Regulatory ambiguity is bad news for fund administrators. Unfortunately, the European Securities and Markets Authority’s latest guidelines on performance fees for UCITS and certain retail AIFs has left market participants facing precisely that.
The ESMA guidelines, which took effect last year, aim to ensure the performance fees investment managers charge are equitable for every investor, a laudable goal all parties can support. The guidance wording though has sparked confusion around how the objective should be achieved in practice – leaving fund admins and depositary banks to interpret the rules, creating unwelcome risk and uncertainty.
This is not just some arcane accounting debate. Irish domiciled UCITS funds hold more than €3 trillion in assets under management. Across the EU, 29,000 active UCITS funds manage over €8 trillion in assets. So it is a sizable market with a lot at stake.
Potential performance fee inequalities
Key to the discussion is a statement included in the ESMA report and subsequently transposed into the Central Bank of Ireland (CBI) guidance:
“The performance fee calculation method should be designed to ensure that the performance fees are always proportionate to the actual investment performance of the fund. Artificial increases resulting from new subscriptions should not be taken into account when calculating fund performance.”
In other words, that investors only pay fees on the gains made. However, we believe some interpretations of the guidelines may result in inequitable treatment, with either investors or the investment manager potentially losing out.
Fee model confusion
The ambiguity stems from the use of high water mark (HWM) or high on high (HoH) fee models and how the fund has been performing at the point at which subscriptions are made into it.
In its response to the initial CBI consultation paper, the Irish Funds Industry Association pointed to the HoH method, which is typically used where performance fee crystallisation is more frequent than annual. “Given that the Draft Guidance provides only for annual crystallisation,” it said, “can the CBI confirm that the HoH method is currently not permitted under the CBI Draft Guidance?”
The CBI Feedback Statement said that wasn’t the case, and that use of the HoH methodology is not dependent on the frequency of crystallisation. Rather, the distinction between the HWM and HoH models lies in the level at which the performance is calculated – with performance fees payable once the fund achieves either:
- a new high net asset value per share or unit during the reference period (HWM),
- the net asset value of the fund exceeds the previous high (HoH).
Nevertheless, question marks have remained around the applicability of HoH models.
Accepted performance fee methodologies no longer valid
Irish Funds also queried whether existing approved performance fee methodologies that mitigate against “artificial increases resulting from new subscriptions” will remain valid.
The CBI response: that it is up to a Responsible Person or Retail Investor AIF to review the performance fee practices to make sure they comply with applicable law and the published Guidance. “The onus to ensure such compliance rests firmly with those entities,” it said.
Our interpretation of the CBI statement is that performance fee methodologies that were already in place, and can be shown to be equitable to investors in the fund, remain acceptable. Yet following introduction of the guidelines, previously accepted methodologies are in some cases no longer being approved by depositary banks for new fund launches.
While we are not legal experts, we believe market participants are applying too much weight to the wording around the requirement to exceed the static HWM per share. Using the static HWM per share value in situations where investors subscribe below the class level HWM would be unfair, as in the event of a redemption at a gain or loss, some element of the trading gains and losses will have crystallised and no longer exist in that class post redemption. Fees based on any new subscriptions post these redemptions will then be distorted if the fees have a condition that the static HWM per share has to be achieved.
Using a simple example, a Class launches at a price of 1,000 with $1m and 1,000 shares subscribed. At the end of the year, profit of $500k has been made with performance fees of $100k accrued at a rate of 20% leaving an ending NAV of 1,400 Bid price per share and also 1,400 start HWM for the next year. The next period sees a substantial loss of $400k made with the NAV dropping to 1,000 per share. At this point redemptions are processed with $900k being redeemed leaving 100 shares of the original investment at 1,000 per share. If I now subscribe $10m into the fund – the Class would have 10,100 shares and if we have the requirement to attain the 1,400 prior crystallised HWM, we would not accrue performance fees again until the GAV increases to a value of $14,140,000, meaning that the second investment would be getting a free ride of $4m until fees are accrued on its gains.
Where a weighted average HWM is used, this concept of the free ride is removed by reducing the HWM per share value down to an amount of 1,003.9604 ($10,140,000 / 10,100 shares). Under this approach, when the $40,000 of losses sustained by the Class to this point are recovered, performance fees will again be charged. Other methods of equalisation are also possible to achieve the goals of the guidance while avoiding this free ride including lot level performance fee calculations.
So including a mechanism to equalise investors who subscribe above the class level HWM, but not employing a similar mechanism for equalisation of the investors subscribing below the class HWM could result in a conflict between protecting investors versus compensating investment managers fairly for the returns they generate.
The regulators’ stated goal is to ensure that any performance fees charged by investment managers are in line with a fund’s actual performance. As they stand, the guidelines don’t provide sufficient clarity for how those calculations should be made to ensure all market participants are treated fairly.
An open conversation and further unequivocal guidance from the Central Bank on this matter are sorely needed.
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