ESMA published on 3 April 2020, its Final Report, ‘Guidelines on performance fees in UCITS and certain types of AIFs’ (the “Guidelines”). The Guidelines are the culmination of a consultation process started by ESMA in July 2019 (the “Consultation”) which sought stakeholder feedback on a range of issues relating to the use of performance fees by fund managers.
The Consultation
Our OnPoint issued in August 2019 provided detailed analysis of the Consultation and other various regulatory initiatives which sought to harmonise the way fund managers charge performance fees to retail investors, as well as the circumstances in which performance fees can be paid.
The following five guidelines, as set out in the Consultation, now form part of the final guidance:
- Performance fee calculation methodologies;
- Consistency between performance fee calculation models and investment objectives, strategies and policies;
- Frequency of crystallisation;
- Negative performance (loss) recovery; and
- Disclosure of performance fee models in fund documents.
ESMA’s Consultation was initially aimed at UCITS funds only. In order to ensure a level playing field and consistent protection for all retail investors, the Guidelines will now apply to certain types of AIFs, further details of which are set out below.
ESMA received 48 responses to the Consultation, 14 of which were confidential, primarily from asset management industry associations and asset managers. The answers received are available on ESMA’s website.
Who is within the scope of the Guidelines?
The Guidelines apply to managers 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. While the applicability of the Guidelines to UCITS is clear, it will be necessary for alternative investment fund managers to determine if any of their AIF shareholders bring them within the scope of the Guidelines.
When do the Guidelines take effect?
The Guidelines apply from two months after the date of publication on ESMA’s website in all EU official languages (the “Effective Date”). We set out below the various compliance dates for funds.
Funds
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Compliance Date
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New funds created after the Effective Date with a performance fee
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Immediate compliance
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Funds existing before the Effective Date that introduce a performance fee for the first time after that date
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Immediate compliance
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Funds with a performance fee existing before the Effective Date
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Compliance by the beginning of the financial year following six months from the Effective Date. Subject to the publication on ESMA’s website, for funds with a financial year-end of 31 December, it is likely that compliance will be required from January 2022. In its Consultation, ESMA initially proposed compliance within 12 months of the Effective Date.
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Given the potential complexities in formulating and implementing changes to performance fee methodologies and disclosures, early compliance analysis with the Guidelines is advisable.
What has changed from the Consultation?
For the purposes of this OnPoint, we examine below the requirements that have been included in the final Guidelines that did not form part of the Consultation. Detailed analysis of each guideline is set out in our previous OnPoint.
Guideline
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Requirements
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Performance fee calculation methodologies
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Performance fees can be calculated on a single investor basis.
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Consistency between performance fee calculation models and investment objectives, strategies and policies
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Managers must implement and maintain a process to review and demonstrate that the performance fee model is consistent with a fund’s investment objective, strategy and policy.
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. Consistency indicators which should be taken into account by the manager include: expected return; investment universe; beta exposure to an underlying asset class; geographical exposure; sector exposure; income distribution of the fund; liquidity measures (e.g. daily trading volumes, bid-ask spreads etc.); duration; credit rating category; and volatility and/or historical volatility.
If the reference indicator changes during the reference period, the performance of the reference indicator for this period should be calculated by linking the benchmark index that was previously in force until the date of the change and the new reference indicator used afterwards.
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Frequency for the crystallisation of the performance fee
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The crystallisation frequency should not be more than once a year.
The above requirement does not apply where the fund employs a high water-mark (HWM) model or a high-on-high model where the performance reference period is equal to the whole life of the fund and it cannot be reset.
The crystallisation date should be the same for all share classes of a fund that levies a performance fee.
In the case of closure/merger of funds and/or upon investors’ redemptions, performance fees, if any, should crystallise in due proportions on the date of the closure/merger and/or investors’ redemption. In the case of the merger of funds, the crystallisation of the performance fees of the merging fund should be authorised subject to the best interest of investors of both the merging and the receiving funds.
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Negative performance (loss) recovery
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In order to avoid misalignment of interests between the fund manager and the investors, a performance fee could also be payable in case the fund has overperformed the reference benchmark but had a negative performance, as long as a prominent warning to the investor is provided.
In case the fund employs a performance fee model based on a benchmark index, it should be ensured that any underperformance of the fund compared to the benchmark is clawed back before any performance fee becomes payable. To this purpose, the length of the performance reference period, if this is shorter than the whole life of the fund, should be set equal to at least five years.
For the HWM model, in case the performance reference period is shorter than the whole life of the fund, the performance reference period should be set equal to at least five years on a rolling basis. In this case, performance fees may only be claimed if the outperformance exceeds any underperformances during the previous five years and performance fees should not crystallise more than once a year.
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Disclosure of performance fee models in fund documents
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In case a fund allows for a performance fee to be paid in times of negative performance (for example, the fund has overperformed its reference benchmark index but, overall, has a negative performance), a prominent warning to investors should be included in the KIID.
In case a fund managed in reference to a benchmark computes performance fees with a benchmark model based on a different but consistent benchmark, the manager should be able to explain the choice of benchmark in the prospectus.
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 methodology allows for performance fees to be charged even in case of negative performance.
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Please do not hesitate to get in touch with the Dechert Financial Services team if you have any queries in relation to this OnPoint, or if we can assist you in assessing the impact of the Guidelines on your business.
