Alternative Investment Management Association Representing the global hedge fund industry
Deferred remuneration has become an increasingly common feature of the hedge fund industry in recent years, as investors have pushed for greater alignment with managers’ interests, while managers themselves have aimed to tie key personnel into their businesses. The external pressures on managers are still a long way from those that banks find themselves under, exemplified by one leading bank that is reportedly operating 100% deferrals on bonuses awarded to its entire managing director population. However, since 2011, many managers in the UK have needed to be compliant with regulatory requirements on remuneration due to coming within scope of the FSA’s revised “Remuneration Code”. The regulatory environment will change again in July 2013, with the introduction of the Alternative Investment Fund Managers Directive (AIFMD), which brings with it a new set of rules on remuneration, albeit rules closely modelled on the existing Capital Requirements Directive (CRD) regime that the Remuneration Code implements. The drivers may therefore be commercial, regulatory, or both. Whatever the reason for its introduction, deferring remuneration presents both challenges and opportunities for managers.
On 11 February 2013, the European Securities and Markets Authority (ESMA) published the final text of its Guidelines on Sound Remuneration Policies under the AIFMD. These guidelines effectively form part of the AIFMD under delegated authority and will be transposed into national rules. The final text is not fundamentally different from the draft version published for public consultation in June 2012, but a number of clarifications and limited modifications have been made. One important addition to the text that will be of interest to many managers is a clarification that, for the purposes of AIFMD, distributions of business profit in the form of dividends or similar distributions from partnerships are not remuneration, “unless the material outcome of payment of such dividends results in a circumvention of the relevant remuneration rules”.1 This establishes an anti-avoidance principle, yet it remains unclear as to how a business owner who is also active in the business, and in scope of the remuneration provisions in that capacity, should determine what element of their reward is “remuneration” and what is “profit”. This is especially relevant in the context of LLPs and other partnerships where there is no distinction between the two in the form of delivery.
The final guidelines also align the provisions on proportional application of the remuneration rules more closely with the equivalent guidance produced by the Committee of European Banking Supervisors in relation to the CRD. These amendments offer no answers to the fundamental question of which managers will be subject to the requirement to defer 40%–60% of variable compensation and which will not. Under the Remuneration Code, fund managers have generally been classified as Tier 4 (now Level 3) businesses, and so have not been subject to the equivalent mandatory deferral requirement under CRD, but must now await the FSA’s verdict on how it should address the same subject in the context of AIFMD. It appears likely that many managers will again benefit from proportionality and will not face mandatory deferral, but in its November 2012 consultation paper on implementing AIFMD2 the FSA warned that, “larger, more complex AIFM investment firms may end up having to comply with more requirements than has so far been the case under the [Remuneration] Code.”3 It should be noted that the final ESMA guidelines clarify that the deferral requirement is an all-or-nothing measure – the 40%–60% threshold can be eliminated under proportionality but cannot be reduced if it is not appropriate to disapply the rule in its entirety. The FSA’s decision on how it will implement this part of AIFMD will therefore be of critical interest to managers.
Challenges presented by deferral
The mandatory remuneration provisions in AIFMD and CRD not only require deferral, but also state that deferred remuneration features “ex post incorporation of risk”, such that it can be reduced, forfeited or clawed back. In addition, 50% of total variable compensation must be paid in non-cash instruments, these being either equity interests in the manager or units in funds it manages. Furthermore, these instruments must be split between the deferred and non-deferred components. Finally, instruments must be awarded subject to retention such that the recipient must hold the instrument for a certain minimum period either from award (if not deferred) or vesting (if deferred).
It has been previously noted by industry commentators that these requirements present considerable structural and tax challenges for privately held businesses in particular, especially those organized as LLPs. The illiquidity of equity instruments in a private business is one major concern. Another is how to comply with the rules and defer remuneration effectively within a tax transparent structure, where all the profits of the business are taxable on the members regardless of whether the members actually receive them in cash or another form of value (and any provision in the accounts for future profit shares to members would not be deductible in arriving at taxable profits). There are also significant complexities around forfeiture and recycling of forfeited remuneration. Regulators have not generally addressed these concerns – the FSA has, in the past, not been inclined to adjust remuneration measures to take into account tax issues, and while ESMA has noted that representations have been made on the subject4 it is silent in offering any form of view or guidance on the topic.
In addition to the UK challenges presented by tax transparent partnerships, many managers have personnel who are US taxpayers or who are resident outside of the UK, and will therefore need to consider how to accommodate not only UK tax, but one or more sets of foreign tax rules into the deferred remuneration structure adopted.
Mandatory deferral could also leave managers with offices both within and outside of the EU having to decide between introducing consistent remuneration practices across their locations on the one hand, and not introducing deferral arrangements that are out of line with local market practices on the other. In the event that managers in this position decide some degree of deferral globally is preferable, they will need to consider the taxation and other issues concerning deferred remuneration in each relevant jurisdiction.
Managers who will not face mandatory deferral, but who ultimately choose to adopt a deferred remuneration policy anyway, will likely tackle the same structural issues as those facing mandatory deferral, as most voluntary policies will have many of the same features even if (for example) the percentage deferred is lower or the deferral period is shorter.
A significant and growing number of managers have already adopted some form of deferred remuneration policy voluntarily in response to existing commercial trends. Investor pressure on long-term alignment is one such trend, but another is managers increasingly wanting to use deferral and non-cash reward for staff retention purposes. Imposing vesting and forfeiture provisions over a portion of remuneration is an obvious way of making it more difficult for talent to walk out of the door immediately after bonus time, but it can also address other issues within the standard manager reward model.
One example of this is the impact of netting, which can arise whenever managers allocate capital to multiple trading desks and reward each desk based on its own performance. This system works when all desks are positive, but hits problems when there are both positive and negative performers. This is because fees are only earned on the fund’s net performance, leaving the manager short of the amount it needs to pay the positive performers. A deferred remuneration policy gives the manager in these circumstances the ability to operate a claw back system effectively, such that deferred remuneration earmarked for the negative performers in a prior period (and therefore still under the manager’s control) can be used to make whole the positive performers in the current period. Not only is this aligned to the ex post incorporation of risk that regulation is looking for, but it also preserves overall profitability for the business owners, as they need to give up their own profits to the positive performing teams.
The commercial opportunities afforded by deferred remuneration policies still need to be considered, alongside the structural and tax challenges, to ensure that any policy is workable to implement, and ideally does not increase the tax risks for both the business and the individuals in scope. Many managers have been able to overcome both the illiquidity issue (e.g., through creating an internal market or using fund units as currency) and the transparency issue (e.g., through corporate member planning) to allow their commercial objectives to be achieved. It is not always straightforward, however, to arrive at a “one-size fits all” deferral policy that does not create extra tax risk for any of the parties involved, and so, in some cases, parallel plans for different groups of personnel may be needed. Any deferral planning has cost implications and these generally increase with complexity, so a balance needs to be found with the commercial benefits.
What should managers be doing?
Managers who ultimately find themselves in scope of mandatory deferral will have no choice in the matter, but all managers should consider reviewing their reward policies over the coming months to determine not only how aligned they are to regulatory requirements as the final rules emerge, but also whether deferral actually offers positive benefits to the business. It is usually possible to implement an effective deferral structure to deliver the commercial goal whatever the business form and so this should not be seen as an insurmountable obstacle.
The views reflected in this article are the views of the author and do not necessarily reflect the views of the global Ernst & Young organization or its member firms. EYG no. DL0699
 Para 17 of the Guidelines, Guidelines on sound remuneration policies under AIFMD, ESMA, February 2013.
 CP12/32 – Implementation of the Alternative Investment Fund Managers Directive, FSA, November 2012.
 Ibid. – Para 7.79.
 Ibid. – Para 3(iii) of the consultation response.