ESMA Issues guidance on performance fees in Investment Funds
In November 2020, ESMA published its "Guidance on performance fees in investment funds – applicable to undertakings for Collective Investment in Transferable Securities (UCITS) and certain types of Alternative Investment Funds (AIFs)" (hereinafter referred to as the "Guidelines"). Keeping in mind the best interest of investors, and for the purposes of ensuring that applicable performance methodologies are implemented in a harmonised manner, the Malta Financial Services Authority (MFSA), in January 2021 published its updated Investment Services Rulebooks.
Through these new Guidelines, when designing performance fee models, fund managers are provided with a comprehensive list of principles, thereby being better placed to assess the consistency between performance fee models, and a fund's investment objectives, policies, and strategies. The Guidelines provide a performance fee calculation method with the aim of ensuring that any fees levied are not disproportionate and truly reflect the investment performance of a fund. Additionally, the Guidelines also establish provisions on the manner in which assessments of the crystallisation frequency may be made, and this with reference to different models for accrual and payment of performance fees.
When delving into further detail as to the changes made within the Investment Services Rulebooks, it should be noted that changes were made to Part B II the Investment Services Rules for Retail Collective Investment Schemes (the "UCITS Rules"); Part B of the Investment Services Rules for Alternative Investment Funds (the "AIF Rules"); Part BII of the Investment Services Rules for Investment Services Providers (the "UCITS Manco Rules"); and Part BIII of the Investment Services Rules for Investment Services Providers (the "AIFM Rules"). The salient features of these changes are delineated thereunder:
Referring to the UCITS Rules, new sub-section 6.3 to Part BII, details what disclosures should be made to Investors in connection with performance fees model adopted by a Fund Manager. Under these new rules, a scheme is obliged to inform its investors of the existence of performance fees and also regarding the potential impact these may have on the investment return. Moreover, the rules require that the main elements of the performance fee calculation method must necessarily be disclosed. In instances where a performance fee is charged also in times of negative performance, investors must receive a prominent warning in this regard.
Where a scheme is managed against a benchmark, the computation of the performance fees shall be made against a benchmark model based on a different but consistent benchmark. The Offering Document should detail the reasons behind the choice of the benchmark. Additionally, the Performance fee model and applicable computation methodology should be clearly delineated and explained in the Offering Document, any ex-ante information documents, and marketing material; such that investors would be able to properly understand same. The rules provide further details on the minimum information such documentation should include.
Similarly, the Key Investor Information should set out all the key information relating to the performance fee in line with Article 10(2)(c) of the Commission Regulation (EU) No 583/2010 of 1 July 2010. The name of the benchmark and its past performance should be displayed in the Key Investor Information and the Offering document in instances where the performance fees are calculated on the basis of performance against a reference benchmark index.
Finally, any reports whether annual or half-yearly, and any other ex-post information should indicate for each share class, the impact the performance fees had thereby detailing the number of performance fees charged and the percentage of the fees based on the net asset value of the share class.
New Section 27 to Part BII of the UCITS Rules details the specific rules applicable to performance fees. Primarily this new section states which minimum elements should be included in the performance fee calculation method. Importantly the performance fee calculation method must be verifiable and cannot allow manipulation. In designing the performance fee calculation method, one must ensure that performance fees are proportionate to the actual investment performance of the fund, and that the model provides reasonable incentives and remains aligned with investors' interests.
This new section also seeks to determine the manner in which consistency between the performance fee model and the fund's investment objectives, strategy and policy, shall be achieved. The rules further state that the interests between the portfolio manager and the investors must be aligned through the frequency for the crystallisation and the subsequent payment of the performance fee to the manager. The crystallisation frequency shall be once a year, as a maximum.
Further detail on what happens in a negative performance (loss) recovery instance is provided in this section. The Rules establish that performance fees shall be payable only when positive performance has been accrued. Any loss or underperformance must be recovered before the payment of the performance fee. In cases where the fund overperforms the reference benchmark but has a negative performance, a performance fee may be payable however, as explained above, a prominent warning shall be given to the investors. The performance fee must be designed, as such to ensure that the manager does not take excessive risks and that cumulative gains are offset by cumulative losses. When assessing the performance of the manager and remunerating him accordingly, the rules require that same must be made on a time horizon consistent with the investors' holding period.
Similar changes were respectively made to the AIF Rules, through the introduction of new section 9 to Part B; to the UCITS Manco Rules through the introduction of new sub-section 1.24 to Part BII; and to the AIFM Rules through the introduction of new sub-section 10.19 to Part BIII.
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.