UCITS Performance Fee Thematic Review

by Dechert LLP
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The Central Bank of Ireland (the “Central Bank”) recently issued an industry letter1 highlighting issues identified during its recent thematic review of the calculation and payment of performance fees by UCITS. The review was carried out in parallel to its consultation on potential amendments to the Central Bank UCITS Regulations (CP 119).2

The Central Bank, as part of its thematic review, reviewed a sample of approximately 30% of Irish UCITS funds which charge performance fees. In about 10% of those reviewed, the Central Bank identified instances of non-compliance with the Central Bank’s UCITS performance fee guidance (the “Guidance”).3

The Central Bank industry letter, together with its accompanying press release,4 highlighted a number of key supervisory issues relating to the payment of performance fees by UCITS. The Central Bank industry letter is required to be brought to the attention of all members of the board of a UCITS management company (or board of the UCITS in respect of a self-managed investment company) (the “Fund Management Company”) and to the relevant responsible persons within the depositary of the UCITS (the “Depositaries”) and administrator of the UCITS (the “Administrators”) (together the “Fund Service Providers”). The Central Bank will have regard to the contents of the industry letter as part of future supervisory engagement.

Some of the main issues identified by the Central Bank were:

  • In some instances performance fees were not calculated in accordance with the Guidance.
  • Inadequate disclosure informing investors that, where performance fees are paid on the basis of achieving a new high net asset value per share (the “High Water Mark approach”), fees may be accrued as a result of market movements rather than due to the performance of the investment manager.
  • Where performance fees are based on the outperformance of an index, it was unclear as to which version of the index was being used in some cases.
  • Poor practices were observed at Depositaries in the verification of the calculation of performance fees.
  • Poor practices were observed at Administrators in certain areas of the calculation of performance fees.

The Central Bank’s Director General of Financial Conduct, Derville Rowland said: “We are concerned that the Guidance is not being applied in a consistent and comprehensive manner across Industry, which could lead to the overpayment of performance fees by UCITS and their investors.

“Investors in regulated funds have a right to expect that they will be charged the right fee and that the firms and individuals overseeing this process are operating to a high standard. The findings of this review highlight the need for individuals within regulated firms to be vigilant, especially as we now move to have our Guidance on performance fees become binding rules. We are requiring all fund management companies whose UCITS charge performance fees to review their existing methodologies and confirm their compliance to the Central Bank, and we will continue to engage with those individual UCITS that were the subject of this review and to monitor fees charged to ensure that the best interests of investors are protected.”

All Fund Management Companies managing UCITS that charge performance fees are required to confirm to the Central Bank, by 30 November 2018, that they have carried out a review of the existing methodologies in order satisfy themselves that performance fees charged comply with the Guidance. The confirmation will need to confirm whether in the course of the review:

  • Any required changes to existing methodologies have been identified;
  • Any required changes to prospectus disclosure have been identified;
  • Any instances of improper payment of performance fee have been identified; and
  • Actions are being taken to remedy the above.

In carrying out its review, the Fund Management Company should be cognisant of, and take appropriate action, to address the following:

  • The Central Bank has identified cases where performance fees were calculated based on Gross Asset Value (“GAV”) contrary to the Guidance to pay UCITS performance fees based on Net Asset Value (“NAV”). UCITS performance fees must only be calculated based on NAV.
  • The Central Bank also identified instances of UCITS calculating performance fees based on the outperformance of a benchmark or index, which did not appear to be relevant in the context of the UCITS policy, as set out in the Guidance. Any UCITS calculating performance fees based on outperforming an index must be able to demonstrate that the index is relevant in the context of the UCITS policy. As part of the review, the Fund Management Company should satisfy itself that the benchmark chosen complies with this requirement and record in writing the basis for being so satisfied.
  • The Central Bank, as outlined above, identified that, where performance fees are paid on the basis of the High Water Mark approach, such fees accruing may be the result of market movements rather than due to the performance of the Investment Manager. The Central Bank identified inadequate disclosure practices in this regard and considers that investors may not be fully aware of the circumstances which led to the payment of the performance fee.
  • The Central Bank’s review also identified instances where UCITS calculating performance fees on the basis of the High Water Mark approach were not using the initial offer price as the starting price for calculations as set out in the Guidance. Any UCITS calculating a performance fee on the basis of the High Water Mark approach must ensure that the initial offer price is taken as the starting price for calculations.
  • The Guidance provides that any underperformance of the index in preceding periods be clawed back before a performance fee becomes due in subsequent periods. UCITS have been identified where underperformance of the index is only clawed back for a specified period. The Fund Management Company must satisfy itself that investors were not disadvantaged where clawback was limited to a certain period and amend the UCITS performance fee methodology to comply with the Guidance.
  • Where performance fees are based on the outperformance of an index, the Central Bank found cases where it was unclear as to which version of the index was being used. The Central Bank requires that the prospectus clearly disclose the version of the index being used. For example, UCITS may consider disclosing the ticker code relating to the index in order to identify it.
  • The Central Bank observed poor practices at Administrators in certain areas of the calculation of UCITS performance fees including:
    • Performance fees paid on invoiced amount issued by the investment manager without full reconciliation to the Administrator calculation; and
    • Fund Administrators using pre-designed manual calculation tools created by investment managers of the UCITS without any independent validation of the methodology.
  • The Central Bank requires that the Fund Management Company reviews the calculation procedures adopted by Administrators to ensure that the calculation of performance fees is applied in a consistent and independent manner.
  • The Central Bank observed poor practices at Depositaries in the verification of the calculation of UCITS performance fees (the “verification process”), including:
    • The verification process only being applied to a sample of UCITS performance fee calculations;
    • The verification process carried out post payment of the performance fee; and
    • The verification process only carried out where a performance fee is due for payment.

Where the Fund Management Company identifies any issues as outlined in the industry letter or any other instances of non-compliance with the Guidance, the Central Bank must be notified of the steps being taken by the relevant Fund Management Company to rectify the situation including any adverse impact on the UCITS and its investors.

The Central Bank will also commence supervisory engagement with the individual UCITS that were the subject of the Central Bank’s thematic review.

Conclusion

Given the scope of the review which Fund Management Companies are now tasked with conducting and the deadline of responding to the Central Bank by no later than 30 November 2018, Fund Management Companies should begin conducting the necessary reviews as soon as possible.

Footnotes

 

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