The Financial Markets Authority (FMA) has issued draft guidelines to give KiwiSaver managers and trustees a basis for determining that performance fees meet the “not unreasonable” requirement under the KiwiSaver Scheme Rules.
The FMA is seeking comments before finalising and formally publishing the Guidance Note.
The consultation window is tight, with submissions due by Friday 2 December 2011.
The Guidance Note (the Note) proposes two principles:
- that it is reasonable to offer fair reward for the application of investment manager skill, and
- that performance fees should adequately reflect the risks taken by both the investment manager and the investor.
The FMA further elaborates on these general principles by noting that:
- performance fees should reward only truly exceptional skill and performance in comparison to the “market” (which will be given a case-by-case meaning depending on a fund’s characteristics)
- investors should not pay twice for the same return
- performance fees should ensure alignment of the manager’s interests with the investors’ interests, and
- fee structures should share the downside (as well as the upside) of performance between the manager and the investor, and should not have the potential to encourage inappropriate or undue risk taking by the manager.
Proposed specific requirements
In applying the principles, the FMA indicates it will expect that performance fees will contain the following elements:
- performance fees expressed as a percentage of assets under management and based on returns (after deduction of all fixed base investment management fees) in excess of a hurdle rate of return
- a hurdle rate of return reflecting the risk characteristics of the fund and an appropriate return benchmark (based on a suitable market-related index) with an allowance where there are active management fees already implicit in any fixed base fee
- a high water mark so that past under-performance is recovered before any subsequent over-performance is rewarded
- assessment periods extending beyond one year - the FMA envisages that this would include deferred payment or claw-back provisions (with corresponding adjustments to the high water mark) to capture the unders and overs of an uneven performance within an assessment period, and
- the performance fee being subject to an annual cap.
These elements will have to be justified in the scheme’s offering documents and the documents will need to explain any inconsistencies with the FMA’s criteria. The FMA expects that if any element is not present “this will be reflected in other terms or in any fixed fee payable”.
“Reset” provisions (which allow the manager to adjust either the hurdle rate of return or the high water mark) will be regarded with scepticism by the FMA, particularly where the adjustments can be made without seeking the approval of either the investors or the trustee. The FMA indicates that resets would require its approval.
Our take on the proposals
We think, for the most part, the proposed framework is a helpful guide and that, in principle, prescribing minimum standards for performance fees will make it easier for potential investors to make like-for-like comparisons between schemes.
The Note seems to us to set out an overall “counsel of perfection” though, rather than just essential minimum standards. We think the Note should clarify what the FMA will consider to be unacceptable and then separately describe what are desirable best practice standards.
In particular, we think that the FMA is seeking to prescribe best practice standards when:
- proposing to prescribe a multi-year assessment with deferred payments and claw-backs and an annual cap as standard
- resisting resets (which may be appropriate in some contexts) to ensure the performance fee continues to motivate out-performance, and
- seeking to apply the guidelines as a disclosure benchmark for fees paid on an arms-length basis to third party product managers.
The “not unreasonable” test in the Act does not expressly apply to the fees charged by the managers of underlying products into which a scheme invests, so the FMA may be over-reaching in requiring managers to disclose the key elements of such performance fee structures. Despite this disclosure requirement, it appears that the FMA does not intend requiring third party sub-managers’ performance fee structures to be approved against the criteria in the guidelines. This point needs to be clarified.