Hedge funds and other alternative investment fund managers could see further restrictions on the way in which they are able to remunerate their employees once the remuneration provisions of the EU’s Alternative Investment Fund Managers Directive (AIFMD) are transposed into national provisions. These provisions are due to come in to effect by 22 July 2013.
Although hedge fund managers are already caught by the FSA’s Remuneration Code, which implemented in the UK the remuneration provisions of the amended European Capital Requirements Directive (known as “CRD III”), those managers will generally have been able to take advantage of the proportionality provisions developed by the FSA to neutralise the most onerous requirements. However, because the AIFMD is specifically designed to target hedge funds and other alternative investment fund managers, rather than a wider class of financial firms, the largest, most complex, managers will now have to apply the same remuneration rules as were imposed on the biggest European banks and building societies under CRD III.
Supplementing the AIFMD text are the recently consulted upon draft guidelines from the European Securities and Markets Authority (ESMA). Unfortunately, both the AIFMD provisions and ESMA’s draft guidance follow the same structure as CRD III and do not take into account issues specific to the alternative investment fund sector. Unlike banks and building societies, most hedge funds are small or medium-size companies or partnerships run by their owners; they do not have complex governance structures and are likely to find it burdensome and impractical to comply with the guidelines as currently drafted. Further, unlike bank depositors, investors in funds make their investment decisions based on an understood risk exposure – there is no guaranteed return either on the invested amount or at any specified time. Such issues are not specifically addressed currently, and it will therefore be imperative that local regulators take these points into account in transposing the AIFMD provisions into local regulations.
Not all managers must be treated in the same way, however, as the AIFMD makes reference to applying the rules on the basis of proportionality. This will allow the FSA scope in applying the rules differently depending on the size and complexity of each manager. The clear, objective approach taken by the FSA to proportionality in drafting its Remuneration Code helped minimise uncertainty and compliance costs. Whilst the FSA has previously indicated that it would seek to follow a similar approach in implementing the AIFMD, perhaps assessing proportionality using a quantitative measure such as assets under management, this may be forestalled by the ESMA draft guidelines. Unlike previous implementation guidelines, ESMA does not refer to the ability to “neutralise” the AIFMD remuneration provisions, but only to “tailor” them, meaning that more managers may be required to overhaul their remuneration structure once the AIFMD is in force.
The effect of the AIFMD remuneration rules on a manager will therefore depend on the manager’s proportionality status. The largest and most complex managers will bear the burden of implementing the provisions in full, requiring them to impose bonus deferral, claw-back and payment in fund units on their employees. Key employees will see up to 60% of their bonus deferred for periods of up to five years, with at least half of the overall bonus being paid in the form of fund units subject to a further retention period. This could have the effect of driving a coach and horses through the competition for talent within the industry, as some of the smaller players will not be constrained to the same extent. For those who are able to take advantage of their size or scope of activities in order to tailor the level at which they are required to comply, this may therefore be seen as an opportunity to be used in approaching talented portfolio managers who may see their current remuneration hit by the new provisions.
Unless further clarification is given in relation to deferral, this could also give rise to significant tax issues for many firms structured as limited liability partnerships or limited partnerships. Partnerships are required to allocate their profits each year to their members, giving rise to a tax liability on each member in relation to their profit allocation. The requirement to impose deferral on the receipt of such amounts would not delay the liability to tax, and could result in an unfunded obligation for the relevant individual. This is surely an unintended result, and will need to be addressed by local regulators.
Of particular concern to hedge funds will be the issue raised by ESMA in relation to staff of delegates, including entities providing investment advisory services. Under the AIFMD, a fund can have only one manager and so, where activities are delegated, the staff of the delegate would appear to fall outside the scope of the remuneration rules. Notwithstanding this principle, the ESMA consultation asks for views as to whether the AIFMD remuneration rules should extend to such staff. This approach could significantly widen the scope of the remuneration rules, including in some instances to staff of delegates where the manager is not itself caught. This could include, for example, a UK advisory firm providing services to a US manager which would be out of scope in respect of its own employees. This issue may be addressed by a second consultation paper recently published by ESMA introducing proposals for further guidelines to apply to MiFID investment firms, which are designed to complement those already applying under CRD III, but focus on investor protection rather than capital adequacy. These new provisions flow from the requirement on MiFID investment firms to avoid conflicts of interests and act in the best interests of clients and, whilst clearly designed to seek to avoid the mis-selling of investments by client-facing, front-line, sales force staff, are wide enough also to capture employees who may be incentivised to put pressure on such sales staff or, for example, financial analysts who are able to influence investment decisions. It is questionable whether such additional protections are necessary – the majority of hedge fund clients are sophisticated institutional investors, who fully understand the risks involved and have the ability to manage them. Those investors require a certain level of risk to be taken, and the concern is that such additional regulation may result in portfolio managers taking a more conservative approach than their investors require.
The AIFMD text does not provide scope for performance fees or management fees payable by a fund to its manager to be brought within the remuneration rules, and ESMA’s draft guidance does not seek to apply the rules to either. ESMA does, however, pose the question in its consultation as to whether a better approach would be to apply the requirements of the AIFMD remuneration rules directly to the performance fee, presumably instead of applying the rules at the level of payment of remuneration by the manager to the staff member.
ESMA implies that the regulation of performance fees in this way could be justified by treating them as remuneration payable on behalf of the manager’s staff. This would seem to stretch the AIFMD provisions too far, and be beyond the powers of both ESMA and the FSA without further primary EU legislation. Such an approach would in any event be inappropriate on the basis of the rationale behind the AIFMD – investor protection: performance fees are a point on which investors make an informed commercial decision, as compared to the remuneration of individual staff members of which they will often have no visibility. It will, however, be important to watch for any move towards such an approach in ESMA’s final guidance.
Whilst ESMA’s aim has been to try to ensure consistency in the rules which apply to remuneration across the financial services industry, the fear is that it has done nothing to stem the concern that the AIFMD provisions, of which remuneration is only one aspect, may force UK hedge fund managers to consider leaving the UK to avoid considerable uncertainty and associated compliance costs.