The European Securities and Markets Authority has published on June 28 a consultation paper on proposed guidelines on remuneration of alternative investment fund managers, which will apply to managers of alternative funds including hedge funds, private equity funds and real estate funds.
Under the Alternative Investment Fund Managers Directive, which is due to be implemented by EU member states by July 22, 2013, all management firms covered by the directive will be asked to introduce sound and prudent remuneration policies and structures designed to increase investor protection and avoid conflicts of interest that could lead to excessive risk-taking.
The rules are also designed to ensure that managers maintain a prudent balance between a sound financial situation and the award, payment or vesting of variable remuneration – that is, if need be managers should be in a position to reduce or claw back bonuses or other payments in order to avoid running into financial difficulties.
Esma is seeking feedback from industry participants by September. The final guidelines should be issued before the end of the year and will enter into force on the date of the implementation deadline.
The AIFM Directive establishes a set of rules that managers must comply with in establishing and applying a remuneration policy for certain categories of staff, and it gives Esma the task of drawing up guidelines to clarify the legislation’s provisions in detail.
According to Esma, the proposed guidelines are aligned with remuneration policies in other financial sectors as well as the commitments made by the G20 countries and embodied in the Financial Stability Forum’s Principles for Sound Compensation Practices, and are inspired by the 2006 Capital Requirements Directive.
Esma says the proposed guidelines are a key element in a common EU rulebook that will ensure consistent compliance with the AIFM Directive throughout the 27 member states, and reflect the regulator’s co-operation with the European Banking Authority on remuneration principles.
Esma says managers should ensure that their remuneration systems are well designed and implemented, including notably maintaining a “proper” balance of variable to fixed remuneration, the measurement of performance as well as the structure and, where appropriate, the risk-adjustment of variable remuneration. Even smaller or less sophisticated managers should make the best possible attempt to align their remuneration policy with the interests of the manager itself, the funds it managers and their investors.
The guidelines are subject to the proportionality principle; not all managers will be required to implement the requirements in the same way and to the same extent. Esma says some managers will need to apply more sophisticated policies or practices in fulfilling the requirements, while others can meet the requirements in a simpler or less burdensome way.
This will depend in part on the risk profile, risk appetite and strategy of the manager and the funds it manages, as well as their size, internal organisation and the nature, scope and complexity of their activities. Esma says there should be no exemption for managers that are subsidiaries of banks, even though they may already fall under the separate requirements of the Capital Requirements Directive.
The key elements of the guidelines include the internal governance of alternative funds and/or managers, depending on their structure. They stipulate that the governing body of each manager should ensure that sound and prudent remuneration policies and structures exist and are not improperly circumvented. Managers should also determine what kind of staff should be covered by a remuneration policy and disclose the criteria by which they were selected.
The draft guidelines identify the categories of employees to be covered by a remuneration policy. These include members of the governing body of the manager, depending on its legal structure, such as directors, the chief executive and partners. The governing body is distinct from the senior management who effectively conduct the business of management firm, and whom it directs, but they may well be overlap of membership.
They cover control functions, comprising staff other than senior management responsible for risk management, compliance, internal audit and similar functions, including for example the chief financial officer in relation to their responsibility for preparing financial statements.
Staff members responsible for heading the portfolio management, administration, marketing and human resources should have remuneration requirements specific to their category. The guidelines also apply to other risk-takers such as staff members whose professional activities, either individually or as a group, can exert material influence on the manager’s risk profile or on a fund that it manages, including anyone capable of entering into contracts or positions and taking decisions that materially affect the risk positions of the manager or a fund, such as staff, individual traders and specific trading desks. They may also include other high-earning staff that do not fall into any of these categories.
To assess the materiality of influence on the risk profile of a manager of fund, the management firm must define what constitutes materiality within their particular context.
According to Esma, remuneration consists of all types of payment or benefit paid by the manager, any payments by the fund itself, such as carried interest, and any receipt of participation in the fund through shares or units in exchange for services provided by the manager’s staff.
The guidelines distinguish between fixed remuneration, which does not take into account any performance criteria, and variable remuneration that depends upon fund performance or possibly other contractual criteria.
Both types of remuneration can include direct monetary payments and benefits. The latter may include cash, shares, options, cancellation of loans to staff members upon the end of their employment, pension contributions, remuneration by funds, and non-monetary benefits such as discounts, fringe benefits or special allowances toward the cost of items such as cars or mobile phones.
Esma says that ancillary payments or benefits that are part of a general, non-discretionary policy throughout the management firm and do not represent any kind of incentive for employees to take on risks can be excluded from the definition of remuneration for the purposes of the AIFM Directive requirements.
In addition, the requirements do not cover any payments made directly by the fund for the benefit of the selected staff that consists of a pro-rata return on any investment they have made into the fund.
Esma argues that retention bonuses should be considered as a form of variable remuneration and only be allowed as long as risk alignment requirements are properly applied. However, fees and commissions paid to intermediaries and external providers of outsourced functions are not covered by the guidelines.
The guidelines include detailed rules on the establishment, structure and functioning of the remuneration committees that managers that are significant in size or that manage funds that are significant are required to create (and that for others may be considered good practice).
They also cover the principle of alignment of risks, which may for instance entail the retention by the manager of discretionary pension benefits accruing to employees for five years after they have left the firm.
The consultation runs until September 27. Esma is inviting feedback from industry participants and other interested parties, indicating the specific aspects of the guidelines on which they are commenting, a clear rationale clearly stating the costs and benefits, and any alternatives the authority should consider. Esma says it aims to publish a final report before the end of the year, ensuring that the guidelines are in place in advance of the directive’s transposition deadline in July next year.
Investment Management
12 July 2012