AIFMD lays down principles for firms to ensure that their remuneration policies and practices “are consistent with and promote sound and effective risk management and do not encourage risk-taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs they manage.”
The remuneration provisions fall into three categories:
- Governance - who gets involved in the decision-making;
- Risk alignment - the design and structure of remuneration; and
- Transparency - disclosure of the amounts paid and the processes involved.
In addition to an authorised AIFM being subject to the remuneration rules, the rules also require an authorised AIFM to (i) ensure that a delegate is subject to regulatory remuneration requirements that are equally as effective as those under AIFMD; or (ii) put in place contractual arrangements with a delegate to ensure that there is no circumvention of AIFMD remuneration rules.
Where are the rules?
AIFMD contains an annex setting out the detailed principles to be adhered to when establishing and applying remuneration policies for staff whose professional activities have a material impact on the risk profiles of the AIFM and/or the AIF they manage. Click here for a link to the remuneration rules set out in Annex II of AIFMD. In addition to the rules set out in Annex II of AIFMD, the Level 2 Regulations contain remuneration provisions including relating to conflicts of interest and the disclosure of remuneration.
ESMA has issued guidelines (the “Guidelines”) on remuneration policies and practices to assist in the implementation of AIFMD. Click here for a link to the Guidelines (and here for ESMA’s Guidelines on remuneration policies under the UCITS Directive which also include a change to paragraph 33 of the AIFMD Guidelines on the last page). The Guidelines do not have direct effect in EU Member States. However, Member States were required to implement AIFMD in accordance with the final Guidelines, and so firms should also refer to the relevant Member State’s own rules/ guidance on AIFMD remuneration. In Luxembourg, the Guidelines have been directly transposed.
Not all the remuneration rules apply in the same way to all firms: They should apply “in a way and to the extent that is appropriate to [the AIFM’s] size, internal organisation and the nature, scope and complexity of its activities”.
On the basis of this principle (called ‘proportionality’), the FCA generally does not require UK regulated AIFMs with assets under management of less than £1bn (or less than £5bn for AIFMs managing unleveraged AIFs with no redemption rights exercisable for 5 years following the initial investment in each AIF) to follow the rules on:
- payment in AIF units, shares or other instruments and retention;
- deferral; and
- performance adjustment,
which are discussed below (the “Payout Process Rules”).
In Luxembourg, based on the law of AIFM, a similar derogation exists for Luxembourg regulated AIFMs with assets under management of less than €100,000,000 (or less than €500,000,000 for AIFMs managing unleveraged AIFs with no redemption rights exercisable for 5 years following the initial investment in each AIF).
AIFMs are required to have remuneration policies which:
- are consistent with and promote sound and effective risk management
- do not encourage risk-taking inconsistent with the risk profile of the fund
- are in line with the business strategy, objectives, values and interests of the AIFM, the AIFs it manages and their investors, and
- include measures to avoid conflicts of interest.
The policy and its implementation should be maintained and reviewed periodically.
Firms which are ‘significant’ in terms of size, internal organisation etc. are also required to have a suitably independent remuneration committee which is responsible for the policy and key decisions made under it.
Linkage to performance
Pay that is linked to performance should be:
- based on business unit or AIF performance and the overall results of the AIFM;
- based on individual performance, taking account of financial and non-financial criteria;
- based on longer term performance, tested over a period appropriate to the life-cycle of the AIFs; and
- paid out over a period which takes account of the redemption policy of the AIFs the AIFM manages and their investment risks.
Performance assessment in respect of such pay should be set in a multi-year framework appropriate to the life-cycle of the AIFs managed by the AIFM.
The balance of fixed and variable pay should be appropriate and the proportion of fixed pay should be high enough to allow complete flexibility on variable pay (including flexibility to pay no variable pay, where appropriate).
Variable pay and bonus pools should be risk-adjusted for current and future risks.
At least 40% of variable pay must be deferred for at least 3-5 years, unless the life cycle of the AIF is shorter. This is increased to (at least) 60% for staff receiving variable pay of a particularly high amount (and may include lower amounts, depending on the circumstances).
The actual period for deferral must be appropriate in view of the life cycle and redemption policy of the AIF and its risks.
This deferral requirement is usually met through some combination of:
- delayed payment of cash bonuses;
- long-term incentive arrangements; and
- bonus deferral.
Note that this requirement does not apply to all staff (see ‘Which Staff?’ below).
Payment in AIF units, shares etc and retention
At least 50% of variable pay should be paid in units or shares of the relevant AIF or equivalent ownership interests or share-linked instruments or equivalent non-cash instruments (unless the AIF accounts for less than 50% of the total portfolio). But this is subject to the structure of the AIFM, the AIF etc. On this basis the FCA gives firms some flexibility not to follow this rule where it would be impracticable to do so considering the objectives of the remuneration rules, e.g. where:
- the AIF is closed-ended;
- the AIF cannot practicably be offered to staff (e.g. for legal reasons or because of large minimum investments);
- participation by staff could result in adverse tax consequences for any third-party investors in the AIF.
Where this is the case, firms often pay the relevant proportion of variable pay in the form of share incentives (or phantom arrangements) relating to the AIFM or its parent, or interests linked to the performance of AIFs or other portfolios managed by the AIFM or its affiliates, but there is no requirement to do that under the UK FCA guidance where the legal structure or instrument of the AIF makes the rule’s application impracticable considering the objectives of the AIFMD remuneration rules. In Luxembourg, the CSSF applies the ESMA Guidelines without applying the same flexibility as the FCA on this point.
Firms should be prepared to demonstrate that any instruments used to deliver pay align the risks taken by staff with those of the relevant AIFs, the investors in such AIFs and the AIFM itself, and do not represent a conflict of interest.
Where variable pay has to be paid in instruments or shares etc, they must be retained for a period aligned to the long-term interests of the AIFM and the AIFs it manages and their investors. Based on market practice, a retention period of 6 months is normally sufficient in both the UK and in Luxembourg, provided that other risk management techniques within the firm are operating to secure sound and effective risk management.
Note that this requirement does not apply to all staff (see ‘Which Staff?’ below).
An AIFM must not award, pay or provide guaranteed variable remuneration unless it;
- is exceptional;
- occurs only in the context of hiring new staff; and
- is limited to the first year of service.
This rule covers retention awards, buy-out awards, golden handshakes etc.
Payments to staff leaving the AIFM must reflect performance achieved over time and must not reward failure.
Variable pay, including any amounts deferred, should be paid out or vest only if:
- sustainable according to the financial situation of the AIFM as a whole and
- justified according to the performance of the AIF, the business unit and the individual concerned.
Malus or clawback arrangements should be used to reduce variable pay where the financial performance of the AIFM or of the AIF is subdued or negative, (though this requirement does not have to apply to all staff - see ‘Which Staff?’ below).
Carried interest awarded to staff may be treated as an investment (and so not subject to the remuneration rules) or as remuneration or some combination of the two.
The Payout Process Rules are generally considered not to apply to a carried interest arrangement which requires the AIFM to return all capital and profits at the agreed hurdle rate to the investors before staff are paid out.
The Payout Process Rules apply to staff (not just employees) “whose professional activities have a material impact on the risk profiles of the AIFM or of the AIFs the AIFM manages”. This includes:
- senior management;
- risk takers, e.g. staff who can take decisions that materially affect the risk positions of the AIFM or of the AIFs it manages;
- control functions - e.g. risk, compliance, internal audit etc; and
- staff in the same pay bracket as senior management and risk takers.
The AIFM must ensure that staff of entities to which it has delegated portfolio or risk management and who fall into the categories above are subject to the same rules.
In the UK, the Payout Process Rules do not have to be applied in relation to staff:
- whose variable pay is no more than 33% of total pay; and
- whose total pay is no more than £500,000.
Particular care is required in relation to control functions to ensure that their remuneration does not lead to conflicts of interest – e.g. bonuses should not be linked to the profits of the businesses which the control function is supposed to oversee. In general, their remuneration should be based on the achievement of objectives linked to their functions, independent of the performance of the business areas they control.