[authors: Stephen G. Sims, Patrick Brandt, Greg T. Norman]
On 28 June 2012, the European Securities and Markets Authority (ESMA) published a consultation paper titled “Guidelines on Sound Remuneration Policies Under the AIFMD” (the ESMA Paper). The ESMA Paper represents the first step in elaborating the remuneration policies for alternative investment fund managers (AIFMs) set out in the Alternative Investment Fund Managers Directive (the AIFMD).
In an important development for fund managers, the ESMA Paper:
Sets out how the proportionality principle in the AIFMD will apply to allow certain AIFMs to disapply some parts of the policies;
Gives guidance on what constitutes “remuneration” (including carried interest), which is subject to the policies, as opposed to a return on the AIFM’s own investment;
Details the staff subject to the policies and asks respondents for their views on whether, even though the AIFMD only applies the remuneration policies to the AIFM’s staff, the guidelines should be extended to cover any entity to whom an activity has been delegated by the AIFM (e.g., a delegated investment manager); and
In an apparent concession to the private equity industry, recognises that there are diverse types of AIFMs and alternative investment funds (AIFs), and states that certain fund structures may inherently have in place remuneration policies that naturally align the interests of staff with investors, and may be entitled to be outside of the substantive provisions of the policies. ESMA’s example of a fund that may be outside of the provisions is effectively a traditional European-style private equity fund.
The ESMA Paper includes an initial draft of the guidelines. The deadline for providing feedback is 27 September 2012, and ESMA aims to produce final guidelines during Q4 2012.
The AIFMD establishes a high-level principle that AIFMs must have remuneration policies that “are consistent with and promote sound and effective risk management and do not encourage risk-taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs they manage.”
The remuneration provisions in the AIFMD can be split into three categories: transparency, governance and risk alignment. An EU-based AIFM will be subject to all three categories. Initially, a non-EU AIFM who markets its funds within the EU will only need to comply with the transparency requirements.
Annex II of the AIFMD, which sets out the detailed provisions regarding governance and risk alignment, also includes a requirement that the provisions should be subject to a proportionality test, so that AIFMs are subject to remuneration policies that are “appropriate to their size, internal organisation and the nature, scope and complexity of their activities.” The ESMA Paper states that this proportionality principle means that not all AIFMs have to give substance to the remuneration provisions in the same way or to the same extent.
Under the AIFMD, all AIFMs (whether they are EU or non-EU) will be required to produce an annual report in respect of each fund they manage or market within the EU. The annual report must contain, inter alia: “the total amount of remuneration, split into fixed and variable remuneration, paid by the AIFM to its staff, and the number of beneficiaries, and, where relevant, carried interest paid by the AIF”; and “the aggregate amount of remuneration broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF.”
The ESMA Paper provides further detail on what is meant by “senior management and member of staff of the AIFM whose actions have a material impact on the risk profile of the AIF.” Such “Identified Staff” will include the following unless they demonstrably have no material impact on the AIFM’s risk profile:
Members of the AIFM’s governing body;
Control functions (including risk management, compliance and internal audit);
Heads of departments for portfolio management, administration, marketing and human resources; and
Other risk takers whose activities can exert material influence.
The AIFMD also requires ESMA to consider the European Commission’s Recommendation 2009/384/EC on remuneration policies in the financial services sector (the Recommendation). Accordingly, an AIFM must include in its report information on:
The decision-making process used to determine the remuneration policy, including the bodies (such as the Remuneration Committee or external consultants) that played a significant role in developing the remuneration policy;
How pay and performance are linked, including a description of the main performance metrics used;
The design and structure of remuneration processes, such as the key features and objectives of the remuneration policy and how the AIFM ensures that staff members in control functions are remunerated independently of the business units they oversee; and
The different forms of variable remuneration and rationales for using these different forms and for their allocation amongst staff, as well as detail around the parameters used to allocate deferred and non-deferred remuneration.
The governance provisions require the management body of an AIFM to design, approve and have oversight over its remuneration policy. In certain AIFMs, this will be achieved through the establishment of an independent remuneration committee. The remuneration committee should be composed of nonexecutive members “of the supervisory function,” the majority of whom should be independent. The chairperson also should be an independent nonexecutive.
In determining whether to establish an independent remuneration committee, AIFMs must consider three factors listed in paragraph 3 of Annex II to the AIFMD, namely size, internal organisation and the nature, scope and complexity of its activities. An AIFM whose assets under management do not exceed €250 million would not need to establish a separate remuneration committee.
The AIFMD aims to align remuneration with prudent risk taking. The ESMA Paper is accordingly primarily concerned with variable compensation. Fixed and variable compensation must be appropriately balanced so that the fixed component is sufficiently high to give an AIFM flexibility to not award any variable remuneration in appropriate circumstances.
For variable remuneration, the AIFMD requires at least 50 percent to be awarded in the form of interests in the relevant fund (or appropriately linked instruments), provided that the legal structure of the fund permits this. In addition, at least 40 percent of the variable remuneration must be deferred over a period that is appropriate to the life cycle and redemption policy of the fund concerned. The minimum deferral period is three to five years unless the AIFM can demonstrate that the life cycle of the fund is shorter. The ESMA Paper states that the deferral period should not be shorter than the life cycle, so if the life cycle can be shown to be one year, then the deferral period must be at least one year.
The ESMA Paper also builds on two general restrictions in the AIFMD, namely that severance payments must not reward failure and that staff must not use personal hedging strategies or remuneration-related insurance against falling remuneration. An AIFM will need to be able to explain to its regulator the criteria used to determine the amount of severance pay. In relation to personal hedging strategies, the ESMA Paper states that the effectiveness of risk alignment would be undermined if staff members were able to buy an insurance contract that compensates them if their remuneration fell. This should not, however, prevent staff from buying health-related insurance that would cover, for example, mortgage instalments.
The ESMA Paper recognises the difficulty in seeking to establish a single set of remuneration guidelines covering the entire spectrum of hedge, private equity, real estate and wider alternative asset managers.
The private equity industry, in particular, should welcome the suggestion that a European-style private equity mechanism (whereby investors receive all of their capital back plus a hurdle before any variable compensation is paid to staff of the AIFM and those staff are subject to claw-back requirements) may of itself be sufficient to meet the risk-alignment requirements.
Unfortunately, the ESMA Paper does not give as much clarity for hedge fund managers. ESMA links the deferral period for certain remuneration to the “life cycle” of a fund without providing a clear definition of what is meant by “life cycle” or how it fits with (or is different from) a fund’s redemption policy and more guidance would be welcomed.