ESMA’s final guidelines on performance fees for UCITS and retail AIFs

The Guidelines – what are they, who do they apply to and when do they come into force?

ESMA has now published its Final Report “Guidelines on performance fees in UCITS and certain types of AIF”.

The Guidelines are intended to harmonise how and when fund managers charge performance fees to retail investors and apply to managers of UCITS and of AIFs marketed to retail investors (with some exceptions such as closed-ended AIFs and open-ended AIFs that are EuVECAs or EuSEFs).

The Final Report takes into account feedback received to ESMA’s consultation paper (CP) of July 2019, our summary of which can be found here. ESMA has taken into account a number of suggestions from respondents and made limited changes to its original proposals – the key changes are summarised below.

The Guidelines will now be translated and will apply two months after they are formally published on the ESMA website. In that two month period, NCAs must notify ESMA whether they comply or intend to comply with the guidelines.

When do the Guidelines start to apply to me?

As under ESMA’s original proposal

• if the fund is created after the date of application of the Guidelines and uses a performance fee, the Guidelines will apply immediately
• if the fund was in existence at the date of application of the Guidelines and subsequently introduces a performance fee, the Guidelines will apply immediately.

However, there is a change in respect of a fund which is already in existence at the date of application of the Guidelines and uses a performance fee.

Under ESMA’s original proposals, such a fund would have to comply “within 12 months of the application date”. In the Final Report, this deadline has been changed to “the beginning of the financial year following 6 months from the application date of the Guidelines”.

Because there is a two month gap between the Guidelines being formally published and them taking effect, they cannot now apply until June 2020 at the earliest and “6 months from the application date of the Guidelines”, then, takes us into January 2021 (again, at the earliest).

This means that a fund meeting the two conditions above which has a FYE of 31 December would need to comply from 1 January 2022 (being the beginning of the first financial year following six months from the application date.)

The Guidelines

These are arranged under the following five headings:

1. Performance fee calculation method;

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

3. Frequency for the crystallisation of the performance fee;

4. Negative performance (loss) recovery;

5. Disclosure of the performance fee model.

However, there is no longer a separate section on transitional provisions. These have now been folded into the introductory wording on Scope.

Looking at each in turn:

Guideline 1 - Performance fee calculation method

The performance fee calculation method should include, at least, the following elements:

• a reference indicator to measure the relative performance of the fund - this can be an index, a high water mark (HWM), a hurdle rate or a combination of these last two;
• the crystallisation frequency at which the performance fee accrues and becomes payable to the manager and a crystallisation date at which it is credited to the manager;
• the performance reference period;
• the performance fee rate (or flat rate), ie the rate of performance fee which may be applied in all models;
• a performance fee methodology defining the method for the calculation of the performance fees; and
• the computation frequency – this should coincide with the calculation frequency of the NAV, so, where NAV is calculated daily, the performance fee should be calculated and accrued in the NAV on a daily basis.

ESMA has taken note of the feedback regarding how the guidelines will standardise current practices applied across EU jurisdictions in the field of performance fees and, to avoid jeopardising the split of competences between the home and host NCAs, the Guidelines now refer to crystallisation “frequency” rather than crystallisation “period”.

ESMA has also included a provision specifying that calculation of a performance fee must be “verifiable and not open to the possibility of manipulation”.

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

A manager must ensure that the performance fee model is consistent with the fund’s investment objectives, policy and strategy (so, for an absolute return fund, an HWM or hurdle model would be more appropriate than a performance fee calculated with reference to an index).

If the fund calculates the performance fee with reference to a benchmark, the benchmark must be appropriate in the context of the fund’s investment policy and must adequately represent the fund’s risk-reward profile. Furthermore, where a fund is managed in reference to a benchmark index and its performance fee model is based on a benchmark index, the two indices should be the same.

ESMA has included in the final Guidelines a “non-exhaustive cumulative list” of indicators, which should be used when assessing the consistency between the index used to calculate a performance fee and the one to which the fund is referenced.

The consistency indicators include:

• expected return;
• geographical and sector exposure;
• income distribution of the fund;
• liquidity measures;
• duration;
• credit rating category; and
• volatility.

Excess performance should always be calculated net of all costs (such as management fees or administrative fees) but can be calculated without deducting the performance fee itself provided this would result in the investor paying less in the way of fees.

Guideline 3 - Frequency for the crystallisation of the performance fee

The final Guidelines confirm that:

• the minimum crystallisation frequency and subsequent payment to the manager should be defined to ensure that the interests of the portfolio manager and shareholders are aligned;
• the crystallisation frequency should not be more than once a year;
• this could not be applied where the fund employs a HWM or high-on-high model, where the performance reference period is equal to the whole life of the fund and cannot be reset;
• the one year crystallisation frequency should not apply to fulcrum fee models as the characteristics of this model are not compatible with the general recommendation; and
• generally, the crystallisation date should coincide with 31 December or with the end of the financial year of the fund.

More specific guidance has been included in the final Guidelines in respect of the creation of a new share class and investor redemptions – here, to avoid operational risks, the payment of a performance fee should be aligned among different share classes and crystallised on investors’ redemptions, in line with the principle of equal treatment of investors

Guideline 4 - Negative performance (loss) recovery

To safeguard investors’ best interests, a performance fee should only be payable where positive performance has been accrued during the relevant reference period. However, in response to feedback to the CP, ESMA has accepted that a performance fee could also be payable where the fund has overperformed the reference benchmark but had a negative performance, as long as a prominent warning to the investor is provided in the KIID. To keep the KIID concise, ESMA recommends that a warning, in the form of a brief sentence, could be included that performance fees may be charged even where the investment has suffered losses.

The performance fee model should ensure that the manager is not incentivised to take excessive risks - cumulative gains should be offset by cumulative losses, with the manager’s performance being on a time horizon that is, as far as possible, consistent with the recommended investors’ holding period.

• Where a fund uses a performance fee model based on a benchmark index, any underperformance of the fund against the benchmark must be clawed back before any performance fee becomes payable. To this end, the length of the performance reference period, if shorter than the whole life of the fund, should be at least 5 years.
• Where a fund uses an HWM model, a performance fee should be payable only where, during the performance reference period, the new HWM exceeds the last HWM. The starting point for the calculations should be the initial offering price per share. Again, where the performance reference period is shorter than the whole life of the fund, it should be at least five years on a rolling basis, with a performance fee only being claimed where the outperformance exceeds any underperformances during the previous five years. Performance fees should not crystallise more than once a year.
• 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.

Guideline 5 - Disclosure of the performance fee model

Information on performance fees 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, with investors being "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.

The prospectus should include concrete examples of how the performance fee will be calculated especially where the performance fee model allows performance fees to be charged even when there has been negative performance.

A KIID should clearly 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 final Guidelines recommend that, in the case of a fund managed in reference to a benchmark but which calculates performance fees based on a different but consistent benchmark, its prospectus should include an explanation of why the same index is not used.

The annual and half yearly reports, and any other ex post information, should include at least the actual total amount of performances fees charged and the percentage of fees based on the share class NAV.