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ESMA Final Report - “Guidelines on performance fees in UCITS and certain types of AIFs"

  • United Kingdom
  • Financial services and markets regulation
  • Financial services - Asset managers and funds


Background and Initial Consultation Paper

Harmonising how performance fees are structured and disclosed to investors has long been identified as a key priority of ESMA, as there are currently inconsistencies across the EU. Following its public consultation of July 1019 in respect of draft guidelines on performance fees for UCITS funds (the “Consultation”), ESMA has now published its final report and guidelines (the “Guidelines”). The Guidelines, which are set out as Annex IV of the Final Report, take into account the responses to the Consultation.

Please see our previous briefing on this topic “ESMA Consultation Paper – Guidelines on Performance Fees in UCITS (September 2019)”.

This briefing summarises the Guidelines and the implications for UK managers. The Guidelines will be formally published in June, as set out in more detail below.

Who is in scope and are existing performance fees impacted?

ESMA states that the Guidelines will apply two months after they have been published. However, ESMA treats (i) new performance fees (post-publication of the Guidelines), and (ii) existing performance fees (in place before the Guidelines) separately. So the Guidelines will apply immediately to any new performance fees introduced after that date. This is unaffected by the date the fund itself was established. And any existing performance fees must comply with the Guidelines by the beginning of the first financial year which commences at least six months after the Guidelines’ effective date.  

In a change from the initial consultation, ESMA confirmed that the final Guidelines will apply to fund management companies of UCITS funds but they will also apply to managers of certain alternative investment funds (“AIFs”) which market to retail investors.

The Guidelines

ESMA’s Final Report reviewed asset managers’ and investors’ feedback to the Consultation and how they responded to the draft Guidelines. ESMA’s aim is to safeguard retail investors from discretionary, excessive, or unclear performance fees. Overall ESMA identified support for improved EU supervision of management fees based on minimum standards. These minimum standards are the five separate Guidelines, from which we have summarised the key points below:

Guideline 1 – Performance Fee Calculation Method

ESMA commented that they aimed to ensure a balance between prescriptive rules and a more “principle based approach” which could encourage innovation and use of different models, while satisfying the overall aim of supervisory convergence.

A manager should ensure that the performance fee model of the fund constitutes a reasonable incentive for the manager and is aligned to investors’ interests. Certain minimum elements must be included in the design of a performance fee, including a reference indicator (which can be an index, a high water mark (HWM), a hurdle or a combination of these), a reference period, crystallisation frequency and crystallisation date and a computation frequency for the calculation and accrual of the performance fee (which must coincide with the calculation of the NAV).

Guideline 2 – Consistency between the performance fee model and the fund’s investment objectives, strategy and policy

The performance fee model should be consistent with the fund’s investment policy and strategy, as well as its risk reward profile. For example a HWM and hurdle would be more appropriate for absolute return funds as opposed to reference to an index. As a general principle, if a fund is managed to a benchmark index and it employs a performance model based on a benchmark index, the two indices should be the same.

ESMA now gives a non-exhaustive list of ‘consistency indicators’ which must be considered by investment managers. ‘Consistency indicators’ give clearer guidance of how to assess consistency between benchmarks by which performance fees are calculated and the fund itself. They are mandatory considerations for managers when using a certain performance fee and are conditions to assess whether certain benchmark indexes (such as LIBOR) are suitable for a manager to use when calculating its fees. These considerations are, for example, expected return, investment universe, underlying asset classes, duration and the liquidity measures of the fund.

Guideline 3 - Frequency of the crystallisation of the performance fee

As a general rule, the performance fee should “crystallise” no more than once a year and this date should be the same for all share classes in the fund. More frequent crystallisation can apply when the fund manager employs a HWM model where the performance reference period is equal to the whole life of the fund and cannot be reset (as you cannot accrue or pay more than once for the same level of performance over the whole life of the fund).

Guideline 4 – Negative performance (loss recovery)

A performance fee should only be payable in circumstances where under-performance has been recovered i.e. the HWM has been exceeded.

However, this only applies for the “performance reference period” of five years (the minimum period allowed, NCAs can set a longer period) – after which the HWM can be re-set.  In addition, a performance fee is also allowed to be payable in cases where the fund has out-performed the reference benchmark but had negative performance, as long as there is prominent risk warning (as set out below).

The performance fee should also be aligned with the investors’ recommended holding period.

Guideline 5 – Disclosure of performance fee models in fund documents

The existence of a performance fee should be clearly sign-posted to investors and the impact on their return made clear. The prospectus should include examples of how the performance fee will be calculated to provide investors with a better understanding of the methodology. If a fund allows for a performance fee to be paid in times of negative performance (e.g. by outperforming a reference benchmark, but still suffering negative performance), a warning to investors must be included in the KIID. In addition, if a different benchmark is used to that which is used in fund management, the choice of benchmark should be explained in the prospectus.

Next Steps

EU national competent authorities will apply the Guidelines by incorporating them into their national regulation. The Guidelines are currently being translated. They will apply two months from when they are formally published on the ESMA website. This publication date would be June 2020 at the earliest.  

What is the impact on UK managers?

As stated in our previous briefing on the Consultation, from a UK perspective, many of the requirements of the Guidelines will be familiar. There are already existing additional disclosure requirements for UK domiciled retail funds at COLL 4.2.5R around such performance fees, as well as guidance at COLL 6.7.6G and the IMA (now the IA) guidance (albeit now several years old). For example, the IMA guidance already discuss the principles of the performance fee calculation, the benchmark chosen, hurdle rates, crystallisation of the fee and high water marks. The FCA rules also require that where a performance fee is taken, examples of its operation in plain English and the maximum it can amount to are included in the prospectus. However, there may still be some differences between the new Guidelines and existing models particularly around use of high-water marks, how these are reset and how the reference period is defined as well as the period of crystallisation (which in the UK must be “reasonable”). In particular, with the more recent focus on benchmarks as a result of the Market Study and Benchmark Regulation, many managers now must disclose the use of benchmarks in the objectives and policies in the prospectus where they previously did not. This is one area where consistency between benchmarks used to manage the fund and those used in performance fees should be checked.

While therefore there is a significant degree of overlap between these requirements and the existing guidance set out by the IA and in COLL, we would recommend that fund managers promptly review all fund collateral, including the prospectus, KIID and any marketing material, to ensure compliance with the Guidelines. 

What is the impact of the end of the Brexit transitional period on 31 December 2020?

The UK government and the EU have now confirmed that there will be no extension of the Brexit transitional and implementation period (“TIP”) and so new EU law and regulation, including ESMA guidance, will no longer become part of UK law if they come into force on or after 31 December 2020.

Further, under the provisions of the EU (Withdrawal) Act 2018, existing ESMA guidance and other non-legislative material will not become part of UK law on 31 December 2020.  The EU laws that give the ESAs power to give guidance will be, however, ”onshored”, with those powers being transferred to HM Treasury, the FCA, the PRA and other appropriate bodies.  It will be open to those agencies to issue equivalent guidance to the ESMA guidance on performance fees, with or without modification, or to issue no guidance at all.

In practice it is likely that the FCA will continue to rely upon the ESMA guidance to the extent it considers it fit for purpose.  In the context of ESMA guidance on existing regulations, in Policy Statement PS19/5 the FCA said that, “we consider that the EU non-legislative material will remain relevant post-exit day to the FCA and market participants in their compliance with regulatory requirements, including provisions in our Handbook.” (Appendix 3, para 8)  While PS19/5 does not explicitly consider ESMA guidance which comes into force during or after the TIP, it is reasonable to expect the FCA to take a similar approach to such ESMA guidance as to ESMA guidance which predates the legal Brexit on 31 January 2020.

So the question will be whether the FCA accepts the ESMA approach to performance fees or thinks that there is a better approach for the UK market.  At the moment, it is not possible to predict what will happen.  On the one hand, the FCA will be busy with a wide range of other matters, and may consider this not a priority.  On the other hand the FCA has said that it wants to ensure the regulation of the UK financial services sector is fit for purpose, outcomes based and not unduly onerous and has said that it is prepared to deviate from EU rules in order to achieve this.  The matter will be one on which market participants may seek to lobby the FCA and if you would like help to do this, please contact one of the contacts below or your usual Eversheds Sutherland contact.

How Eversheds Sutherland can help

Eversheds Sutherland’s market-leading retail funds team has depth in expertise and unrivalled breadth in its experience. We are well placed to advise you the possible implications of the consultation paper and any gap analysis required against your existing performance fee models and the final Guidelines.