Article 13 of the forthcoming Alternative Investment Fund Managers Directive (AIFM) imposes restrictions on the amount and form of remuneration that fund managers can pay those categories of staff whose professional activities have a material impact on the risk profiles of the fund managers or of the funds they manage.
These categories include senior management, risk-takers, those in control functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk-takers.
The directive does not define which staff would be classified as risk-takers or in a control function. However, it is generally assumed that risk-takers may include staff that sit on investment committees and/or make investment decisions on behalf of the funds that they manage. Similarly, control functions may include legal, compliance, human resources and risk management staff.
The basic principles
The overriding requirement of the directive is for fund managers to have policies and practices designed to promote sound and effective risk management – and not to encourage risk-taking that is inconsistent with the risk profiles, rules or instruments of incorporation of the funds they manage.
The principles set out in Appendix II of the directive include:
• the remuneration policy must be in line with the business strategy, objectives, values and interests of the fund manager and the funds they manage;
• staff engaged in control functions must be compensated in accordance with the achievement of the objectives linked to their functions, independent of the performance of the business areas they control;
• where remuneration is based on performance, the total amount of remuneration must be based on a combination of the assessment of the performance of the relevant individual (both financial as well as non-financial criteria) and of the business unit or fund concerned and of the overall results of the fund manager;
• performance assessments must be based on longer-term performance in a multi-year framework appropriate to the lifecycle of the funds managed by the fund manager – while payment by a fund manager of any performance-based component must be spread over a period, taking into account redemption policies of the funds it manages and their investment risks; and
• payments related to the early termination of a contract must reflect performance achieved over time and should not be designed in a way that rewards failure
Various principles also specifically consider the variable component of remuneration, including:
• limitations on guaranteed variable remuneration – to be limited to exceptional circumstances in the context of hiring new staff and limited to the first year;
• appropriate balance between the fixed and variable components of total remunerationwith the fixed component being high enough to allow a fully flexible variable policy (flexible enough to permit no variable payment);
• the measure of performance for variable compensation must include a comprehensive adjustment mechanism to integrate all relevant types of current and future risks;
• subject to the structure and rules of the fund, at least 50 percent of any variable remuneration must consist of interests in the fund or equivalent non-cash instruments (unless the management of funds accounts for less than 50 percent of the manager’s total portfolio);
• deferring a substantial portion (at least 40 percent and may go up to 60 percent) of the variable remuneration component over a period of at least five years, unless the lifecycle of the fund concerned is shorter and such deferred remuneration component should be paid out on prorated basis; and
• the variable remuneration component must only be paid/ vest if it is sustainable for the fund manager’s financial situation or justified by the performance of the business unit, the fund and the individual concerned.
The principles also restrict relevant staff from using personal hedging strategies or remuneration- and liability-related insurance products to undermine the riskalignment effects in their remuneration arrangements. Similarly, payments through vehicles or methods that facilitate the avoidance of the requirements of the directive are prohibited.
How it will work in practice
Alternative investment fund managers are required to comply with these principles to an extent that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities.
The European Securities and Markets Authority (ESMA) is required to provide guidelines on best practices for remuneration policies. These guidelines will not be binding, but authorities will have to state whether they intend to comply with the guidelines and, if not, to state their reasons (the ‘comply or explain’ principle).
If the size, internal organisation and the nature, scope or complexity of the fund manager’s activities or the fund’s is significant, then the fund manager is required to establish an independent remuneration committee. This must be constituted in a way that enables it to exercise competent and independent judgement on remuneration policies and practices and the incentives created for managing risks.
A fund manager will also be required (for each EU fund it manages and for each fund it markets to EU investors) to make available to the fund’s investors, and to the competent authority of its home member state, an annual report disclosing (among other things) its remuneration policies and practices. The report must, at least, contain the total amount of remuneration paid by the fund manager to its staff for the financial year (split into fixed and variable remuneration), the number of beneficiaries and, where relevant, the carried interest paid by the fund.
The report should also contain the aggregate amount of remuneration broken down by senior management and members of staff of the fund manager whose actions have a material impact on the risk profile of the fund.
As AIFM works through the various implementation stages, the full impact of the directive on remuneration in the private equity industry remains to be seen. However, it is now clear that the remuneration of most senior private equity professionals who are involved in the investment decisions of the funds they manage will now be subject to a very detailed and a somewhat complex set of rules and regulations. Previously, remuneration had been determined largely by a combination of market forces and detailed negotiations between a fund manager and its investors.
The main question most fund managers will need to address is whether their existing compensation arrangements comply with the detailed and prescriptive remuneration rules of the directive. But given the well-established use of carried interest and co-investment as a tool to align the interests of investors and fund managers, in general the private equity industry is well placed to meet the central objectives of the AIFM – that is, to promote sound and effective risk management.
Solomon Wifa is managing partner of O’Melveny & Myers’ London office and a member of the firm’s Investment Funds & Securitisation Group.
NB. This is an abridged extract from ‘Private Equity Compensation and Incentives’, which was published by PEI Media in April 2012. Order it online HERE