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Financial Conduct Authority Guidance on AIFM Directive Remuneration Provisions
By Dechert LLP
The UK Financial Conduct Authority (FCA) released proposed guidance on 6 September 2013 on its implementation of the remuneration provisions in the AIFM Directive (the AIFM Remuneration Code) for UK alternative investment fund managers (AIFMs).
Investment managers taking advantage of the transitional period will need a compliant remuneration policy in place by the time they apply for authorisation as AIFMs and, if one is not in place by then, explain why and say when they expect to have one in place. The FCA has advised firms to make this application by 22 January 2014. The remuneration policy must reflect the remuneration rules in the AIFM Directive and the European Securities and Markets Authority’s (ESMA) guidelines on sound remuneration policies under the AIFM Directive (Guidelines). There may well be a number of changes to the guidance following consultation. Nonetheless, it provides an insight into the likely application of the rules to different types and sizes of investment managers in practice. Perhaps most importantly, the FCA indicates the approach firms should take in applying the “proportionality” principle to the application of the rules – in particular, by reference to a firm’s assets under management.
Firms have until 6 November 2013 to provide feedback on the consultation.
AIFMD Remuneration Principles
The principles set out in the FCA’s AIFM Remuneration Code (SYSC 19B) are similar to those of its CRD Remuneration Code (SYSC 19A). The general principle is that an AIFM must implement and maintain remuneration policies and practices for AIFM Code staff that are consistent with effective risk management and do not encourage risk taking which is inconsistent with the relevant fund documentation. Other principles cover a range of aspects of the design and determination of remuneration including (among others) avoiding conflicts of interest, prohibiting guaranteed variable remuneration (unless exceptional, in the context of hiring and limited to the first year of service), assessing performance in a multi-year framework and by reference to a combination of financial and non financial criteria, adjusting any measurement of performance for risk, fixing an appropriate ratio between fixed and variable remuneration, avoiding severance payments that reward failure, preventing staff using personal investment strategies to avoid the impact of the Code and anti-avoidance generally.
When complying with these principles, an AIFM should do so in a way and to an extent that is appropriate to its size, internal organisation and the nature, scope and complexity of its activities. This is known as the “proportionality principle”.
The FCA consultation focuses principally on the application of the proportionality principles to the remuneration rules relating to governance and what the FCA terms the “pay out process”.
Under the principle on governance, an AIFM that is significant in terms of its size, internal organisation and the nature, scope and complexity of its activities must establish a remuneration committee. The remuneration committee should comprise members of the AIFM’s governing body who do not perform an executive function.
The pay out process principles are:
Payment in kind: a substantial proportion of variable remuneration (at least 50%) should be paid in AIF units which are subject to an appropriate retention policy.
Deferral: a substantial proportion of variable remuneration (at least 40%, and at least 60% in the case of particularly high variable remuneration) should be deferred for at least three to five years.
Performance adjustment: variable remuneration (including deferred variable remuneration) should only be paid if sustainable according to the financial situation of the AIFM, the performance of the AIF, the business unit and the individual concerned. Variable remuneration should be reduced for negative or subdued financial performance of the AIFM or the AIF through “malus” (the power to reduce the value of deferred remuneration) or clawback provisions.
Under the proportionality principle, AIFMs can potentially disapply the requirement to establish a remuneration committee and the three pay out process principles.
For individuals, the FCA proposes that an AIFM may disapply these key requirements in relation to any individual whose variable remuneration is no more than 33% of total remuneration and total remuneration is no more than £500,000. This is the same de minimis threshold that the FCA has applied in its existing CRD Remuneration Code.
For AIFMs, the FCA proposes the following thresholds based on the value of fund assets under management (AuM) to give a working presumption to firms on whether it is proportionate to disapply certain principles.
Presumption that it is appropriate to disapply the requirement for a remuneration committee and the pay out process principles
AuM Thresholds, less than:
AIFM which manages portfolios of AIFs including assets acquired through leverage:
[£500m – £1.5bn]
AIFM which manages portfolios of AIFs which are unleveraged and have no redemption rights during a period of 5 years following the date of initial investment:
An AIFM may be able to disapply the key requirements if it is below the AuM threshold, but this is not automatic. Having looked at its AuM, a firm should then look at how the relevant proportionality criteria (size, internal organisation, nature, scope and complexity of its activities) apply to its business in ultimately deciding whether or not it is appropriate to disapply. For example, it may not be appropriate for an AIFM with AuM below the threshold to disapply these rules if it has a complex internal ownership structure or takes high levels of risk in its AIF activities. Similarly, an AIFM with AuM above the threshold may be able to disapply these principles if it is owner managed, has a limited number of strategies and narrowly defined risk parameters for investment decisions. Each firm must in a position to explain its rationale for disapplying any principle to the FCA, if requested by the FCA.
The FCA has produced a table outlining the factors that an AIFM might take into account when assessing its business against these criteria.
For size: the FCA suggests looking at the number of employees and LLP members performing services relative to peer firms.
For internal organisation: the FCA suggests looking at whether the AIFM is listed on a regulated market and whether the senior management own the majority stake in the AIFM. It says that a listing favours the application of the pay out process to align interest with external investors. This is not the case, by contrast, where senior management own a majority stake.
For nature, scope and complexity of activities: the FCA suggests looking at the number of strategies; whether or not there are defined parameters for risk taking in investment management; the nature of the incentive fee arrangements (carried interest having inbuilt risk alignment); and also the FCA’s own internal conduct and prudential supervision categories (C1 to C4, P1 to P4).
As far as the requirement for a remuneration committee is concerned, the FCA guidance says that the working presumption for AIFMs above the AuM thresholds is that they are significant in size. Also, an AIFM that is listed on a regulated market is likely to be significant in terms of internal organisation. In either case, such firms will typically need to establish a remuneration committee.
Delegation of portfolio or risk management
The FCA also provided guidance regarding the requirement for an AIFM to apply the AIFMD remuneration rules to any entity to which it has delegated portfolio or risk management. ESMA’s Guidelines require an AIFM which is delegating portfolio or risk management either (i) to ensure that the delegate is subject to regulatory requirements on remuneration that are equally as effective as those applicable under the Guidelines or (ii) to put in place appropriate contractual arrangements with the delegate to ensure that there is no circumvention of the remuneration rules set out in the Guidelines.
There has been much doubt over how this obligation will play out in practice. The FCA provides the following guidance:
The FCA considers the Capital Requirements Directive (CRD) and Markets in Financial Instruments Directive (MiFID) remuneration regimes to be “equally as effective” as AIFMD.
The AIFM may apply proportionality to the remuneration requirements in respect of its delegate in a similar way as proportionality is applied to the AIFM itself. The FCA has provided an example of an UK AIFM delegating portfolio management to a US manager under strict investment guidelines. As the US manager has limited discretion, the US manager will not need to comply with the pay out process rules. Potentially, this could mean that the full AIFM Remuneration Code need not apply to a delegate performing a “stock-picking” role, where risk management is reserved to the AIFM.
Where the AIFM puts in place contractual arrangements with a delegate, these arrangements need only apply to the delegate’s relevant staff and to their remuneration which is connected to the delegated activities. In other words, an AIFM only needs to apply the remuneration guidelines to the income derived from the relevant AIF and received by the individual portfolio or risk managers at the delegate involved in the delegated mandate.
Payment in kind
The FCA provides some guidance in relation to the obligation to pay at least 50% of variable remuneration in units of the AIF concerned. First, it does not apply if the AIFs managed by the AIFM account for less than 50% of the total portfolio. Second, the rule itself is subject to the legal structure of the AIF and its documentation.
The FCA acknowledges that it is impractical to apply this rule where:
the AIF is closed-ended,
the AIF documentation precludes staff investment or has a high minimum investment threshold,
it is not permissible to market the AIF to staff or for staff to hold units in the AIF,
an investment in the AIF would have a negative tax effect for third party investors, or
the creation of structured “equivalent ownership interests” would be unduly costly against the benefits gained.
The FCA also acknowledges that it may be disproportionate to apply the rule for AIFMs managing many AIFs and for staff such as senior management or compliance, whose performance cannot be linked to a given fund. In those cases, the FCA suggests that firms may pay staff either in interests in the AIFM itself (or its parent) or in shares linked to the weighted average of all the AIFs managed.
The proposed starting point for a minimum retention period for such payments in kind is 6 months, consistent with the guidance under the CRD Remuneration Code.
Payments to partners of an AIFM
The last key area on which the FCA provides guidance is the application of the AIFM Remuneration Code to members of an AIFM set up as a partnership. There were two main areas of concern here.
The first was how to distinguish between payments made to partners in exchange for professional services (in scope of the AIFM Remuneration Code) and distributions received by partners as owners of the AIFM (out of scope). There were three main aspects to the FCA guidance:
For an approach based on existing payments, the FCA draws a distinction between “discretionary profit share distributed to all partners” (effectively a bonus pool, so in scope) and “additional profit share for senior or founding partners” (more likely to be a distribution on equity in the business, so out of scope). Many AIFMs have profit waterfalls which include a discretionary performance based tranche and a residual tranche distributed on a fixed percentage basis. For these AIFMs, the residual profit allocations are likely to be outside scope andthe discretionary allocations will be in scope. Some AIFMs will have arrangements with partners who are individual portfolio managers involving the allocation of a share of performance fee. These will most likely be in scope.
An alternative approach envisaged by the FCA involves the use of benchmarks – namely looking at the remuneration structures of others performing similar tasks or working in the same or similar businesses. It appears that an AIFM could (in theory) calculate the proportion of an individual partner’s profit that is in scope by estimating the amount which that individual would have earned if employed by a firm which was not structured as a partnership. The significant obstacle in following this approach, however, will be obtaining the relevant benchmark data – especially when this information is unlikely to be public and, in any event, the relevant AIFM’s peers may also be structured as partnerships.
If an individual works full-time, the FCA would expect a larger percentage of the partner’s profit share to be considered a profit distribution (out of scope). If an individual works part-time, the FCA would expect a “reasonable portion” of the partner’s profit share to be considered remuneration (in scope).
The second concern relates to the tax effect of deferral. The FCA acknowledges that this may result in a “dry” tax charge and states that it is discussing a mechanism to address this with HM Revenue & Customs (HMRC) which will form part of the ongoing HRMC consultation on the taxation of partnerships. The FCA states that what is envisaged is that the deferred remuneration will be on a “net of tax” basis, with tax and national insurance contributions on the remuneration accounted for by the partnership.
Which individuals are caught?
There is relatively little in the consultation paper about how to identify AIFM Remuneration Code Staff, although the AIFM should be able to show how it has carried out that identification exercise. The starting point is staff whose professional activities have a material impact on an AIFM’s risk profile or the risk profiles of the AIFs that it manages, which will entail an analysis of job functions and responsibilities.
According to the Guidelines, the following categories should be included unless the AIFM can establish that the activities of such individuals have no material impact on the AIFM’s risk profile:
Members of the AIFM’s governing body: so the directors or management committee members.
Control functions: staff responsible for risk, compliance, internal audit.
Heads of certain business lines: portfolio management, HR, marketing, administration.
Other risk takers who individually or together can assert material influence of the AIFM or AIF’s risk profile. Examples include individual traders or trading desks.
In addition, any other employees should also be AIFM Remuneration Code Staff if they have a material impact on the risk profile of the AIFM or AIF and their total remuneration takes them into the same bracket as senior managers.
The FCA accepts that where employees are not involved in the management of AIFs but instead manage other funds, such as UCITS funds, an AIFM may take that into account in its proportionality analysis as to who is AIFM Remuneration Code Staff. If they are deemed Code Staff, the FCA suggested that the AIFM can take it into account to disapply the pay out process principles for those individuals.
The FCA also suggests that, where an individual does a mixture of AIFMD and non-AIFMD work, an AIFM may apportion that individual’s remuneration for the purpose of compliance with the AIFM Remuneration Code. It suggests apportionment on the basis of time spent or AuM.
Timing and scope
A final, but important, aspect of the FCA consultation relates to the timing. The FCA confirms that it expects firms to implement the AIFMD remuneration regime for new awards of variable remuneration to relevant staff for the first full performance period after the firm becomes authorised as an AIFM. This appears to allow firms to delay application of the rules until the end of the next full performance period. So for firms with calendar year performance periods who are authorised during 2014, the first year to which the AIFM Remuneration Code applies would appear to be 2015.