Performance Fees: how portfolio managers earn their money – or is there more to it?
Aligning portfolio management and investor interests with fair reward is what most people associate with performance fees. However, this perception neglects the other major ways that performance fees can impact your business.
As indicated in our previous blog post ("Performance fees for the Fund industry: it's decision time"), EU-wide, non-harmonized requirements on performance fees do not only lead to unequal investor protection, but could also cause sizeable market uncertainties regarding the EU passporting system. There is recent evidence that different local European authorities are imposing inconsistent requirements on performance fee calculation and disclosure rules. This has caused some confusion about whether complying with these requirements is an additional condition of marketing a fund in a foreign country, on top of the EU passport.
ESMA has already unearthed this very issue by conducting market analysis on different EU jurisdictions' performance fee design requirements. Eager to level the playing field, ESMA has issued an EU-wide Consultation Paper for Guidelines that lists performance fee requirements for UCITS funds.
The ESMA Consultation Paper: new regulatory burden or effective harmonization?
At first glance, additional regulatory requirements are seen as further burdening businesses. In this case, ESMA's guiding principles were to harmonize the level of retail investor protection and avoid regulatory arbitrage. ESMA's suggested guidelines cover five general areas:
- General principles on performance fee calculation methods.
- Consistency between the performance fee model and the fund's investment objectives, strategy and policy.
- Frequency of performance fee crystallization and payment, with the minimum crystallization period being consistent with the investors' holding period and one-year minimum.
- Circumstances where a performance fee should be payable.
- Disclosures of performance fee models.
By their very nature, these requirements curtail market participants' discretion over the design of their performance fee models. However, they also offer clear advantages such as higher market transparency and lower information costs when marketing funds in other EU countries. And since retail funds typically depend on a large-scale investor base, this is undoubtedly an important factor.
What can be done at this stage?
The suggested guidelines are still at an early phase and could undergo significant changes. However, some road signs are already visible, including ESMA's choice to heavily base their Consulting Paper on the IOSCO Final Report on "Good practice for fees and expenses of Collective Investment Schemes (CIS)".
So, it's worthwhile to consider the following questions at this stage of the game:
- Are the design of your performance fee model and selected benchmarks linked in any way to your fund's investment strategy and risk/reward profile?
- Is your selected crystallization and fee payment period linked in any way to the average holding period of your fund's shares/units?
- Does your prospectus clearly and
unambiguously describe the performance fee calculation?
- For example: has your auditor ever commented that the performance fee calculation described in your prospectus does not reconcile with the fees actually computed and charged?
To fulfill the leading principles of the draft guidelines, the answers to these three questions should ideally be yes. Compliance aside, it must be stressed that performance fees are typically a key income source for portfolio managers. Therefore, should related models consequently need to be revised, this could majorly impact a ManCo's and portfolio manager's income and trigger an amendment of the respective business model.
In fact, we foresee that a significant portion of performance fee models currently in use would need to undergo major overhauls because they do not meet ESMA's suggested requirements.
The bigger picture
As stated previously, the suggested guidelines are far from set in stone. Nevertheless, the direction we are traveling in is becoming fairly clear. In one way or another, general market trends will duly impact the design of performance fee models such as increasing retail investor protection, faster information dissemination and digitization.
So, it's more important than ever to set up a proper performance fee framework along those lines—as it is a quintessential component of the industry's wider asset management transformation
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.