ESMA Seeks Peak Performance

ESMA Seeks Peak Performance

With industry competition constantly at fever pitch, the regulatory scrutiny on fees charged to investors remains equally intense in Europe. We recently flagged that European Securities Markets Authority (ESMA) wish to look beyond fee disclosures to concepts such as “value for money”, fairness, and competitiveness to execute its investor protection mandate. A key sub-set of this debate is performance fees.

Last year, we covered ESMA’s performance fee consultation primarily focused on harmonization of how UCITS funds calculate, disclose, and pay performance fees where there was evidence identified that rules and market practices remained inconsistent across the EU.

More recently, last month, ESMA published its final report on guidelines on performance fees in UCITS and Retail Alternative Investment Funds. This publication kicked off a two-month window for EU national regulators to confirm to ESMA whether they already comply or intend to comply with the final guidelines.

In response to the ESMA Guidelines, last week in Ireland, the Central Bank of Ireland (CBI) issued a consultation paper (CP134) to garner industry feedback on incorporation of the ESMA guidelines into the existing CBI performance fee framework. CP134 identifies a couple of specific areas of the ESMA guidelines not covered in the CBI’s existing ruleset.  At its core, CP134 looks to bridge these gaps. For the intervening period where the ESMA and CBI rulesets diverge, in the case of any inconsistencies, the existing CBI guidance will prevail. The CP134 consultation period closes on January 15, 2021.

In Luxembourg, the other dominant UCITS fund domicile, the Commission de Surveillance du Sector Financier (CSSF) has not yet commented, however a similar industry dialogue would not be unusual.  Indeed, to a great extent, many funds already operate to the principles contained in the ESMA guidelines as a matter of course, or through regulator supervisory engagement made revisions as the direction of travel on the issue became clear. 

As such, reading through the guidelines, some asset managers have wondered aloud why such matters of common sense required this additional formal guidance. However, within the consultation ESMA had noted enough irregularities through their supervisory engagement to feel that the guidelines were not only warranted but required for transparency and investor protection. As with many regulatory recalibrations, often regulators are changing the rules to temper the few, and not the many.

Scope of Guidelines

The performance fee guidelines apply to managers of UCITS and certain types of AIFs (those marketed to retail investors except for (a) closed-ended AIFs; and (b) open-ended AIFs that are EuVECAs [or other types of venture capital AIFs], EuSEFs, private equity AIFs, or real estate AIFs).

Fund TypeCompliance Date
New Funds with a Performance Fee created after January 5, 2021Immediate
Existing Funds who introduce PF after January 5, 2021Immediate
Existing Funds with an existing PF pre-January 5, 2021Beginning of the financial year following 6 months from the application date of the Guidelines. In effect, from financial years commencing 6th July 2021 onwards.

Below is a summary of some of the main points for each guideline. Please refer to the guidelines for all points in full.

Guideline 1:  Performance fee calculation method  Sets out several technical criteria which form the baseline of any performance fee calculation such as performance benchmark and period, calculation frequency and methodologies which must be broadly aligned with the investors’ best interests.
It also confirms that the methodology should be verifiable and not open to the possibility of manipulation.
Finally, it notes that they can be calculated on a single investor basis.  
Guideline 2:   Consistency between the performance fee model and the fund’s investment objectives, strategy, and policy  Managers should implement and maintain a process in order to demonstrate and periodically review that the performance fee model is consistent with the fund’s investment objectives, strategy, and policy.
If a fund is managed in reference to a benchmark index and it employs a performance fee model based on a benchmark index, the two indices should be the same.
Consistency indicators to be considered:
Expected return
Investment universe
Beta exposure to an underlying asset class
Geographical exposure;
Sector exposure
Income distribution of the fund
Liquidity measures (e.g.: daily trading volumes, bid-ask spreads etc.)
Duration Credit rating category
Volatility and/or historical volatility.

If the reference indicator changes during the reference period, the performance of the reference indicator for this period should be calculated by linking the benchmark index that was previously in force until the date of the change and the new reference indicator used afterwards.
Guideline 3:   Frequency for the crystallization of the performance fee  The crystallization frequency should not be more than once a year.

The above does not apply where the fund employs a high watermark (HWM) model or a high-on-high (HOH) model where the performance reference period is equal to the whole life of the fund and cannot be reset. To put it another way, performance fees cannot be accrued or paid more than once for the same level of performance over the whole life of the fund.

The crystallization date should be the same for all share classes of a fund that levies a performance fee. In case of closure/merger of funds and/or upon investors’ redemptions, performance fees, if any, should crystallize in due proportions on the date of the closure/merger and/or investors’ redemption.

In case of merger of funds, the crystallization of the performance fees of the merging fund should be authorized subject to the best interest of investors of both the merging and the receiving fund.
Guideline 4:
Negative performance (loss) recovery  
In order to avoid misalignment of interests between the fund manager and the investors, a performance fee could also be payable in case the fund has overperformed the referenced benchmark but had a negative performance. In this case, the fund manager must provide a warning to the investor to achieve full transparency.

In case the fund employs a performance fee model based on a benchmark index, it should be ensured that any underperformance of the fund compared to the benchmark is clawed back before any performance fee becomes payable. To this purpose, the length of the performance reference period, if this is shorter than the whole life of the fund, should be set equal to at least 5 years.

For the HWM model, in case the performance reference period is shorter than the whole life of the fund, the performance reference period should be set equal to at least five years on a rolling basis. In this case, performance fee may only be claimed if the outperformance exceeds any underperformances during the previous five years and performance fees should not crystallize more than once a year.
Guideline 5: Disclosure of the performance fee model  In case a fund allows for a performance fee to be paid also in times of negative performance (for example, the fund has overperformed its reference benchmark index but, overall, has a negative performance), a prominent warning to investors should be included in the Key Investor Information Document (KIID). In case a fund managed in reference to a benchmark computes performance fees with a benchmark model based on a different but consistent benchmark, the manager should be able to explain the choice of benchmark in the prospectus.

The prospectus should include concrete examples of how the performance fee will be calculated to provide investors with a better understanding of the performance fee model especially where the performance fee model allows for performance fees to be charged even in case of negative performance

While many funds may already comply with these guidelines, for certainty it makes sense for asset managers to double check current or planned performance fee models, making alterations where required in order to comply with both the detail and the spirit of the new ESMA guidelines. It is worth noting that in recent industry discussions upon detailed review, the minimum 5 year reset for losses within performance reference periods may materially impact certain funds. The funds previously may have reset as frequently as each year under their current methodology. A highly technical and specific point, but one which has consequence if a change from your existing norm. 

Let’s Discuss

To arrange a more detailed discussion on what this update means for your funds or any other global fund accounting developments, please contact Melissa McDonough or speak with your usual BBH client relationship contact.

This article was contributed by BBH Vice President Caitriona Flynn.