AIFMD also applies to AIFMs established outside of the EU which manage one or more AIF(s) established in the EU or which market one or more (EU or non-EU) AIF(s) within the EU. AIFs include hedge funds, private equity funds, venture capital firms and commodities and real estate funds.
What is the main impact from a remuneration perspective?
The AIFMD will impose restrictions on the structure and form of remuneration that an AIFM can provide to certain categories of its employees. It also requires all AIFMs to implement policies and practices governing the remuneration of these employees which are designed to promote sound and effective risk management and not to encourage risk taking which is inconsistent with the risk profiles and rules of its AIFs.
Is this the same as CRD III?
Many firms which are subject to or aware of the terms of the amended Capital Requirements Directive ("CRD III") and/or the FSA's revised Remuneration Code (the "FSA Code") will find these concepts very familiar but, at this stage, there has been no confirmation that the remuneration regimes will be precisely aligned. The FSA Code, which came into force on 1 January 2011, implements the requirements in CRD III. The AIFMD remuneration requirements are based heavily on those in CRD III but there are likely to be some differences when implemented locally. Asset managers and hedge funds may, for example, have relied on certain of the proportionality provisions in the FSA Code when considering its application to their business. However, for these AIFMs, it may potentially no longer be proportionate simply to disapply the relevant principles and/or rules of CRD III and the FSA Code following implementation of the AIFMD. Essentially, this is because CRD III applies to a very broad range of financial institutions and the proportionality provisions take into account that firms should apply the rules in different ways to reflect their size and the nature of their activities, in particular providing for neutralisation of certain provisions by limited licence/limited activity firms. However given that the AIFMD applies only to AIFMs, there may be difficulties in arguing for the same wide application of proportionality across a spectrum. Therefore, rules under the AIFMD may need to be applied at least to some extent by each AIFM covered by the AIFMD. If this is to be the case, the AIFMD will have an impact not only on those AIFMs which are not currently subject to the FSA Code (in particular, many private equity and real estate managers) but also on AIFMs which are already subject to the FSA Code by potentially imposing additional requirements on them. All AIFMs will need to determine the extent to which they may need to change their policies and remuneration structures and they will have to use the time before the deadline for implementation to transition their remuneration practices.
Which employees will the AIFMD apply to?
Whether or not particular AIFM employees will be caught by the relevant remuneration policies and practices will depend largely on their impact on the risk profile of the AIFM. However, in broad terms this will include senior management, risk takers and those in control functions. Consideration will also have to be given to whether or not employees whose remuneration takes them into the same bracket as senior management or risk takers should also be caught (although we would assume that, in line with the approach under the FSA Code, such employees would only be caught if they were deemed to have a material impact on risk).
What is the scope of the remuneration obligations?
There are 18 remuneration principles set out in the AIFMD which apply to:
- remuneration of any type paid by an AIFM;
- any amount paid directly by the AIF itself, including carried interest; and
- any transfer of shares or units of the AIF, made for the benefit of any of the relevant categories of employee.
What are the principles?
The principles include general requirements which are likely to apply at the firm level (for example, that remuneration is consistent with and promotes sound and effective risk management and does not encourage risk-taking which is inconsistent with the risk profiles, fund rules or instruments of incorporation of the AIFs it manages) and certain specific limitations (some of which are set out below) and principles regarding the implementation and monitoring of remuneration policies.
The principles will all be subject to more detailed implementing rules but some key issues raised by the principles include:
- fixed and variable components of total remuneration need to be appropriately balanced – this may lead to firms considering whether to increase base pay and reduce bonus multiples;
- a substantial proportion (which is at least 40 per cent.) of the variable remuneration component is to be deferred over a period which is appropriate in view of the life cycle and redemption policy of the AIF concerned, with this deferral aligned with the nature of the risks of the AIF in question (in any case, the period should be at least 3 to 5 years unless the lifecycle of the AIF is shorter) and vesting no faster than on a pro rata basis each year;
- in the case where the variable remuneration component is particularly high (which the FSA currently consider to mean £500,000 or more in the context of the FSA Code), at least 60 per cent. of that amount will need to be deferred;
- where remuneration is performance related, the total amount of remuneration should be based on a combined assessment of the performance of the individual and of the business unit or the AIF concerned as well as the overall results of the AIFM, and when assessing individual performance, financial as well as non-financial criteria should be taken into account;
- subject to the legal structure of the AIF and its rules or instruments of incorporation, a substantial portion, and in any event at least 50 per cent. of any variable remuneration is to consist of units or shares of the AIF concerned, or equivalent ownership interests or share-linked instruments or equivalent non-cash instruments, unless the management of AIFs accounts for less than 50 per cent. of the total portfolio managed by the AIFM, in which case the minimum of 50 per cent. does not apply;
- variable remuneration, including any deferred portion, should only vest or be paid if it is "sustainable" according to the financial situation of the AIFM as a whole and justified according to the performance of the business unit, the AIF and the individual concerned;
- total variable remuneration is to be "considerably contracted" where there is subdued or negative financial performance of the AIFM or of the AIF, taking into account both current compensation and reductions in payouts of amounts previously earned, including through malus or clawback arrangements however it remains unclear how malus and/or clawback is expected to apply by way of ex-post risk adjustment;
- guaranteed minimum bonuses are to be "exceptional" and occur only in relation to the first year of employment;
- payments on termination of a contract are to reflect performance achieved over time and should be designed in a way not to reward failure; and
- staff members will need to be required to undertake not to use personal hedging strategies or remuneration and liability related insurance to undermine the risk alignment effects embedded in their remuneration arrangements.
The final version of the implementing rules will need to clarify the application of the principles in respect of AIFMs that manage a number of funds and who have individual teams managing particular AIFs.
The AIFMD provides that the AIFM is to comply with the remuneration principles in a way and to the extent that is appropriate to its size, internal organisation and the nature, scope and complexity of its activities. Detailed guidance on the application of the proportionality principle has been provided by the FSA in relation to the FSA Code (following guidance from the Committee of European Banking Supervisors) and it is hoped that similar guidance will be forthcoming both from ESMA and the FSA on the application of the AIFMD.
AIFMs that are significant in terms of (i) their overall size or the size of the AIFs they manage, (ii) their internal organisation, and (iii) the nature, scope and complexity of their activities, will be required to establish a remuneration committee that shall be responsible for decisions regarding remuneration. The members of the remuneration committee must be non-executives.
AIFMs applying for authorisation will be required to disclose details of their remuneration policies and practices to their regulator. AIFMs must also make available a financial report for each EU AIF (and for each non-EU AIF which it markets into the EU) setting out certain information in relation to the remuneration of employees working for the AIF.
As mentioned above, ESMA published its consultation paper on 13 July 2011 on possible implementing measures for AIFMD in response to the request for assistance sent by the European Commission in December 2010. The consultation will close on 13 September 2011, following which ESMA will finalise its advice to the Commission.