AIFMD: pulling on the purse strings

"For many fund managers, the prognosis has not been rosy," said MM&K director Nigel Mills, speaking at a recent briefing on AIFMD remuneration requirements held in partnership with Bovill. "Returns on funds have been coming down, so carried interest distributions have suffered significantly," he added.

Yet staff numbers are rising. "More focus is being given to infrastructure," said Gail McManus, founder and director of Private Equity Recruitment, highlighting the growing number of communications and investor relations staff as GPs put more man power behind fundraising. "If the pot is getting smaller and returns are getting lower but staff numbers are rising, where does money for this come from?" Pay packages are under pressure. And for those key staff that have an impact on the risk profile of a firm, that pressure is rising.

According to the AIFMD, pay policies and practices must be consistent with and promote sound and effective risk management. And bonuses, so often the bulk of remuneration packages in the financial world, could be about to change.

The directive states that at least 50% of bonuses cannot be paid in cash, but should be paid in units of the fund managed. As this may not always be possible given the closed-end structure of many traditional funds, equivalent instruments are also valid. The payment is subject to an appropriate retention policy, ensuring that employees do not cash in the fund units immediately.

What's more, at least 40% – and possibly more – of any bonus must be deferred over a period deemed appropriate in view of the life cycle of the fund. While the temporal details remain unclear, legislation suggests that the period should be three to five years, with payment in both cash and fund units deferred equally.

The banking industry has had such remuneration requirements for some time, with only a handful of asset managers included under the sweeping regulation. But the incoming AIFMD could affect a much wider number of GPs. Though the threshold, which currently stands at €100m for fund managers using leverage in their vehicles and €500m for those that do not, will see many fund managers left unscathed, for the big boys of private equity the repercussions could be sizable.

Of course, private equity players may be able to resort to the proportionality argument to extract themselves from the reach of AIFMD. Each fund manager will be tasked with assessing its risk profile in the overall spectrum of AIFMs, no longer comparing itself to big international banks but peers alone. But the ill-defined self-assessment approach has left many up in arms. News that the FCA is to publish a consultation on proportionality leaves the industry holding out hope.

"The biggest fund managers aren't going to be able to dis-apply these remuneration requirements on the grounds of proportionality," says John Everett, a principal at Bovill and former manager at the FSA. "The new requirements mean more of people's pay will be invested in the fund," he explains. Should business run smoothly, industry specialists predict that top dogs will continue to take home the same amount of cash, but in a different guise: base pay may rise as bonuses – now much trickier to pocket – fall out of favour.

But should anything go wrong in the fund, there is one clause for concern: malus. "The idea is that if you don't give all the remuneration up front, you have time to see if a decision they made this year leads to a bad outcome in the medium-term," says Everett. "If it does, then you have the ability to cancel some of the later rewards," he adds. Malus may seem all too familiar to some UBS bankers, who had their outstanding bonuses revoked following the Libor scandal, but this is new to private equity.

And there are also serious repercussions for fund managers structured as a partnership. "If you're a partnership, you are taxed on the profits that are allocated to you each year; those are what you pay your income tax on," Everett highlights. "So with deferred payments, you are going to be taxed on money you haven't yet been paid. There are discussions underway with HMRC regarding that. But what happens if you have paid the tax on an amount that has been awarded but not yet paid, but then that amount is cancelled? Are you going to get the tax back?"

And those fund managers considering a sub-threshold smaller fund, exempt from such requirements, are not safe yet. They are experiencing increasing pressure from another source, which may result in AIFMD-style compliance. The Institutional Limited Partners Association (ILPA) is growing in credence and, with a growing number of large institutional investors on its books, its voice is increasingly amplified.

"When it comes to new entities starting out, they are having to take this pressure on management fees very seriously," explained Mills. "This might be a good thing as far as AIFMD is concerned, as they might fall into the bracket whereby most, if not all, variable remuneration cannot be paid other than through their carried interest plans, which are typically not able to be paid until investors have had all their money back." Pressure from LPs has seen management fees fall from a standard 2-2.5% to 1.5-1.75% and carried interest on a deal-by-deal basis a thing of the past. And their power is growing.

But not all staff members have the same take on AIFMD. "Some HR professionals are taking a more positive approach to the directive," said Mills. "They recognise that it is making them think more about pay structures in their business, and the way fund managers should be incentivised." And with an increasingly long-term structure to remuneration packages, the directive has the potential to ensure staff members stick around for longer, if only to get deferred bonus payments; a bit of light relief for recruitment staff.

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