End of last week the European Securities and Markets Authority ("ESMA") published the long awaited consultation paper on guidelines relating to sound remuneration policies under the AIFMD. ("Guidelines").
Pursuant to the AIFMD, for purposes of effective risk management, AIFMs are required to have certain remuneration policies and practices for those categories of staff whose professional activities have a material impact on the risk profiles of the AIFMs or of the AIFs they manage.
The Guidelines are based on the remuneration guidelines under the Capital Requirements Directive ("CRD") applicable to credit institutions and investment banks. Unfortunately little tailoring has been made to take into account the specific arrangements of alternative investments structures. The requirements cover in particular:
- Who determines the remuneration policy and who controls that remuneration reflects the required risk alignment;
- General and specific requirements on risk alignment; and
- Disclosure requirements.
ESMA aims to adopt the final text of the Guidelines in Q4 2012. The consultation runs until 27 September 2012. The final Guidelines will apply as of 22 July 2013.
I. Summary of proposed Guidelines
The Guidelines apply to AIFMs subject to authorization and supervision by competent authorities under the AIFMD. With the exception of disclosure requirements (still to be determined), the Guidelines do not apply to non-EU AIFMs marketing under national private placement regimes.
The Guidelines cover any kind of remuneration (including carried interest) paid to members of the management body as well as personnel assuming control, risk and portfolio management functions of the AIFM (e.g. investment committee members but also compliance staff).
ESMA emphasizes the principle of proportionality. Not all AIFMs have to apply the remuneration requirements in the same way and to the same extent. However, ESMA leaves it to the management body and the competent authority to determine whether a more tailored approach is justified. This certainly creates legal uncertainty. The rules/guidelines relevant to private equity fund managers (and fund managers of closed ended funds with similar compensation schemes) are in particular:
- The management body (or supervisory unit) of the AIFM is in charge of determining and implementing the remuneration policy. ESMA requires that the remuneration policy should not be primarily controlled by executive members of the management body. This does not reflect reality ina private equity context, where remuneration is generally determined/negotiated by the investors.
- Depending on the nature, size and complexity of the AIF they manage, the AIFM must set up a remuneration committee which is responsible for assisting the supervisory unit/management body regarding determination and implementation of remuneration policies. It must consist of members of the management body (or supervisory board) with no executive functions, at least a majority of whom must qualify as "independent". This requirement will be difficult to achieve for private equity fund managers where members of the management board typically have executive functions and are not independent. Hopefully, the principle of proportionality may be applicable with respect to such requirements also for bigger fund managers
- The compensation of the management body/supervisory unit and staff which assume "control functions", may not be linked to the performance of the "unit" they are supposed to control. This seems to imply that any such staff may not receive carried interest.
- Fixed remuneration must be sufficient taking into account that variable remuneration may also decrease down to zero. However, ESMA recognizes that remuneration is the result of negotiations and hence seems to leave a certain amount of flexibility here.
- Variable remuneration is subject to complex risk alignment rules. The good news is that fund-as-a-whole carried interest structures with clawback mechanism are accepted as special risk alignment model. Hence the complicated requirements intended to reflect risk aligned compensation for variable remuneration do not apply. However, the proposed rules still need improved drafting to properly reflect the private equity compensation scheme and carried interest models Moreover, ESMA only refers to the carried interest arrangement as such and not to bonus payments and other variable payments made by the AIFM to its staff. Such other variable payments seem to remain subject to the very complex risk assessment, award and pay-out processes (including very conservative deferred pay-out requirements) some of which are summarized below under VII.
II.Scope of the Guidelines
1.Types of remuneration
ESMA proposes a broad scope of the Guidelines to cover all forms of payment or benefit paid by the AIFM, of any amount paid by the AIF and of any transfer of units or shares of the AIF, "in exchange for professional services" rendered by the AIFM staff regardless of whether the remuneration is fixed or variable. According to ESMA that seems to include carried interest to the extent it constitutes a disproportionate return on investments made by the carry beneficiaries (ESMA refers to "pro rata" return on investment which should be left out of account).
ESMA excludes from the scope of the Guidelines the following payments:
- Ancillary payments or benefits that are part of a general, non-discretionary, AIFM-wide policy and pose no incentive effects in terms of risk assumption;
- Any Payment made directly by the AIF to the benefit of staff members which consists of a "pro-rata return" on any investment made by those staff members into the AIF (it is unclear what ESMA means by "pro rata");
- Fees and commissions received by intermediaries and external service providers in case of delegated activities. Hence, advisory fees and management fees paid to management companies to which management functions are delegated may not be covered. However, ESMA announces that separate remuneration guidelines will be implemented for firms subject to MiFID which may well be the case for such entities.
2. AIFMs covered by the Guidelines
The Guidelines are applicable to all AIFMs which are subject to authorisation and supervision by competent authorities pursuant to the AIFMD. Non-EU AIFMs are not within the scope of the Guidelines if they market units or shares of AIFs they manage under the national private placement rules.
The Guidelines shall also be applicable to AIFMs which are subsidiaries of a credit institution. Although such AIFMs being part of a banking group are covered by the remuneration principles under the CRD, ESMA considers that the application of the Guidelines to these AIFMs should ensure that risk-taking that exceeds the level of tolerated risk of the credit institution is avoided not only at the level of the parent credit institution to which the CRD principles apply, but also at a group level.
3. Staff subject to the Guidelines
The Guidelines shall be applicable to staff members whose professional activities have a material impact on the AIFM's risk profile or the risk profiles of the AIF that it manages. ESMA considers the following categories of AIFM staff as covered, unless it is demonstrated that they have no material impact on the AIFM's risk profile:
- Members of the governing body of the AIFM;
- Senior management (e.g. investment committee members);
- Staff members with controlling functions other than senior managers (e.g. staff responsible for risk management, compliance, internal audit and similar functions);
- Staff members responsible for heading the portfolio management, administration, marketing, human resources;
- Other risk takers.
III. Proportionate application of the Guidelines principles
According to ESMA the application of the proportionality principle (set forth in Level I) may lead to a tailored application of the remuneration policies and practises provided that this is reconcilable with the risk profile and the strategy of the AIFM and the AIFs it manages. As a consequence, not all AIFMs have to apply the remuneration requirements in the same way and to the same extent. However, AIFM must be able to justify each tailoring to the competent authority.
The application of the proportionality principle depends on the size of the AIFM or the AIFs it manages; its internal organisation and the nature, scope and complexity of the activities.
IV. Overall cap on variable remuneration: sound financial situation of the AIFM
The AIFM should ensure that its financial situation will not be adversely affected by the overall pool of variable remuneration that will be awarded for that year, and the amount of variable remuneration that will be paid or vested in that year. The fact that an AIFM is becoming unable to maintain a sound financial situation (i.e. comply with capital requirements pursuant to Art. 9 of AIFMD), should be a trigger for, inter alia: a) reducing the variable remuneration pool for that year and b) the application of performance adjustment measures in that financial year.
V. Governance of remuneration
Under the "governance" rules ESMA determines (1) who is in charge of determining and implementing the remuneration policy, (2) the requirement to have a remuneration committee (and its composition and role) and (3) the remuneration of personnel assuming control functions.
1.Role and remuneration of management body
The Guidelines (and AIFMD) differentiate between the following bodies/units:
- Senior management: persons who effectively conduct the investment management business of an AIFM;
- Management body (i.e. the body with ultimate decision making power, e.g. the board of directors, which may include some or all members of the senior management but also non-executives directors);
- The supervisory function: persons or bodies responsible for the supervision of the senior management. If there is no separate supervisory unit, the supervisory function will be assumed by the management body in its supervisory function ("Supervisory Function") in which case the management body should include also non-executive members that "collectively have sufficient knowledge of remuneration policies and structures".
The Supervisory Function (i.e. management body or separate supervisory unitis responsible for approving and maintaining the remuneration policy of the AIFM, and overseeing its implementation. The remuneration policy should not primarily be controlled by executive members of the management. The supervisory function approves any subsequent material exemptions or changes to the remuneration policy and carefully considers and monitors their effects. The supervisory function should ensure that the following elements are taken into account: the clear distinction between operating and control functions, the skills and independence of members of the management body, the role performed by internal committees, including the remuneration committee, the safeguards for preventing conflicts of interests and the internal reporting system and the related parties' transactions rules).
Where appropriate (considering size, nature and complexity of activities), Supervisory Function should not determine its own remuneration. For example, the approval of the management's remuneration may be assigned to the meeting of shareholders of the AIFM whose vote may be consultative or binding.
2. Remuneration committee
The role of the remuneration committee is to advise the Supervisory Function (i.e. management body or supervisory unit) with respect to the determination and implementation of the remuneration policy and processes.
b) Who must have a remuneration committee?
AIFMs which are significant in terms of their size of the AIFs they manage, internal organisation and the nature, scope and complexity of their activities must have a remuneration committee. In order to identify whether a remuneration committee is expected to be set up, consideration should be given to all three factors meaning that for example an AIFM which is significant in size but is not significant in terms of its internal organisation and/or nature, scope and complexity of its activities should not be required to set up a remuneration committee. ESMA provides the following examples for situations in which no remuneration committee would need to be set up:
- AIFMs for which the value of the portfolios of AIFS they manage does not exceed EUR 250 million; ESMA does not clarify whether such AIFs would be closed or open ended / leveraged or unleveraged. If it were to refer also to closed ended and unleveraged AIFs, this would be an alarming conservative example as such AIFM would only be covered by the rules if they opted in.
- AIFMs which are a subsidiary of a credit institutions which is obliged to set up a remuneration committee which performs its tasks and duties for the whole group.
The remuneration committee should comprise members of the supervisory function who do not perform executive functions, and at least the majority of whom qualify as independent. The chairperson must be and independent non-executive member. It is unclear what ESMA understands by "independent", no guidance is given in that respect.
3. Control function
The remuneration at the level of staff in control functions should allow the AIFM to employ qualified and experienced personnel in these functions. If they receive variable remuneration, it should be based in function-specific objectives and should not be determined by the individual financial performance of the business area they monitor.
For AIFMs which are required to have a remuneration committee remuneration of control functions should be overseen by such committee and otherwise by the management body.
VI. General requirements on risk alignment
The remuneration system should be consistent with the risk profiles, the articles of associations of the AIF and investment objectives of the AIF. This includes, in particular, a proper balance of variable to fixed remuneration, the measurement of performance as well as the structure and, where appropriate, the risk-adjustment of the variable remuneration. ESMA expects even smaller AIFMs to ensure they make the best possible attempt to align their remuneration policy with their interests and the interests of the AIFs they manage and their investors. ESMA states certain examples where this general principle becomes relevant.
Without prejudice to employment law or contract law, severance payments may include payments related to the duration of a notice period, redundancy remuneration for loss of office, and may also include a non-competition clause in the contract. But AIFMs should set up a framework in which severance pay is determined and approved, in line with the AIFM's general governance structures for employment. The framework should ensure that there is no reward for failure. AIFMs should be able to explain to competent authorities the criteria they use to determine the amount of severance pay. It is good practice to defer any outstanding variable payments or long-term incentive plans and for these to mirror the original deferral schemes.
2. Prohibition of hedging or insurance to cover downside risks:
ESMA takes the view that an appropriate remuneration policy which is aligned with risks will, if sufficiently effective, occasionally result in a downward adjustment to the amount of variable remuneration awarded to staff. The effectiveness of risk alignment will be significantly weakened if staff members are able to transfer the downside risks to another party through hedging or certain types of insurance.
VII. Special requirements on risk alignment
The Directive foresees the requirement of a fully flexible policy on variable remuneration which implies that variable remuneration should decrease as a result of negative performance and that it can go down to zero in some cases. Hence, the Directive requires that the fixed remuneration should be "sufficiently high" to remunerate the professional services rendered. However, ESMA recognizes that the fixed remuneration is primarily the result of negotiations between a staff member and the AIFM.
2. Variable remuneration
To limit excessive risk taking, variable remuneration should be performance-based and risk adjusted. ESMA differentiates between three steps for such purposes: (i) the performance and risk measurement process, (ii) the award process and (iii) the payout process:
(i) The performance assessment should link the remuneration with the achievement of the investment strategy of the AIFs concerned and the business plan, if any, or the objectives of the AIFM. When assessing performance, only the effective results should be taken into account.
(ii) After the period during which the performance of the staff member is assessed and measured for the purposes of determining its remuneration ("accrual period"), the AIFM should use a specified award process in order to translate performance assessment into the variable remuneration component for each staff member.
(iii) In order to align the actual payment of remuneration to the life-cycle of the AIF managed by the AIFM and the investment risks, the variable remuneration should partly be paid upfront (short-term) and partly deferred (long-term). The short-term component should be paid directly after the award to the staff for performance delivered in the accrual period, subject to ex post risk adjustment. The long-term component should be awarded to staff during and after the deferral period. ESMA foresees strict deferred pay out mechanism of at least 40 to 60%.
Each of such steps is subject to a complex quantitative and qualitative risk measurement.
Whereas the above principles regarding variable remuneration will be relevant to bonus payments to staff within the AIFM, it should not be relevant for carried interest payments.
3. Assumption for Carried Interest Schemes
ESMA recognizes that the objectives of the requirements on risk alignment of variable remuneration may be more naturally met by certain remuneration structures which are structured in a very specific way with the aim of ensuring the alignment of the interests of the respective staff with those of the investors of the AIFs the AIFM manages. ESMA is of the view that this is the case where:
(i)An AIFM must first return all capital contributed by the investors of the AIF it manages and "an amount of profits at a previously agreed hurdle rate (if any)" to the investors of the AIF, before the relevant staff may receive "any compensation" for the management of the relevant AIF; and
(ii) The compensation received by the relevant staff is subject to clawback arrangements until the liquidation of the relevant AIF
ESMA considers that the carry clawback and the hurdle rate mechanism could operate in a manner which satisfies both the retention, deferral and investing requirements set out in the Directive. However, it is unclear from the proposal whether the up-front payment of management fee/profit priority share would have the effect that this assumption/exemption does not apply: ESMA states that "any compensation" must be subject to such waterfall mechanism described in (i). However, in practice distributions to investors and carried interest (if any) are only made after payment of the profit priority share. It is also unclear what the clawback arrangements referred to under (ii) would have to look like: whether they would have to cover the full carried interest or only the after tax amount. Hopefully, clarification will be obtained on these points following the consultation process.
AIFMs should publicly disclose detailed information regarding their remuneration policies and practices on an annual basis and as soon as practicable after the information becomes available. Further, AIFMs shall provide general information about the basic characteristics of their AIFM-wide remuneration policies and practices. The disclosure should be produced and owed by the management body that has the ultimate sign-off on remuneration decisions and be clear and easily understandable and accessible.
In accordance with the Commission recommendation 2009/384/EC on remuneration policies in the financial services sector ("Recommendation") the following information should be disclosed:
- Information concerning the decision-making process used to determine the remuneration policy, including information about the governance procedure and the significant bodies (e.g. remuneration committee, external consultants) relating to the development of the remuneration policy, and information about the role of all relevant stakeholders involved in the determination of the remuneration policy; additionally, the disclosure should include a description of the regional scope of the AIFM's remuneration policy, the type of staff considered as material risk takers and the criteria used to determine such staff;
- Information on linkage between pay and performance, including information about the main performance metrics, the design and structure of the remuneration process, the different forms of variable remuneration used and the rationale for using them and for allocating them to different categories of staff; additionally, the disclosure should include a discussion of the parameters used to allocate deferred and non-deferred remuneration for different staff categories;
- Information on the criteria used for risk determination, risk measurement and risk adjustment
- Information on the quantitative (financial) and qualitative (non-financial) parameters for assessing individual performances relevant for determining the remuneration policies and practices.
However, the Recommendation's remuneration disclosures may be made on a proportionate basis under consideration of the proportionality principle. ESMA states that small or non-complex AIFMs/AIFs will only be expected to provide some qualitative information and very basic quantitative information where appropriate. In practice, they are not expected to provide all the information pursuant to the Recommendation.
For any comments and questions please do not hesitate to contact us. Our partner Patricia Volhard based in our Frankfurt office (contact details below) advises the European Venture Capital Association (EVCA) and the German Private Equity and Venture Capital Association (BVK) on AIFMD. Patricia chairs the technical committee of the public affairs executives of EVCA preparing responses to AIFMD related consultations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.