More than seven months after publishing its consultation paper, the European Securities and Markets Authority (ESMA) recently published final guidelines (Guidelines) on sound remuneration policies under the Alternative Investment Fund Managers Directive (AIFMD).
EU Member States are required to implement the AIFMD by 22 July 2013. Annex II of the AIFMD contains a set of remuneration principles with which alternative investment fund managers (AIFMs) managing certain alternative investment funds (AIFs) within the scope of AIFMD must comply when establishing and applying remuneration policies for certain types of employees. These principles will apply to a wide range of AIFMs, including managers of hedge funds, private equity funds and real estate funds to the extent that they are within scope of the AIFMD and require authorisation as "EU AIFMs".
The remuneration principles of AIFMD are substantially similar, but not identical, to those adopted in the Capital Requirements Directive III (CRD III). The CRD III remuneration principles were implemented in the UK through revisions made to the FSA’s Remuneration Code on 1 January 2011 (SYSC 19A of the FSA Handbook). In amending its Remuneration Code, the FSA followed guidelines on sound remuneration principles under CRD III developed by the Committee of European Banking Supervisors (CEBS).
ESMA was required to develop the Guidelines to ensure common, uniform and consistent application of the provisions on remuneration in the AIFMD.
The principles discussed in this note apply to EU AIFMs. However, non EU AIFMs marketing AIFs in Europe will have to disclose certain information about remuneration in the annual report of the AIF (discussed further below).
Perhaps the most significant feature of the Guidelines is that they apply a “look through” of the remuneration principles to entities to which portfolio management or risk management activities have been delegated (discussed further below). The decision to extend the remuneration principles to delegated entities appears to represent a considerable departure from ESMA’s consultation paper. It also appears to fly in the face of the responses to ESMA’s consultation and, arguably, stretches the boundaries of the provisions of the AIFMD itself.
What happens next?
EU competent authorities, including the FSA’s successor, the Financial Conduct Authority (the “FCA”), will have two months, following the publication by ESMA of translations of the Guidelines, to confirm whether they comply or intend to comply with the Guidelines by incorporating them into their supervisory provisions. To date, these translations have not been published. It is expected that most EU competent authorities will broadly comply with the Guidelines.
The Guidelines provide flesh to the bare bones of the AIFMD remuneration principles. The principles include a number of general provisions relating to the design, adoption, and review of remuneration policies, the overarching principle being to ensure that such policies are consistent with and promote sound and effective risk management. One particular principle requires certain AIFMs to establish a remuneration committee. Other principles require AIFMs (in broad terms) to ensure that for certain staff:
Performance related remuneration is based on the performance of the AIFM overall, the relevant business unit and the individual (including non-financial criteria).
- Performance is assessed in a multi-year framework.
- Guaranteed variable remuneration is exceptional, only occurring in the context of hiring new staff and is limited to the first year.
- Fixed and variable remuneration are appropriately balanced.
- Severance payments reflect performance over time and are not designed to reward failure.
- Where appropriate, a substantial portion, and in any event at least 50%, of both deferred and non-deferred variable remuneration consists of units or shares of the AIF concerned.
- Such non-cash units or shares are subject to an appropriate retention policy.
- A substantial portion of variable remuneration, and in any event at least 40% (or 60% where remuneration is particularly high), is deferred over a minimum period of three to five years.
- There is a power to adjust variable remuneration to take account of negative financial performance of the AIFM or the relevant AIF.
Points of interest
This OnPoint focuses on the following key issues:
- Who will be affected?
- How are delegates of AIFMs affected?
- Will partner profits be caught?
- Will carried interest and co-investment income be caught?
- How does ESMA deal with proportionality?
- What remuneration information do AIFMs need to disclose and to whom?
Whilst this OnPoint covers issues (and raises questions) which are equally applicable to all EU jurisdictions, its focus is the UK.
Who will be affected?
Certain requirements relating to risk alignment should only be obligatory in relation to so-called “Identified Staff”, although ESMA strongly recommends that they be applied AIFM-wide. These include the requirements relating to deferral, payment in retained AIF shares or units, and performance adjustment.
The following categories of staff will be assumed to be Identified Staff, unless the AIFM can demonstrate that they have no material impact on the AIFM’s risk profile or the risk profiles of the AIFs they manage:
- Executive and non-executive members of the AIFM’s governing body (which will include the Board of a self-managed AIF).
- Senior management.
- Risk takers.
- Control functions, namely staff other than senior management who are responsible for risk management, compliance, internal audit and similar functions within an AIFM. (This shall not be confused with the concept of “Controlled Function” as defined by the FSA, which would include all FSA Approved Persons).
- Any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers.
There are two important observations arising from the Guidelines in relation to Identified Staff which will be relevant to AIFMs:
- First, the AIFM should be able to demonstrate how they have assessed and selected Identified Staff.
- Second, the scope of Identified Staff under AIFMD will be wider than Code Staff under the FSA’s Remuneration Code. For Code Staff, the AIFM is assessing an individual’s impact on risk to the AIFM itself. For Identified Staff, however, the AIFM also has to assess the impact of an individual’s activities upon the risk profile of the AIF it manages. In practice this means that any portfolio manager who is primarily responsible for managing a particular AIF is likely to be caught as Identified Staff, even though the FSA’s guidance on the Remuneration Code suggested that not all portfolio managers would necessarily be Code Staff.
How are delegates of AIFMs affected?
ESMA has extended the remuneration principles of AIFMD beyond AIFMs to catch entities to which AIFMs outsource or delegate portfolio management or risk management activities. The rationale for doing so was to prevent circumvention of the remuneration principles. This is a departure from ESMA’s consultation paper. It also runs counter to the responses to ESMA’s consultation and arguably goes beyond the scope of the original directive. In more detail, the Guidelines require AIFMs to ensure that:
- Entities to which portfolio management or risk management activities have been delegated are subject to regulatory remuneration requirements which are equally as effective as those applicable under the Guidelines.
- Or, alternatively, that appropriate contractual arrangements are put in place with entities to which such activities have been delegated to ensure there is no circumvention of the remuneration rules.
This gives rise to a number of open questions: Will the FCA or other competent authorities implement this Guideline? If so, what regulatory remuneration requirements will be considered “equally as effective”? Will only remuneration derived from the delegated activities count for these purposes? If so, how should the entity to which activities are delegated approach the task of apportioning total remuneration between delegated activities and other activities?
In Europe, competent authorities will need to consider whether, where an AIFM has delegated portfolio management to a firm authorised under MiFID, the remuneration principles established under CRD III will count as “equally as effective”. The principles underlying both sets of guidance are substantially similar. However, the remuneration principles of CRD III appear to cover a potentially narrower range of staff than AIFMD.
In the US, Dodd Frank does contain provisions with regard to remuneration which have not yet been enacted. The question remains whether, when finalised, these will be deemed to meet the “equally as effective” test.
Will partner profits be caught?
Remuneration is defined widely in the Guidelines as including, in exchange for professional services rendered by the AIFM’s identified staff:
- All forms of payments or benefits paid by the AIFM.
- Any amount paid by the AIF itself (including carried interest).
- Any transfer of units or shares of the AIF.
Given that many AIFMs are structured as limited liability partnerships, there is an important question over whether partnership profits will be covered by the remuneration principles of AIFMD. The Guidelines include a somewhat cryptic statement that: “Dividends and similar distributions that partners receive as owners of an AIFM are not covered by these guidelines, unless the material outcome of the payment of such dividends results in a circumvention of the relevant remuneration rules". Unhelpfully, the Guidelines add that whether there was any intention to circumvent the rules for this purpose is irrelevant. This “strict liability” concept goes beyond what is currently applicable under the CEBS Guidelines relating to CRD III.
The Guidelines again give rise to a number of open questions.
- Since all partner income is received by partners as owners of the business, should it all fall outside the Guidelines? Many AIFMs are limited liability partnerships (LLPs). The members of an LLP can only receive a share of profits if there are profits to allocate. So they all take a risk that they will not be paid. They also take a wider risk. Members may not only lose their capital, they may also face having to repay all payments received from the AIFM in the previous two years in the event of insolvency.
- Will residual profits (namely, the tranche of profit that is left at the bottom of the profit waterfall and is generally distributed in accordance with fixed ownership shares) fall outside the Guidelines? And will it make a difference if those residual percentages are determined from time to time by reference to performance?
- Will fixed drawings be treated as fixed remuneration? LLPs generally allow individual members to make fixed drawings during the year, which are met as a priority first tranche of the profits of the AIFM. These are not generally determined by reference to any performance criteria and would appear to be fixed for that purpose, but they could be repayable if there is insufficient profit.
These questions are important for AIFMs structured as LLPs because there will be important potential tax consequences if the AIFM is required to defer payments to LLP members. LLP members pay tax on their share of the profits of the LLP in the year in which such profit is recognised, regardless of whether they have actually received any cash in respect of those profits. Deferral of 60% of an LLP member’s profits for three years will leave him or her with a dry tax charge.
There are a number of possible answers to this mismatch. It may be that, in the case of LLP members, the deferral percentages will only be applied to the after tax sums. However, there is nothing in the Guidelines to support such an interpretation. Alternatively, it may be that this mismatch constitutes a proper rationale for seeking to disapply the principle of deferral.
Will carried interest and co-investment income be caught?
The Guidelines provide that carried interest will constitute remuneration and therefore be subject to the remuneration principles of AIFMD. Accordingly, private equity firms (and other managers using carried interest models) within the scope of AIFMD will need to consider their carry structures carefully, especially once further FCA guidance is released. Situations where the fund is not on track to pay carry, “deal by deal” models and other more bespoke arrangements are likely to require particular attention. The principle of proportionality may be helpful in the context of preserving existing arrangements that have been negotiated with investors.
By contrast, co-investments will not be caught, provided that:
- Payment made by an AIF to a staff member does not exceed their pro-rata investment return.
- The investment consists of an actual “disbursement” (payment) made by the staff member. So, co-investments funded by loans to staff from an AIFM will be caught, unless the loan has been repaid by the time the investment return becomes due.
How does ESMA deal with proportionality?
One of the most important aspects of the Guidelines relates to the interpretation of the proportionality principle. This is the principle that, in taking measures to comply with the remuneration principles, AIFMs should comply in a way and to the extent that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities.
ESMA declined to adopt a tier or level based approach to proportionality based on size (similar to that applicable under the Remuneration Code) on the grounds that the size of an AIFM is only one element to take into consideration when applying proportionality. However, ESMA did take a more moderate position to that in the consultation paper in relation to proportionality. In its consultation paper, ESMA espoused the view that remuneration principles of AIFMD could be tailored, whatever that might mean, but could not be disapplied. This has changed. A number of remuneration principles may be disapplied or “neutralised” in their entirety, albeit in exceptional circumstances and taking specific facts into account and provided that:
- Doing so is reconcilable with the risk profile, risk appetite and the strategy of the AIFM and the AIFs it manages.
- AIFMs can explain the rationale for every single requirement that is disapplied.
There are four requirements which may be disapplied (and which must be disapplied in their entirety if disapplied at all). These are the requirements that:
- A substantial portion, and in any event at least 50%, of both deferred and non-deferred variable remuneration consist of units or shares of the AIF concerned.
- A substantial portion of variable remuneration, and in any event at least 40% (or 60% where remuneration is “particularly high”), be deferred over a minimum period of three to five years.
- There be a power to adjust variable remuneration to take account of negative financial performance of the AIFM or the relevant AIF.
- An AIFM establishes a remuneration committee. (In fact, the Guidelines suggest that no AIFM need establish a remuneration committee if both the value of the portfolios it manages does not exceed 1.25 billion euros and it does not have more than 50 employees).
What remuneration information do AIFMs need to disclose and to whom?
The AIFMD requires AIFMs (including non EU AIFMs marketing AIFs in Europe) to produce an annual report for each financial year for each of the EU AIFs it manages and for each of the AIFs it markets in the EU. The annual report must be made available to investors on request, and to the relevant competent authorities of both the AIFM’s home Member State (for AIFMs based in the UK this will be the FCA) and where applicable, the home Member State of the AIF. Such annual reports must contain, amongst other things:
- Information on the total amount of remuneration paid by the AIFM (including, where relevant, carried interest distributed by the AIF) to its staff for the financial year, split into fixed and variable remuneration, and including the number of beneficiaries.
- The aggregate amount of remuneration broken down by senior management and AIFM staff members whose actions have a material impact on the risk profile of the AIF.
There was a suggestion under the draft Guidelines that AIFMs would have to disclose this information publicly but the final Guidelines make clear that such disclosure need not necessarily be public, to the extent that the annual report of an AIF is not a public document.
AIFMs which are required to make public an annual financial report in accordance with the Transparency Directive (implemented in the UK by the Financial Services and Markets Act 2000 and the Disclosure Rules and Transparency Rules) can choose to provide any additional information disclosable under the AIFMD to investors either separately on request or as part of the public annual financial report.
The Guidelines state that the proportionality principle will apply to the type and amount of information to be disclosed and suggest that small or non-complex AIFMs and AIFs should only be expected to provide some qualitative information and very basic quantitative information where appropriate. AIFMs which adopt such an approach will need to disclose how they have applied the principle of proportionality.
The Guidelines also require AIFMs to make their remuneration policies accessible to all staff members.
In summary, there are a number of open questions arising out of the Guidelines, and there may be a questions and answers document issued by ESMA in due course. However, AIFMs need to start getting ready to comply now. Even with the transition provisions, the provisions will be in force by 22 July 2014. This means that AIFMs need to think about compliance well before the end of 2013, so that they are in compliance for the whole of the 2014 financial and remuneration year.