On 3 April 2020, ESMA published its Guidelines on performance fees in UCITS and certain types of AIFs (the Guidelines). The Guidelines will apply from two months after the translated versions are published (expected imminently) on ESMA’s website (Effective Date).
Scope of the Guidelines
The Guidelines apply in respect of (i) UCITS and (ii) AIFs marketed to retail investors except for (a) closed-ended AIFs; and (b) open-ended AIFs that are EuVECAs (or other types of venture capital AIFs), EuSEFs, private equity AIFs or real estate AIFs.
The exact Effective Date of the Guidelines depends on the date of publication of the translated versions of the Guidelines by ESMA. As such publication is expected imminently, the Effective Date is likely to be in the first half of June 2020 (being 2 months’ post the publication of the translations).
Funds established after the Effective Date and existing funds which subsequently introduce a performance fee must comply with the Guidelines immediately. Careful consideration of the Guidelines will be necessary ahead of any proposed introduction of a new performance fee following the Effective Date.
Existing funds with a performance fee in place prior to the Effective Date must comply with the Guidelines by the beginning of the financial year following 6 months from the Effective Date e.g. assuming an Effective Date of 30 June 2020 (at the latest), a fund with a financial y/e of 31 December will be required to comply with the Guidelines from 1 January 2021. Given the potential complexities in formulating and implementing any necessary amendments, early compliance analysis of existing performance fee methodologies with the Guidelines is advised.
How do the Guidelines compare with the Central Bank’s performance fee rules?
UCITS: consistency between the performance fee model and the fund’s objectives, strategy and policy
While the Guidelines are materially reflective of the performance fee rules currently applicable to Irish UCITS, their adoption by the Central Bank (competent authorities must adopt within 2 months or notify ESMA of any failure to do so) may necessitate the introduction of some additional regulatory measures. In certain instances, the Guidelines are more expansive than the rules applicable to Irish UCITS under the Central Bank UCITS Regulations 2019 and clarified in regulatory guidance and Q&As. For example, guideline 2 of the Guidelines obliges fund managers to ensure consistency between the performance fee model and the investment objective and policies of the fund:
” 22. When assessing the consistency between the performance fee model and the fund’s investment objectives, strategy and policy, the manager should check:
- whether the chosen performance fee model is suitable for the fund given its investment policy, strategy and objective. For instance, for funds that pursue an absolute return objective, a HWM model or a hurdle is more appropriate than a performance fee calculated with reference to an index because the fund is not managed with a reference to a benchmark; in addition, a HWM model for an absolute return objective, might need to include a hurdle to align the model to the fund’s risk-reward profile;
- whether, for funds that calculate the performance fee with reference to a benchmark, 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 the consistency indicators included below under paragraph. For example, it should not be deemed appropriate for a fund with a predominantly long equity-focused strategy to calculate the performance.”
Regulation 40(3) of the Central Bank UCITS Regulations addresses the requirement for consistency between the performance fee model and the investment policy of the fund by providing that “where performance fees are payable on the basis of out-performance of an index, the responsible person shall ensure that the index is consistent with the UCITS investment policy.” Accordingly, the Central Bank’s requirement for consistency focusses on performance fee models which reference a benchmark and may be met by ensuring the benchmark used in the model is consistent with the fund’s investment policy.
ESMA’s Guidelines, however, are not similarly restricted and apply the requirement for consistency more broadly i.e. to all performance fee models whether the model references a benchmark, a high-water mark or other hurdle. In doing so, ESMA also references the use of “consistency indicators” for determining whether the performance fee model is consistent with the fund’s objective, policy and strategy. The Guidelines also state that that “As a general principle, if a fund is managed in reference to a benchmark index and it employs a performance fee model based on a benchmark index, the two indices should be the same.”.
The Central Bank UCITS Regulations do not provide for an assessment of indicators in considering whether a performance fee model is consistent with the investment policy of the fund. It is relevant to note, however, that that on 4 September 2018 the Central Bank published, by way industry correspondence, the outcome of its inspection into UCITS performance fees. In its correspondence the Central Bank noted its expectation that “the boards of the UCITS Fund Management Company discusses and approves the appropriateness and suitability of the UCITS performance fee methodology before implementation.”
UCITS: performance fees based on a benchmark index model & absolute performance
The Guidelines include a welcome amendment to the version of guideline 4 (Negative performance (loss) recovery) tabled by ESMA for consultation last July. The final version of guideline 4 in the Guidelines specifically recognises the permissibility of performance fees based on a benchmark index model charging a performance fee where the fund has overperformed the reference benchmark but had a negative performance overall as long as a prominent warning to the investor is provided. The final guideline 4 is therefore in line with the Central Bank’s rules for performance fees based on a benchmark index model in this regard.
UCITS: prospectus disclosures
Paragraph 46 of guideline 5 (Disclosure of the performance fee model) provides that “the prospectus should include concrete examples of how the performance fee will be calculated to provide investors with a better understanding of the performance fee model especially where the performance fee model allows for performance fees to be charged even in case of negative performance.” While intended to support investors’ understanding of the fee calculation methodology, fund managers should be cognisant, particularly when selecting possible performance outcomes for worked examples, of the potential to mislead investors through the inclusion of inappropriate or voluminous disclosure.
AIFs: retail investor alternative investment funds now in-scope
As Retail Investor AIFs (RIAIFs) are not currently subject to rules similar to those set out in the Guidelines, existing RIAIFs with a performance fee will require to review the calculation methodology to ensure compliance with the Guidelines ahead of the Effective Date.
Contributed by Nessa Joyce