ESMA consults on performance fees for UCITS

What has ESMA published?

On 16 July 2019, the European Securities and Markets Authority (ESMA) published a consultation paper, “Guidelines on performance fees in UCITS” (the CP).

The CP sets out a set of proposed guidelines (for fuller detail, see the section What does the CP contain? below) which contain common criteria intended to both align the interests of the fund manager and the fund investors and promote supervisory convergence.

What happens next?

ESMA invites feedback on its proposals from industry and other stakeholders by 31 October 2019.

During Q4 2019, ESMA will consider the responses received and intends to publish final guidelines thereafter.

The Simmons view

Although it is arguable whether further regulation is needed in this area, ESMA has determined that a lack of convergence around the NCAs’ policies on performance fees indicates a need for guidance.

UCITS do not, of course, typically utilise performance fees and so the ESMA Guidelines are likely to have limited impact on the industry in a broad sense. For those managers who operate on a performance fee model, however - such as those implementing many hedge fund and absolute return strategies in a UCITS format - the draft Guidelines enshrine the IOSCO Good Practice principles which, to large extent, codify best practice in the industry.

There will be some concern around the suggestion for a requirement that “absolute positive performance” be achieved before a fee can be paid which in a benchmark/ relative performance fee model is a higher hurdle than is often currently applied. Investing is, after all, not a risk-free activity and it might be argued that there is a place for rewarding positive performance relative to a benchmark even if actual performance is negative where that is properly disclosed.

Proper disclosure is, in itself, also an area that will require some attention as the draft Guidelines re-state (not unreasonably) that “all features necessary to get a proper understanding of the computation methodology should be described…” Disclosure should certainly be understandable to retail investors and this can present challenges with some of the more complex fee methodologies, particularly in the context of the KIID.

What led to the publication of the CP?

One of the key objectives flagged in ESMA’s Supervisory Convergence Work Programme for 2019 was to increase supervisory convergence across the EU in the area of performance fees (both how these are structured and the circumstances in which they can be paid).

A mapping exercise among the EU’s National Competent Authorities (NCAs), which ESMA carried out in 2018, showed that there was a lack of convergence as to how different Member States deal with performance-based fee models and computation mechanisms. So, while, for example, most NCAs require daily calculation and annual charging of performance fees, some allow monthly calculation and quarterly payments.

Such lack of consistency creates the risk of regulatory arbitrage and can lead to variations in the level of investor protection between Member States.

Further convergence work which ESMA has undertaken in light of these results, along with consideration of IOSCO’s Good Practice for Fees and Expenses of Collective Investment Schemes, has led to the publication of the CP.

What does the CP contain?

The CP sets out ESMA’s proposed guidelines on performance fees for UCITS in the following areas:

• general principles on calculating the performance fee

• consistency between the performance fee model and the fund’s investment objectives, strategy and policy

• frequency for when the performance fee should crystallise

• the circumstances in which a performance fee should be payable, and

• disclosure of the performance fee model.

The common principles set out in the Guidelines are intended to apply to UCITS since, in ESMA’s view “the existence of the EU retail passport and the importance of actual cross border marketing of UCITS make supervisory convergence a key issue to achieve the objectives of the EU legislation”.

The Guidelines would be without prejudice to ESMA’s Guidelines on sound remuneration policies under the UCITS Directive.

Taking each proposed Guideline in turn:

Proposed Guideline 1 - Performance fee calculation method

ESMA proposes that the performance fee calculation method should include, at least, the following elements:

• a reference indicator to measure the relative performance of the fund such as an index, a high water mark (HWM) or a hurdle rate
• a crystallisation period within which any performance fee is accrued
• a crystallisation date (which coincides with the end of the crystallisation period) at which the performance fee crystallises and is credited to the UCITS ManCo
• a performance reference period at the end of which the mechanism for compensating for past underperformance or negative performance can be reset
• a performance fee rate (or flat rate) ie the rate of performance fee which may be applied in all models
• a performance fee methodology enabling the calculation of the performance fees based on the above and other relevant inputs, and
• a computation frequency - this should coincide with the calculation frequency of the NAV so, if the fund calculates its NAV daily, the performance fee should be calculated and accrued in the NAV on a daily basis.

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

The proposed Guideline would require the ManCo to ensure that the performance fee model is consistent with the fund’s investment objectives, policy and strategy.

The assessment of consistency would involve the ManCo checking the suitability of the performance fee given the fund’s investment policy (for example, for an absolute return fund, an HWM or hurdle model would be more appropriate than a performance fee calculated with reference to an index). The ManCo should also check whether the performance fee is appropriate and adequately reflects the fund’s risk-reward profile.

Where the performance fee is based on out-performing a benchmark, this benchmark should be consistent with the fund’s investment policy and strategy.

Proposed Guideline 3 - Frequency for the crystallisation of the performance fee

ESMA is of the view that:

• in principle, the minimum crystallisation period should be linked to the recommended holding period of the fund and the performance fee should ideally be charged to each investor when exiting the fund
• the minimum crystallisation period for performance fees should, as a result, be defined so as to ensure alignment of interests between the portfolio manager and the shareholders and fair treatment among investors
• the manager’s performance should be assessed and remunerated on a time horizon that is, as far as possible, consistent with the investors’ holding period
• the crystallisation period should be long enough to ensure that any over-performance by the fund does not reflect short-term gains due to random market factors
• the crystallisation period should not be shorter than one year and, generally, should end either on 31 December or at the fund’s FYE, and
• in line with the IOSCO Good Practice, the one year minimum crystallisation period should not apply to fulcrum fee models as the characteristics of this model are not compatible with a minimum crystallisation period.

Proposed Guideline 4 - Negative performance (loss) recovery

To safeguard investors’ best interests, ESMA is proposing that a performance fee should only be payable where positive performance has been accrued during the relevant reference period.

Any underperformance or previous loss during the performance reference period should be recovered before a performance fee becomes payable. The ManCo should not be incentivised to take excessive risks - cumulative gains should be duly offset by cumulative losses.

In the case of an HWM model, ESMA proposes that this should only be reset where, during the performance reference period

• the new HWM exceeds the last HWM, or
• the fund has undergone significant structural changes.

For the purpose of resetting the HWM, a performance reference period should be defined.

A performance reference period should not apply to the fulcrum fee model as, in such a model, the level of the performance fees increases or decreases proportionately with the fund’s investment performance.

Proposed Guideline 5 - Disclosure of the performance fee model

ESMA’s Guideline 5 outlines the content of the information on performance fees which must be disclosed:

• ex ante in the KIID and prospectus, and
• ex post, in the annual report.

A performance fee should be disclosed in such a way that retail investors will understand.

Investors should be "adequately informed" about the existence of performance fees and about their potential impact on the investment return. To achieve this, there should be a description of all features necessary to get a proper understanding of the computation methodology. ESMA suggests that tables might help give investors a better understanding, while the prospectus could include examples of performance fees computation.

A KIID should set out all information necessary to explain the existence of the performance fee, the basis on which it is charged and when it applies. Where performance fees are calculated based on performance against a reference benchmark index, the KIID and the prospectus should display the name of the benchmark and show past performance against it.

The ex post information should include at least the actual total amount of performances fees collected per share class.

Transitional provisions

A new UCITS created after the date on which the Guidelines become applicable which includes a performance fee must comply with the Guidelines immediately.

An existing UCITS which introduces a performance fee for the first time after the date on which the Guidelines become applicable must comply with the Guidelines immediately.

An existing UCITS that operated a performance fee before the date on which the Guidelines become applicable will be given 12 months from that date in which to align its procedures with the Guidelines.