Memo #
31887

ESMA Consultation on UCITS Performance Fees - Member Call on 4 September 2019 at 3pm BST/10am ET
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[31887]

August 5, 2019 TO: ICI Global Regulated Funds Committee
International Compliance Advisory Committee
International Operations Advisory Committee RE: ESMA Consultation on UCITS Performance Fees - Member Call on 4 September 2019 at 3pm BST/10am ET

 

On 16 July 2019, the European Securities and Markets Authority (ESMA) published a consultation paper (CP)[1] on proposed guidelines for performance fees in UCITS. ESMA is inviting comments by 31 October 2019 via an online portal.[2] We will hold a member call to discuss the CP on Wednesday 4 September 2019 at 3pm BST/10am ET. Dial-in details for the member call are below:

UK: 0330 336 0036
US: +1 917 793 0005
PIN: 066875

Other telephone numbers: https://static.powwownow.co.uk/media/pdf/Powwownow-Dial-in-Numbers.pdf

Background

In its 2019 Supervisory Convergence Work Programme,[3] ESMA highlighted, as a key priority, the need for supervisory convergence regarding performance fee structures and the circumstances in which performance fees are paid. The UCITS framework contains high level requirements concerning performance fees, including general obligations on management companies,[4] disclosure requirements[5] and staff remuneration rules[6] (see annex for select provisions). Several Member States, including Ireland and Germany, have domestic requirements for performance fees which have been recently revised.[7] The International Organization of Securities Commissions (IOSCO) has also set out good practice for fees and expenses of collective investment schemes, including concerning performance fees.[8]

Consultation Paper

A survey conducted by ESMA of performance-based fee models and payments across the European Economic Area (EEA) identified the following commonly applied methodologies (see Annex IV, CP):

  • performance fees subject to a High-Water Mark (HWM), sometimes combined with a hurdle rate;
  • performance fee models based on the comparison between present and past performance (for example, performance fees can be charged if the NAV at the end of the period “t” is higher than the NAV at the end of the period “t-3");
  • remuneration of performance exceeding a certain threshold (for example: performance exceeding a benchmark or a fixed pre-determined amount; returns exceeding the central bank’s deposit rate or the rate of return of the benchmark; relative performance of the share class compared to the benchmark over the last three years).

Furthermore, the survey considered disclosure requirements applicable to performance fees and identified that these typically fall into following three categories:

  • information to be provided in the constitutional document / fund rules / instrument of incorporation (such as: computation methodology and payment of performance fees; disclosure that a performance fee may be charged and potential increases in fees subject to prior approval by unitholders; computation methodology, reference parameters and due date);
  • information to be provided in the annual report (such as: disclosure of the index used for a performance fee computation; disclosure of all the fees which can be charged, including performance fees; reference period used for calculations, the base for calculation and the impact that a performance fee model may entail);
  • information to be provided in the prospectus (such as: the impact of the fees on the fund’s return over a certain period, or the actual fees charged).

From the survey, ESMA identified differences in approach to a fund’s selection of a benchmark or index used in the performance fee computation – ESMA noted that in several Member States there are not specific conditions or limitations on the benchmark or index that can be used by a fund.

ESMA is seeking feedback on the merits of greater standardisation concerning performance fee calculation (Q1) and whether there are obstacles to standardisation that can be removed by regulatory action (Q2).

Proposed Guidelines

As outlined in greater detail in the sub-sections below, ESMA has proposed guidelines aimed at converging the principles for UCITS performance fees in the following five areas:

  • general principles on performance fee calculation methods (Guideline 1);
  • consistency between the performance fee model and the fund’s investment objectives, strategy and policy (Guideline 2);
  • frequency for the performance fee crystallisation and payment (Guideline 3);
  • the circumstances where a performance fee should be payable (Guideline 4); and
  • disclosure of performance fee model (Guideline 5).

Guideline 1 – General principles on performance fee calculation methods

ESMA is proposing 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 (e.g. Eonia, Eurostoxx 50, etc.), a HWM or a hurdle rate;
  • a crystallisation period[9] within which the performance fee, if any, is accrued and a crystallisation date, coinciding with the end of the crystallisation period, at which the performance fee is crystallised and credited to the management company;
  • a performance reference period[10] at the end of which the mechanism for compensating for past underperformance or negative performance can be reset;
  • a performance fee rate which may also be referred to as the “flat rate” i.e. 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 abovementioned inputs and any other relevant inputs; and
  • a computation frequency which should coincide with the calculation frequency of the NAV (e.g. if the fund calculates its NAV daily, the performance fee should be calculated and accrued in the NAV on a daily basis).

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

ESMA is proposing that the UCITS management company should ensure that the performance fee model is consistent with the UCITS’ investment objectives, strategy and policy including checking the following:

  • whether the chosen performance fee model is suitable for the fund given its investment policy and strategy. For instance, for funds that pursue an absolute return objective, a HWM model or a hurdle is more appropriate than a performance fee calculated with reference to an index because the fund is not managed with a reference to a benchmark; in addition, a HWM model for an absolute return objective, might need to include a hurdle to align the model to the fund’s risk-reward profile; and
  • whether, for funds that calculate the performance fee with reference to a benchmark,[11] the benchmark is appropriate in the context of the fund’s investment policy and strategy and adequately represents the fund’s risk-reward profile. This assessment should also take into account any material difference of risk (e.g. volatility) between the fund’s aims and the chosen benchmark. For example, it should not be deemed appropriate for a fund with a predominantly long equity focused strategy to calculate the performance fee with reference to a money market index.

Furthermore, ESMA proposes that the management company should ensure that:

  • where performance fees are payable on the basis of out-performance of a benchmark that the benchmark is consistent with the investment policy and strategy of the fund; or
  • where the performance fee is based on a fulcrum fee model, the performance fee is based on the same benchmark used to determine excess performance.

In all cases ESMA proposes that excess performance should be calculated net of costs.

ESMA is seeking feedback on the considerations that should be taken into account when assessing consistency between the index used to calculate the performance fees and the investment objectives, strategy and policy of the fund (Q3).

Guideline 3 – Frequency for the crystallisation of the performance fee

ESMA is proposing that 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. Specifically, ESMA proposes the following three aspects:

  • The frequency for the crystallisation and the subsequent payment of the performance fee to the management company should be defined in such a way 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 not be shorter than one year. Generally, it should end either on 31 December or at the end of the financial year of the fund.
  • The minimum crystallisation period should not apply to the fulcrum fee model, as the characteristics of this model are not compatible with a minimum crystallisation period.

ESMA is seeking feedback on its proposed guidelines on the crystallisation of performance fees (Q4), on whether there are models or methodologies other than fulcrum fees that should be exempted from the requirement of a minimum crystallisation period, or whether high water mark models should be subject to a such a minimum period (Q5).

Guideline 4 – Circumstances where a performance fee should be payable

ESMA is proposing that a performance fee should only be payable in circumstances where positive performance has been accrued during the performance reference period. ESMA justifies this on the basis that any underperformance or loss previously incurred during the performance reference period should be recovered before a performance fee becomes payable. Specifically, ESMA also proposes the following three elements:

  • The performance fee model should be designed to ensure that the fund manager is not incentivised to take excessive risks and that cumulative gains are duly offset by cumulative losses.
  • Where a fund utilises a HWM, it should only be reset where during the performance reference period (i) the new HWM exceeds the last HWM or (ii) the fund has undergone significant structural changes. For the purpose of resetting the HWM, a performance reference period should be defined.
  • The performance reference period should not apply to the fulcrum fee model, as in this model the level of the performance fee increases or decreases proportionately with the investment performance of the fund.

ESMA is seeking feedback various aspects of its proposed guidelines including:

  • whether performance fees should be charged only when a fund has achieved absolute positive performance and, furthermore, the financial impact for fund managers of such a requirement (Q6);
  • the extent to which performance fee models permit payment of performance fees in times of negative returns and the “warning” of such a payment to investor disclosures (Q7);
  • the performance reference period for resetting the HWM (Q8) and the merits of setting pre-defined periods (Q9);
  • the length of the performance reference period for performance fee models based on a benchmark index (Q10);
  • whether the performance reference period should coincide with the minimum crystallisation period of be longer or shorter (Q11).

Guideline 5 – Disclosure of the performance fee model

ESMA believes that investors should be adequately informed about the existence of performance fees and about their potential impact on the investment return. ESMA proposes ex ante and ex post disclosure requirements. ESMA proposes that ex ante disclosure should:

  • clearly set out all information necessary to enable investors to understand properly the performance fee model and the computation methodology; and
  • include a description of the performance fee calculation method, with specific reference to parameters and the date when the performance fee is paid, without prejudice to other more specific requirements set out in specific legislation or regulation.

Specifically, ESMA proposes that the prospectus should include concrete examples of how the performance fee will be calculated and the Key Investor Information Document (KIID) should clearly set out all information necessary to explain the existence of the performance fee, the basis on which the fee is charged and when the fee applies. Furthermore, where performance fees are calculated based on performance against a reference benchmark index, ESMA proposes that the prospectus and the KIID should display the name of the benchmark and show past performance against it.

ESMA proposes that ex-post disclosures, including the annual and half-yearly reports and any other ex-post information should indicate, for each relevant share class, the impact of the fees over the crystallisation period, by clearly displaying: (i) the actual amount of performance fees charged and (ii) the percentage of the fees based on the share class NAV.

Implementation

ESMA proposes that UCITS using performance fees for the first time would apply the guidelines immediately after application and UCITS that are already using performance fees would have a transition period of 12 months. ESMA is seeking feedback on this approach to implementation (Q12).

Cost Benefit Analysis

ESMA has analysed the costs and benefits of its guidelines (Section IV, CP) and is seeing feedback in various elements (Q13-19).

Next Steps

ESMA is inviting comments to the CP by 31 October 2019 via an online portal. It will consider the feedback it receives in the last quarter of this year with a view to finalising its guidelines for publication afterwards.

 

Giles Swan
Director of Global Funds Policy, ICI Global

 

Attachment

endnotes

[1] Consultation Paper: Guidelines on performance fees in UCITS, ESMA, 16 July 2019, available from https://www.esma.europa.eu/sites/default/files/library/esma34-39-881_cp_on_performance_fees_guidelines_in_ucits.pdf

[2] https://www.esma.europa.eu/press-news/consultations/consultation-performance-fees-guidelines-in-ucits#registration-form_consultation

[3] Supervisory Convergence Work Programme 2019, ESMA, 6 February 2019, available from https://www.esma.europa.eu/sites/default/files/library/esma42-114-647_2019_supervisory_convergence_work_programme.pdf

[4] Article 14(1), UCITS Directive (2009/65/EU); and Article 22(3) and Article 22(4), UCITS Level 2 Directive (2010/43/EU)

[5] Article 78(3)(d), UCITS Directive; Article 12(3) and Article 14, UCITS Level 2 Regulation; and Article 69(1), UCITS Directive.

[6] Article 14b(3) and Article 69(1) UCITS Directive

[7] For instance, the Central Bank of Ireland revised its guidance following a thematic review in 2018 and BaFin in Germany has changed aspects of its proposed clauses and administrative code concerning performance fees.

[8] Good Practice for Fees and Expenses of Collective Investment Schemes, Final Report, August 2016, available from https://www.iosco.org/library/pubdocs/pdf/IOSCOPD543.pdf

[9] Defined as “the period during which the performance fee, if any, is accrued and at the end of which it becomes payable to the management company.”

[10] Defined as “the time horizon over which the performance is measured and compared with that of the reference indicator.”

[11] Defined as “the market index against which to assess the performance of an investment fund.”