Last week, ESMA put out for consultation quite extensive proposed guidelines to restrict bonuses in those parts of the fund management sector now covered by the Alternative Investment Fund Managers Directive (Directive 2011/61/EC) (the "Directive"). By and large, the paper does not set out anything which should come as a surprise to the industry given that the broad principles had been foreshadowed in the Directive itself and the banking sector has been subject to broadly equivalent guidelines issued by the CEBS, the predecessor to the EBA.
In the UK, where the FSA Remuneration Code already covers most financial services sectors (apart from insurers), these guidelines will be seen as duplicating what the Code already requires of all fund management businesses. But whereas the FSA's proportionate approach reduced many of the requirements for small firms which did not engage in proprietary trading (apart from asset management arms of the larger investment banks), the guidelines potentially encompass such firms within the full spectrum of prescriptive and qualitative rules. The potential scope of the guidelines is therefore wider. Firms may have to revisit the proportionality tier they fall into in light of ESMA guidelines. In short, more people at more funds will find their compensation restricted.
The proposals largely mirror the CEBS restrictions in terms of splitting remuneration between fixed and variable components, deferring portions of the bonus over a 3 to 5 year period, requiring a part of the bonus to be shares or other instruments, clawback and malus arrangements, and requiring various governance and disclosure requirements.
There is no absolute ceiling on bonuses limited to the amount of annual salary. This may be included at a subsequent stage if the idea takes hold in the CRD IV negotiations, although this would be difficult to reconcile with the hedge fund model where remuneration is based on AUM and NAV and is largely uncapped. In the private equity context, carried interest is realised on an ad hoc basis and so would not easily fit with an annual salary-based cap.
For firms that would be subject to these rules for the first time, the costs and burden of compliance will be significant. Quite sensibly, there is an emphasis on a proportionate approach which is intended to apply to different categories of staff within a firm, a level of granularity which does not exist within the FSA rules or the CEBS guidelines. This is helpful in distinguishing between managers and other staff that pose less of a risk to the firm and is probably the most appropriate way to temper the severity of these new rules.
Variable remuneration is defined widely. The only exempted payments are pro rata returns from investments in the fund made by staff who have already paid up the investments.
Hedge funds and private equity firms seeking to reduce the impact of the new rules are advised to focus on categorising staff at differing levels of risk-taking. Measuring risk will now involve a detailed and cumbersome process factoring various quantitative and qualitative matters relevant to individual and firm-wide performance as well as that of the funds managed. The time horizon for measuring performance is multi-year and this will clearly have an impact on ongoing monitoring of awards and potential clawbacks.
These guidelines, albeit at a consultation stage, reflect a sea change in the way remuneration is arranged in the alternative funds industry. For private equity and hedge funds in particular, it creates a significant compliance overlay and undoubted additional cost. And many firms will naturally be wary of the extent of the disclosure requirements. That said, it is unrealistic to expect a sympathetic ear to any concerns raised on this front. Many of these proposals seem likely to go ahead.
Azad Ali is Counsel in the Financial Institutions Advisory and Financial Regulatory Group at Shearman & Sterling.