The final report on guidelines on performance fees in investment funds (the "Guidelines") which is applicable to both UCITS and certain types of alternative investment funds ("AIFs"), was published by the European Securities and Markets Authority ("ESMA") on 3 April 2020.
It was issued in response to the July 2019 ESMA consultation paper containing draft guidelines, which sought industry feedback on performance fees models and disclosures by investment funds across the EU.
The Guidelines are applicable to fund management companies acting for both UCITS and certain types of AIFs which target retail investors (i.e. from an Irish perspective certain retail investor alternative investment funds ("RIAIFs") and from a Luxembourg perspective AIFs established under part II of the law of 17 December 2010 relating to undertakings for collective investment ("Part II Funds")).
The focus of the Guidelines is to harmonise how fund managers charge performance fees to retail investors; the circumstances in which performance fees can be paid, and how they are disclosed.
These are set out in five categories:
- The performance fee calculation method;
- The consistency between the performance fee model and the fund’s investment objectives, strategy and policy;
- The performance fee crystallisation frequency;
- Negative performance recovery; and
- The disclosure of the performance fee model.
The Guidelines introduce a strict requirement for fund managers to be conscious of the policies, strategies and objectives of the fund to ensure each are aligned and, to an extent, justify the performance fee model being implemented.
Performance Fee Calculation
The Guidelines require that the calculation of a performance fee should be verifiable and structured to ensure that performance fees are always proportionate to the actual investment performance of the fund.
The calculation of the performance fee should include the following elements:
- A reference indicator;
- The crystalisation frequency;
- The performance reference period;
- The performance fee rate; and
- The performance fee methodology.
Fund managers must also demonstrate (i) how the performance fee model for each fund constitutes a reasonable incentive for the manager and (ii) how it is aligned with investors’ interests following IOSCO Good Practices.
The Guidelines also state that performance fees could be calculated on a single investor basis.
Performance Fee Consistencies
The Guidelines require fund managers to implement and maintain a process in order to demonstrate and periodically review that the performance fee model is consistent with the fund’s investment objectives, strategy and policy.
For example, for funds that pursue an absolute return objective, a High Water Mark ("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.
Recently, the Central Bank of Ireland's ("Central Bank") Thematic Review on Closet Indexing highlighted the lack of consistency and transparency of fee disclosures with the fund's objectives and policies across fund documentation (i.e. prospectuses, KIIDs, and marketing materials) as a concern.
The Guidelines require that the frequency of crystallisation and the subsequent payment of the performance fee to the fund manager be clearly defined within the fund documentation to ensure that the interests of the portfolio manager and the shareholders are aligned, and investors are fairly treated.
The calculation of the performance fee must not crystallise more than once annually – this is intended to align ESMA's approach to IOSCO Good Practices. The Guidelines also insist that the crystallisation date should be the same for all share classes of a fund that levies a performance fee.
Negative Performance Recovery
The Guidelines reaffirm that a performance fee should only be payable in circumstances where positive performance has been accrued during the performance reference period1. For example, a fund using a HWM model should only be payable during the performance reference period and where the new HWM exceeds the last HWM.
The rationale is to ensure that fund management companies are not incentivised to take excessive risks and that cumulative gains are duly offset by cumulative losses.
The Guidelines also require that in the event of any underperformance or loss previously incurred during the performance reference period it should be recovered before a performance fee becomes payable to the recipient.
Performance Fee Model Disclosure
The Guidelines require that the investors should be adequately informed about the existence of performance fees and their potential impact on the investment return and therefore obliges fund managers to ensure this is the case.
The obligation to provide adequate disclosure in prospectuses was also reflected in the Commission de Surveillance du Secteur Financier's ("CSSF") most recent FAQ concerning the Luxembourg law of 17 December 2010 relating to undertakings for collective investment, which provided clarification on fee disclosure requirements.
The Guidelines will apply two months after their date of publication on the ESMA website, at which point the fund management company and national competent authorities will be obligated to notify ESMA whether they (i) comply; (ii) do not comply, but intend to comply or (iii) do not comply and do not intend to comply with the Guidelines.
The Central Bank is expected to notify industry of the backing of these measures in the coming weeks. It is also expected that the CSSF will apply the Guidelines.
While there is a significant degree of overlap with the Central Bank's and the CSSF's existing performance fee requirements, fund managers should nonetheless promptly review all fund offering documentation to ascertain compliance with the Guidelines and we can assist in this process.
Any offering documentation changes prompted by these Guidelines would be subject to (i) Central Bank or CSSF (as applicable) pre-approval and (ii) will require at least prior shareholder notification (or potentially, in certain circumstances, shareholder consent).
If you would like further information, please liaise with your usual Maples Group contact or any of the team below.
1 For the HWM model, the performance reference period is either (i) the whole life of the fund or (ii) at least every five years on a rolling basis.