In Perfect Harmony? ESMA Seeks Convergence on Performance Fees

Background

On 16 July 2019, ESMA published a consultation paper which proposed common criteria to be provided for in the Guidelines on matters such as:

• performance fee calculation methods;
• consistency of the performance fee model and the investment objectives, strategy and policy of the UCITS;
• frequency for the crystallisation of the performance fee;
• circumstances where a performance fee should be payable; and
• disclosure of the performance fee model.

ESMA views performance fees as a crucial feature of UCITS given their effect on the range of choices afforded to investors and the income available to management companies.

In 2018, ESMA conducted a mapping exercise to analyse current practices. Although some common elements among Member States were identified, they found a lack of harmonisation at EU level on performance-based fee models and computation mechanisms.

Due to the importance of funds’ cross-border distribution, supervisory convergence in this area became a key priority of the 2019 ESMA Supervisory Work Programme. The focus of the regulatory approach in developing the final Guidelines is to promote competitive and informed markets to help investors understand fees and expenses and make informed investment decisions, especially for those funds applying performance fees.

The Guidelines

The Guidelines are to apply to UCITS management companies as defined under Article 2(1)(b) of the UCITS Directive and competent authorities. They also apply to investment companies that have not designated a management company authorised pursuant to the UCITS Directive.

The Guidelines propose the following principles:

The performance fee calculation method should be designed to ensure that fees are proportionate to the actual investment performance of the fund

The management company must demonstrate that the performance fee model constitutes a reasonable incentive and is aligned with investors’ interests. The performance fee calculation method should include:

1. the reference indicator;
2. the crystallisation period;
3. the performance reference period;
4. the performance fee rate;
5. the performance fee methodology; and
6. the computation frequency.

The management company must ensure that the performance fee model is consistent with the fund’s investment objectives, strategy and policy

Managers must not be “incentivised to take excessive risks” and must ensure that “cumulative gains are duly offset by cumulative losses”.

The frequency for the crystallisation and the subsequent payment of the performance fee must be assessed and remunerated on a time horizon that is consistent with the investors’ interests

The crystallisation period should not be shorter than one year.

A performance fee is not payable to the management company in the case of negative performance

Any loss must be recovered before a performance fee becomes payable.

The management company must issue documents adequately informing investors about the potential impact of the performance fee on the investment return

It must also detail a description of the performance fee calculation method “with specific reference to parameters and the date when the performance fee is paid”.

What Next?

The deadline for receipt of responses to the consultation is 31 October 2019. ESMA will consider the feedback it receives in Q4 2019 and intends finalising the Guidelines for publication afterwards.

This initiative demonstrates the regulatory focus on transparency and appropriateness of any and all fees charged within EU based funds (and retail funds in particular). It follows a Central Bank of Ireland thematic review (the “Review”) of the application of performance fees in Irish UCITS in 2018 and subsequent guidance. The principles set out in ESMA’s Guidelines closely follow similar principles to those set out in the Review thereby ensuring some level of consistency for managers with UCITS in multiple jurisdictions. The commitment by ESMA to ensuring universal and consistent application of common regulatory principles on a topic with such potential investor sensitivity across all Member States will be helpful to those managers of Irish UCITS funds who were already in the process of ensuring compliance with the Central Bank guidance on this topic.