Bonus practice for alternative fund managers are likely to change forever under new regulations, say Nick Robertson and Claire Holland at Mayer Brown.
The new guidelines on the remuneration of alternative investment fund managers are looming on the horizon. They are due to come into force by July 22 next year.
The European Securities and Markets Authority (Esma) consultation on the guidelines, which implement the rules in the Alternative Investment Fund Managers Directive, ended on September 27, 2012 and a final report is to be published by the end of the year.
The changes do not seem to be welcome by alternative managers as it is felt that they are being “tarred with the same brush” as investment banks and important factors that differentiate the two are not being taken into account.
In its consultation, Esma recognised that although the basis of the structure of the new remuneration rules should be the same, adaptations for the specific nature of the asset management sector needed to be taken into account. However, applying such regulations to the alternative investment industry raises questions about the extent of any such adaptations and whether they will ever be achievable in the proposed framework.
The guidelines will apply to managers managing alternative investment funds (AIFs) including hedge funds, private equity funds and real estate funds. These funds will be asked to adopt sound and prudent remuneration policies and structures with the aim of increasing investment protection and avoiding conflicts of interest that may lead to excessive risk taking.
They will also have to identify the staff whose professional activities have a material impact on the alternative manager’s risk profile or the risk profile of the AIF that it manages, and to whom the policy will apply, and disclose the basis on which they were selected. This must include those staff who are members of the governing board of the fund, senior management, control functions, staff responsible for heading the portfolio management, administration, marketing and human resources and other risk takers.
The principles will apply to any remuneration paid by the alternative manager, to any amount paid directly by the AIF itself, including carried interest, and to any transfer of units or shares of the AIF, in exchange for professional services rendered by the fund management staff. All remuneration should be divided into either fixed remuneration or variable remuneration: the difference being that variable remuneration depends on performance or, in certain cases, other contractual criteria.
However, the rules will not apply to any payments by the AIF that represent a pro rata return on any investment that staff members have made into the AIF.
From an employment perspective, the main headache for AIFs will be the implementation of the limits around variable remuneration and on the basis on which it can be paid.
At least 50% of any variable remuneration will need to consist of units or shares of the AIF concerned, or equivalent ownership interest, or share-linked instruments or equivalent non-cash instruments, although there are limited exceptions.
Similarly, between 40% and 60% (depending on the size of the payment) of the variable remuneration will need to be deferred over a period which is appropriate in view of the life cycle and redemption policy of the AIF concerned and correctly aligned with the nature of the risks of the AIF in question.
The deferral period of any such payment must be at least three to five years (unless the life cycle of the AIF concerned is shorter) and vesting no faster than on a pro rata basis each year. In addition, such payments will be subject to malus provisions or claw back arrangements to take account of subsequent poor performance by the alternative fund manager as a whole, the business unit, the AIF and, where possible, the individual.
There are also a number of other changes which will affect the way alternative fund managers approach issues throughout the employment relationship. There will be limits placed on guaranteed minimum bonuses, which will be “exceptional” only and only allowed in the first year of employment.
Also, payments relating to early termination of the employment relationship will need to take into account performance achieved and should not reward failure.
From an employment perspective, the proposed changes around variable remuneration are likely to be a challenge for alternative fund managers, particularly when viewed in the context of current bonus arrangements.
Bonus plans will need to be reviewed to take into account the provisions relating to deferral, payment in shares, and so on. Each alternative fund manager must then determine whether it proportionate to apply the rules in the context of its own business.
Similarly, employees’ contracts will need to be amended to take into account the changes, including a clause permitting any subsequent changes to any variable remuneration provisions which are necessary to comply with the guidelines or subsequent regulations.
Where managers do not have the ability to introduce such a clause unilaterally, consent will need to be obtained or, ultimately, this will need to be tied into a future pay rise prior to the guidelines coming into force in July next year.
Similar amendments should be considered to permit necessary changes to be made to enable the provisions of the guidelines to apply. In particular, such schemes will need to encompass a clear contractual right enabling the manager to implement any malus or claw back provisions .
Even then, employers will need to take care that the provisions apply fairly to employees and in accordance with the employer’s implied duty of trust and confidence.
Clearly, if contractual changes are needed, obtaining consent from employees may be difficult given that the guidelines are likely to place restrictions and limits on employees’ current bonus arrangements and payments. It will be interesting to see the outcome of Esma’s consultation but, whatever this may be, there is no doubt that the new guidelines are likely to change manager bonus practice significantly. More than this, it is likely to have a significant effect on the way the industry operates.
Nick Robertson is a partner and Claire Holland is a senior associate at Mayer Brown
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