On 28 June, the European Securities and Markets Authority (ESMA) published a weighty consultation paper on the proposed guidelines on the remuneration of alternative investment fund managers (AIFMs).
These guidelines are intended to assist AIFMs comply with the remuneration requirements contained in the Alternative Investment Fund Management Directive (AIFMD) and in particular Annex II. The fundamental intention here is to ensure that managers managing alternative investment funds, private equity funds and real estate funds “introduce sound and prudent remuneration policies and structures with the aim of increasing investor protection and avoiding conflicts of interest that may lead to excessive risk taking.”
The consultation runs until 27 September 2012 with input specifically requested on 50 carefully stated questions. Final guidelines are intended to be published by the end of 2012 in time for implementation of the AIFMD on 22 July 2013.
ESMA considers the following staff should be included in the remuneration proposals, unless it can be demonstrated that they have no material impact on the AIFM’s risk profile:
- Members of the AIFMs’ governing body including directors, CEO and partners;
- Senior management being those persons who effectively conduct the business;
- Staff holding control functions including staff responsible for risk management, compliance, internal audit and similar functions;
- Those responsible for portfolio management, administration, marketing and human resources; and
- Other risk takers whose professional activities can exert material influence on the AIFM’s risk profile or on the AIF it manages either because of the functions they perform or the quantum of their remuneration. This would appear to encapsulate individuals who are not employed by, members of or owners directly of the AIFM.
The scope of remuneration covered is broad and includes all forms of payment or benefits paid by the AIFM or the AIF including carried interest and shares in the AIF provided in exchange for professional services rendered by AIFM staff.
Remuneration is divided into fixed or variable. Fixed remuneration is considered to be payment or benefit provided without consideration of performance with variable remuneration considered to be additional payment or benefit provided depending on performance or other contractual criteria. Benefits are defined broadly and include monetary remuneration, cash, shares, options, cancellation of loans, pension contributions, discounts, fringe benefits, and vehicle and phone allowances. Retention bonuses are considered to be variable remuneration and are only permitted under the draft guidelines to the extent that risk alignment requirements are properly applied.
Specifically excluded from remuneration are payments directly made by the AIF which consist of a return on investment made into the AIF. ESMA acknowledges that co-investment fulfils a key purpose of these requirements, to align interests of the AIFM with the investors into the AIF it manages. The guidelines permit proportionality depending on the risk profile, risk appetite and strategy of the AIFM and AIF. Proportionality in this context means that a more tailored solution can be applied, however, elements of the guidance cannot be disregarded. Where proportionality is applied and requirements are tailored, an explanation must be able to be provided to justify the action taken.
ESMA requires an AIFM to consider its financial position and ensure that this will not be adversely affected by paying out variable remuneration. If it appears the financial position would be compromised, ESMA requires that the AIFM should reduce the pool of variable remuneration and consider performance adjustment measures such as clawbacks of compensation paid.
Overall, the guidelines have as their backbone three core principles: governance, risk alignment and disclosure.
The draft guidelines require the AIFM’s governing body should include non-executive members and it can ensure that sound and prudent remuneration policies and structures exist. ESMA considers that larger AIFMs should be capable of performing an annual independent review internally whilst acknowledging that smaller AIFMs i.e. those with AUM under €250m, or those that are smaller in relation to size, internal organisation, scope and complexity of activities, can apply proportionality to the remuneration committee (RemCo) function. The guidelines state very clearly that RemCo’s are considered best practice. Overall, ESMA envisages an environment of much greater segregation than that usually deployed within investment management firms and this level of independence may be difficult for some AIFMs to achieve.
Fundamentally remuneration should be aligned with prudent risk taking. ESMA specifies that the design of the remuneration policy should be consistent with the risk profile and strategy of both the AIFM and the AIFs managed. A proper balance of fixed to variable remuneration, a transparent measure of performance, and risk adjustment of variable compensation, are core to this concept.
The AIFMD provides quantitative guidelines stating that 40-60% of variable compensation should be deferred for 3-5 years and are prescriptive about vesting periods as well. It also states that 50% of variable remuneration be paid in shares or units of the AIF (or equivalent) and vesting should apply equally to the cash and non-cash portions. ESMA also considers that the deferral mechanism applied should achieve a retention objective in respect of the AIFM’s business and this must be considered in addition to the profile of the AIF when vesting occurs.
The AIFMD specifies minimum disclosure on remuneration that must be made in the annual report of the AIF which includes the total amount of remuneration split by fixed and variable components paid by the AIFM. A more detailed annual disclosure report made publicly available by the AIFM should include extensive information regarding the remuneration policy and practice. Auditors will be heavily involved in the annual disclosure required by the AIF and all parties should contribute to the annual disclosure report made publically by the AIFM. ESMA has not provided any detail as to where this publically available information should be published and has acknowledged that confidentiality must be maintained. There is no avoiding the fact, however, that remuneration of an AIFM will be much more transparent in the post AIFMD world.
These guidelines further highlight the need to ensure that your regulatory consultants, tax advisors and auditors are providing consistent advice as to your remuneration policies. In particular, tax advice should be sought to ensure that the remuneration structure of the AIFM provides maximum opportunity for the efficiency, flexibility and confidentiality as to how remuneration is paid whilst complying with the regulations. There are significant tax issues to consider including what is considered remuneration as this may differ for tax and regulatory purposes, what is a payment for services, a payment for performance, how to achieve deferral in a tax and regulatory context and the tax position of the clawback. The goal for an AIFM would be to ensure that it is able to deliver discretionary deferred compensation in a manner that is not punitive from a tax perspective.
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