ALERT

FCA publishes final AIFM Remuneration guidance, effective immediately

Following a consultation on its proposals, the Financial Conduct Authority (FCA) published its final guidance on the AIFMD remuneration regime on Friday 31 January 2014. This guidance, which has immediate effect, sets out how the AIFM Remuneration Code, SYSC 19B, (“The AIFM Code”) should be interpreted and applied by alternative investment fund managers (AIFMs).

The AIFM Code will apply to AIFMs from the start of the first full performance period following AIFM authorisation and will primarily affect ‘AIFM Remuneration Code Staff’. These are staff whose activities have a material impact on the risk profile of the AIFM or the alternative investment funds (AIFs) it manages.

The guidance includes the finalized single AUM thresholds under stage one of the FCA’s proportionality assessment process. Firms yet to submit their application for AIFM authorisation will need to examine their AIFMs based on these thresholds and the additional proportionality factors in stage two. Firms already authorised or waiting for their application to be processed that have relied on the proportionality regime to disapply the more onerous requirements should review and test their documented disapplication rationale with their advisers in light of these finalized thresholds and further guidance.

The AIFM remuneration regime will not be fully applicable to many firms until 2015. Having now articulated their remuneration policies, these firms should now be finalising their compliance plans for operating under the new regime and (if relevant) be developing appropriate cash and instruments deferral structures capable of delivering variable remuneration to AIFM Code Staff in a regulatory compliant and tax efficient manner.

The final guidance also gives advice to firms still transitioning to the AIFMD remuneration regime on how best to fulfil the remuneration disclosure requirements for their AIF annual reports.

Proportionality regime for AIFMs

The FCA’s so called Pay-out Process Rules consist of requirements relating to:

  • 40-60% Deferral,
  • Performance adjustment,
  • 50% Payment in instruments, and
  • Retention.

The AIFM remuneration proportionality rule permits AIFMs to disapply the Pay-out Process Rules following a proportionality assessment of the AIFM based on its size and additional proportionality factors. This two stage assessment process must be completed separately for each of the above requirements with the AIFM able to explain the rationale for each disapplication if requested to do so by the FCA.

This proportionality assessment is also used to determine whether an AIFM is ‘significant’ and as a result required to have a remuneration committee.

Stage One – Size

A working presumption as to whether or not proportionality relief is available must first be determined by testing the assets under management of the AIFM’s AIF portfolio against the FCA’s AUM thresholds. The relevant AUM threshold is based on the type of AIF portfolio the AIFM manages: if the AIFM manages unleveraged closed-ended funds the higher £5 billion AUM threshold will apply, with the lower £1 billion threshold applying if the AIFM manages any other type of AIF portfolio (such as leveraged open-ended AIFs). If the AIFM manages a combination of unleveraged closed-ended funds and leveraged open-funds the lower £1 billion threshold will apply.

Despite industry lobbying for a higher AUM threshold for open-ended AIFs, the final AUM thresholds have been set at the mid-point of the ranges in the initial consultation.

Type of AIFM Initial consultation draft AIF AUM thresholds Final AIF AUM thresholds Working Presumption
Closed –ended, unleveraged AIFs(a) Closed – ended, unleveraged AIFs Less than £5 bn Pay-out Process Rules do not apply
Greater than [£4-£6bn] Greater than £5bn Pay-out Process Rules apply
Other types of AIF portfolios (i.e. leveraged open-ended) Less than [£500m- £1.5bn] Less than £1bn Pay-out Process Rules do not apply
Greater than [£500m-£1.5bn] Greater than £1bn Pay-out Process Rules apply

Noteworthy is the statement the FCA has made in its feedback to the consultation: ‘We expect these thresholds to create the presumption that managers of the majority of AIF assets in the UK will be subject to the full regime because of the concentration of assets in a number of very large asset managers’.

Stage Two – Additional proportionality factors

In addition to Stage one, the FCA expect additional  proportionality factors to be applied in determining whether there are characteristics of the AIFM or AIF that render it less complex or smaller scale as compared to its peers in the UK or EU market, which justify the disapplication of all or some of the Pay-out Process Rules.

Examples of AIFM/AIF characteristics that imply full or partial disapplication include:

  • Fewer AIFM Code Staff or fewer or no subsidiaries as compared to peers;
  • Senior management who work in the business and possess the majority ownership stake of the AIFM (the performance adjustment rule may be disapplied and possibly others);
  • Regulatory constraints on AIF investment strategies;
  • Limited investment discretion for AIFM or delegate portfolio manager, e.g. follows a rules based discipline such as use of an index tracker (the deferral and retention rules may be disapplied);
  • The AIFM falls within the lowest risk category of the FCA’s internal conduct and prudential supervision categories or is associated with a low risk level based on an alternative risk measure, such as VAR (possible disapplication of all the rules);
  • Delegate portfolio manager with limited investment discretion or subject to contractual arrangements applying the Capital Requirements Directive (CRD) remuneration regime to Delegate AIFM Code Staff (possible disapplication of all the rules);
  • Fee structures are in place (e.g. carried interest) which align the AIFM Code Staff with investors and discourages inappropriate risk-taking by being paid out towards the end of the fund life-cycle and having been negotiated with prospective investors in advance (possible disapplication of all the rules to this fee structure). NB. Any additional variable remuneration awards paid to that individual such as bonuses from the management fee would be subject to a separate proportionality assessment.

The final guidance also provide examples of the type of AIFM characteristics that imply full application of the Pay-out Process Rules: e.g. listed AIFM, wide range of investment strategies across large AIF portfolio, high risk strategies with volatile returns, use of considerable leverage and extensive use of outward passporting.

Finally, we understand that the FCA intends to undertake a thematic review of the industry’s compliance with the AIFMD remuneration regime later this year, which could give rise to firms above the AUM threshold having their decision to disapply the rules challenged and potentially rejected.

Implementing the delegation provision

The AIFM is required to have contractual arrangements in place (most likely in its delegation agreement) to ensure that the AIFM Code will apply to any delegate entity staff performing risk or portfolio management services on its behalf (irrespective of whether the delegate is outside the EU) unless these individuals are already subject to provisions deemed to be ‘equally as effective’. The FCA has confirmed that the remuneration regimes they consider to be ‘equally as effective’ to the AIFM Code are the Capital Requirements Directive (CRD) and the Markets in Financial Instruments Directive (MIFID). The Undertakings for Collective Investment in Transferable Securities Directive (UCITS V) regime will not be included until the legislation is adopted into law in 2015.

Key developments for partners or members of an LLP

If the AIFM is structured as a partnership or LLP and has individual partners or members who are AIFM Code Staff or in a equivalent position for a delegate entity any payments they receive in exchange for professional services provided to the AIFM will be within the scope of the AIFM Code. Any payment they receive as owners of the AIFM (i.e. dividends or equivalent distributions) will be excluded.

Accordingly, any profit allocation will need to be bifurcated into the portion classified as the ‘return on equity’ in the firm and the portion classified as ‘payment for their services to the AIFM’, the latter being “remuneration” for regulatory purposes. As certain requirements such as the Pay-out Process Rules impact only variable remuneration, a further bifurcation of the “remuneration” portion is then needed to ascertain its fixed and variable elements.

The FCA gives two possible bifurcation processes for the profit share.

1. The Partnership Waterfall

For founding or senior partners in an existing firm any amount of ‘additional profit share’ may be considered to be their out-of-scope equity return (‘especially if it is structured as an automatic yearly allocation that does not reflect performance’). Any ‘discretionary profit share distributed to all partners’ (particularly if it is contingent on performance) would constitute the variable remuneration portion. Any drawings taken in advance of this profit allocation at the end of the year will be considered to be fixed remuneration.

Although the AIFM Code states that the fixed and variable components must be ‘appropriately balanced’ with the ‘fixed component [representing] a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration’ the final guidance offers no steer as to the point at which the FCA would consider the proportion of fixed remuneration too high to be ‘appropriately balanced’.

2. Benchmarking

The FCA recommends two appropriate methodologies:

  • Benchmarking the remuneration structures of partners performing similar tasks or working in similar businesses
  • Benchmarking the equity or capital return for a partner who has invested in the AIFM against a similar investment context

The guidance notes that for partners working part-time in an executive position, a larger portion of their profit share should be considered to be an out-of-scope equity return whilst for full time partners the FCA  ‘will expect a reasonable portion of the partner’s profit share to be considered as remuneration under AIFMD’. Firms are warned that seeking to classify ‘all payments to a certain partner as profit share without sound justification’ may breach the anti-circumvention rule in the AIFM Code.

Tax implications

To prevent the deferral of up to 60% variable remuneration (in cash and units) giving rise to a dry tax charge for partners the Government will introduce in the Finance Bill 2014 a new statutory mechanism (which will take effect from 6 April 2014) to ensure that portions of deferred variable remuneration can be deferred on a ‘net-of-tax’ basis with the partnership or LLP paying the income tax upfront at the additional rate (currently 45%) via self assessment. When the net-of-tax deferred award vests (with its originally intended recipient) this is treated as taxable income for the partner in the year of vesting with a credit available for the income tax initially paid by the partnership or LLP.

National insurance contributions (NIC) will only be payable by the partner on receipt of the deferred remuneration. If malus is to be applied as a result of poor performance, the deferred award (or part of it) will be forfeited prior to vesting and re-allocated back to the partnership or LLP to be distributed to the other partners. If this happens there will be no further income tax liability and no partner will be entitled to recover the initial tax paid on the deferred remuneration.

For partnerships or LLPs that don’t elect to use this net-of-tax statutory mechanism their partners will still be liable for income tax and NIC on deferral.

Remuneration disclosure in the AIF annual report

The AIFM is required to make available to investors, regulators and staff an annual report for each AIF no later than six months from the end of the first financial year following authorisation.

The report must contain for instance the total amount of remuneration paid by the AIFM to its staff, split into a fixed and variable components; the proportion of the total remuneration attributable to the AIF and the aggregate amount alternatively split between senior management, members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF and others.

The FCA appreciates that for many AIFMs their AIF annual reports may need to be made available before the first performance period following authorisation is completed. There is even the possibility that the first AIFMD compliant performance year will not have commenced (e.g. for a firm receiving AIFM authorisation this month with a 31 March year end and a calendar performance year, the first AIF reports will need to be made available by 31 September 2014, before the first performance period with an AIFMD compliant remuneration policy has even started on 1 January 2015).

The annual reports are intended to enable investors to make real comparisons between AIFs and AIFMs to help them make well informed investment decisions. If some remuneration disclosures are made in the context of an AIFMD remuneration policy and others are not this cannot provide investors with a proper basis for comparison. Accordingly, the FCA has suggested that where an AIFM concludes that it does not have the information available and/or it believes that the information ‘would not be materially relevant, reliable, or provide a proper basis for comparison’ it may consider omitting the disclosure from the relevant annual report whilst noting the reason for doing so. Once an AIFM has implemented its AIFMD compliant remuneration policy, the remuneration disclosures must be made fully in the AIFs annual report.

Payment in units, shares or other instruments

The AIFM Code requires 50% of all variable remuneration (upfront and deferred) to be paid in units or shares of the AIF to which the individual mainly provides services. Or alternatively equivalent ownership interests or share linked instruments or equivalent non-cash instruments may be appropriate unless the legal structure of the AIF or its incorporation instrument precludes this. If the proportion of AIF funds managed is less than half of the total managed portfolio, the 50% minimum will be reduced accordingly.

The final guidance states that the legal structure of the AIF or its incorporation instrument will only render the rule impracticable and excludable if:  

  • he AIF is closed-ended and there are no units available to acquire;
  • The AIF’s incorporation instrument prohibits instruments being held by AIFM Code Staff or prescribes a large threshold investment amount that could not be met by individual staff investments;
  • The AIF is subject in its jurisdiction to laws or regulations which prevent it being marketed to some or all of the AIFM Code Staff;
  • Laws or regulations prevent the AIFM or AIFM Code Staff from holding units in the AIF;
  • An investment by AIFM Code Staff would result in adverse tax consequences for any third party AIF investors;
  • The creation of equivalent ownership interests is unduly costly when weighed against the benefits of aligning the Code Staff’s interests to that of investors.

In order to align incentives, the FCA still recommends that firms elect to pay staff in either:

  • Shares, instruments or instruments linked to the AIFM or its parent company if either is listed or the performance of the AIFM business impacts the parent company’s’ valuation; or
  • Shares or instruments linked to a weighted performance average of the AIFs managed by the AIFM or other portfolios managed by the AIFM or its affiliates.
Retention policy

Units, shares or other instruments forming part of a variable remuneration award must be subject to a retention period of at least six months from the award date if part of the upfront portion or post vesting if part of the deferred portion.

If a PAYE tax liability arises in relation to the deferred units, shares or instruments on vesting, some units may be cashed in to fund the tax owed with the remainder subject to the full retention period.

KPMG contacts

Dan Roman
Investment Management Tax, Partner

Rupal Patel
Executive Remuneration, Director

Simon Ross-Skinner
Investment Management Tax
Senior Manager

Rachel Hanger
Investment Management Tax, Partner

Heleen Rietdijk
Global Program Lead AIFMD

Alivia Kratke
AIFMD Reward Manager