_On 3 April ESMA released its Final Report and Guidelines on performance fees in UCITS and certain types of AIFs. The report includes responses to its July 2019 Consultation Paper (CP) on proposed draft Guidelines on performance fees in UCITS and certain types of AIFs.
There are five broad guidelines (the “Guidelines”) covering sound practice relating to the implementation, operation and disclosure of performance fees in UCITS and certain AIFs that are marketed to retail investors.
The aim of the Guidelines is to avoid regulatory divergence and establish a common standard in relation to the disclosure of performance fees to investors by ensuring that “performance fee models … comply with the principles of acting honestly and fairly … in such a way as to prevent undue costs being charged to the fund and its investors”.
Competent authorities are expected to incorporate the Guidelines into their national legal and/or supervisory frameworks to ensure consistent, efficient and effective supervisory practices across the EU. Strictly speaking, there is a comply-or-explain opt-out for competent authorities, but given the pragmatic nature of the Guidelines, it seems unlikely that the opt-out would be exercised (other than for delays in implementation).
The five Guidelines, which are examined in more detail below are:
- performance fee calculation method,
- consistency between the performance fee model and the fund’s investment objectives, strategy and policy,
- frequency for the crystallisation of the performance fee,
- negative performance (loss) recovery, and
- disclosure of the performance fee model.
What types of funds do they apply to?
The Guidelines relate to performance fees in UCITS and certain AIFs; they do not apply to UCITS without a performance fee, although managers of such funds should be aware of them, should they decide to adopt a performance fee model.
The Guidelines apply to open-ended AIFs that are approved to be distributed in any member state other than EuVECAs (and other types of venture capital AIFs), EuSEFs, private equity AIFs and real estate AIFs.
When do they apply?
While the Guidelines apply to new funds (or funds that introduce a performance fee for the first time) two months after the date of publication on ESMA’s website in all the EU’s official languages, they don’t apply to existing funds until the beginning of the financial year for those funds following six months from the application date of the Guidelines. So, for example, assuming publication in all official languages will be before the end of June (highly likely), for funds with a 31 December year-end, the Guidelines will apply from 1 January 2021.
While the themes of each of the Guidelines seem straightforward, it would be easy for managers to be caught out by some of the more granular requirements. We will now consider each of the Guidelines in turn.
1. Performance fee calculation method
The first Guideline is that the calculation of a performance fee should be verifiable and not open to the possibility of manipulation. Such fee should always be proportionate to the actual performance of the fund and align the manager’s interest with those of its investors.
The basic requirements are likely to be incorporated into most manager’s models already, but they should check that their methodology is clearly disclosed and that all of the minimum elements are included, namely:
- a reference indicator, being a benchmark index, hurdle or high watermark (or a combination thereof),
- a crystallisation frequency (see Guideline 3, below), and a date at which the fee is paid to the manager,
- a reference period for the performance fee,
- a computation frequency that coincides with the NAV calculation frequency, and
- a performance fee rate.
The rules allow for variations on the above requirements, so would allow for fees to vary according to whether performance is increasing or decreasing, but these models must operate in a symmetrical manner (i.e. any reversal rate should be the same as the allocation rate). They also allow for performance fees to be calculated on a single investor basis.
2. Consistency between the performance fee model and the fund’s investment objectives, strategy and policy
This Guideline warrants detailed attention, as managers may have to consider the wider questions around performance fee models and, in particular, they may need to question the use and suitability of benchmarks.
Managers are required to implement and maintain a process in order to demonstrate and periodically review that the performance fee model is consistent with the fund’s investment objectives, strategy and policy. Pragmatically, this should be incorporated into a firm’s wider product governance process, whether required under MiFID II or otherwise.
Even firms with a basic or absolute performance fee model should question whether the chosen performance fee model is suitable for the fund given its investment policy, strategy and objective, and they should consider whether a model with reference to an index should be utilised. A typical example of this would be where a manager has an absolute performance fee model with a hurdle or high watermark i.e. no benchmark, but has an investment objective that references a benchmark index.
Where funds calculate the performance fee with reference to a benchmark, they need to ensure that the benchmark is appropriate in the context of the fund’s investment policy and strategy and adequately represents the fund’s risk-reward profile. This assessment should also take into account any material difference of risk (e.g. volatility) between the fund’s investment objective and the chosen benchmark, as well as their respective portfolio compositions.
However, the rules do recognise that a wider index may be referenced in an investment objective, such as where it is used as a universe from which to select securities. In such cases, the manager should be careful to select a benchmark for portfolio composition that is consistent with the benchmark for the performance fee calculation. The Guidelines provide a non-exhaustive list of consistency indicators for managers to consider when making this assessment. Managers who are in the position of having to make this assessment should also consider the requirement for the verifiability of the calculation (Guideline 1, above) and requirements on disclosure (Guideline 5, below).
Finally, managers should ensure that any excess performance over a benchmark should be calculated net of all costs and any changes in reference indicators should be reflected in performance calculations at the point at which those changes occur.
3. Frequency for the crystallisation of the performance fee
Again, ESMA expects an alignment of interests between the portfolio manager and the shareholders when considering the frequency for the crystallisation and the subsequent payment of the performance fee. Fair treatment among investors is also expected, and crystallisation dates should be the same for all classes of each fund.
Crystallisation frequency should not be more than annual, subject to certain limited exceptions, and the date should be 31 December of each year, or the fund’s financial year-end.
4. Negative performance (loss) recovery
This Guideline covers the general requirement for investment loss recovery before any performance fees may be paid again.
Funds that operate a high watermark may expect that their model already incorporates this Guideline; however, they should ensure that the mechanism does indeed allow for an upwards-only high watermark reset in order to be compliant.
It should be noted that the Guidelines do not require an evergreen high watermark for all funds. Funds with a benchmark index may still allow for a performance fee to be paid where performance is negative if the fund has still outperformed its benchmark index and investors have been given sufficiently prominent warnings (see Guideline 5, below). Of course, the benchmark should also be suitable as required under Guideline 3 (above), and where benchmark indices are used, such indices should ensure that any underperformance of the fund compared to the benchmark is clawed back before any performance fee becomes payable.
For both high watermark and benchmark index models, the reference periods for assessing performance fees should be at least five years on a rolling basis, if shorter than the whole life of the fund i.e. crystallisation occurring on an annual basis as long as there has been out-performance over the previous five years.
Finally, Guideline 4 also overlaps with Guideline 3 (above), as it requires that the manager’s performance should be assessed and remunerated on a time horizon that is, as far as possible, consistent with the recommended investors’ holding period.
5. Disclosure of the performance fee model
Investors should be adequately informed about the existence of performance fees and their potential impact on the investment return. The prospectus and all pre-contractual information documents, as well as marketing material, should clearly set out all information necessary to enable investors to understand the performance fee model and the computation methodology. There is also a requirement to include examples of performance fee calculations in the prospectus.
As mentioned above, where a performance fee uses a benchmark index and allows for a manager to receive a performance fee where there has been negative performance in absolute terms, there should be prominent warnings to investors in the KIID (and we would also advise a prominent warning in the prospectus).
Furthermore, where performance fees are calculated based on performance against a reference benchmark index, the KIID and the prospectus should display the name of the benchmark and show past performance against it.
Finally, annual and half-yearly reports should clearly show the actual amount of performance fees charged and the percentage of the fees based on the share class NAV. This should be done for each relevant share class.
In undertaking the consultation process that preceded these Guidelines, a number of concerns arose from industry participants. ESMA has sought to address these, and the standardisation that these Guidelines introduce has been eagerly anticipated by the funds industry. Managers should carefully consider their performance fee models against the Guidelines and prepare to take any action necessary to address shortcomings in their legacy approaches.
The description above is a summary only and should not be considered a substitute for legal advice. Each firm’s challenges will be specific to that firm and should be considered on an individual basis. If you are in any doubt as to your legal or regulatory obligations arising from the above Guidelines or any other issues relating to investment funds in Luxembourg, then please contact a member of Wildgen’s Investment Funds Practice Group.