Luxembourg: Performance Fees For The Fund Industry: It's Decision Time

Last Updated: 29 July 2019
Article by Chrystelle Veeckmans

Most Read Contributor in Luxembourg, September 2019

Regulators and investors desire value-for-money

Recent European regulations related to fees are delivering new requirements for the Fund industry. The regulators' ultimate goal is to improve fee transparency and to reach a standardized cost-reporting framework. There's been a lot of debates and discussions on this topic in the past few months, intensifying pressure on fund managers.

As if that wasn't enough, there's also the looming threat of regulators examining active fees for quasi-passive propositions. For example, the Irish financial regulator recently started investigating asset managers after finding irregularities in many funds.

And, investors' growing awareness of the negative impact of fees on long-term investment returns has partially fueled the growth of index funds. This means that fund managers are being compelled to review and fundamentally change their traditional fee models.

Performance based fee models replacing fixed fee models

The main goal of the new fee models is to align asset managers and investor interests by significantly decreasing the fixed based Assets Under Management (AUM) fees while increasing the performance fee model remuneration. In a nutshell, asset managers are only remunerated if they can deliver Alpha, a performance over a certain benchmark. This should help the industry regain investor trust.

Some asset managers have already launched new products based on this model, with mixed results. "Zero-fee Funds" offered by Fidelity in the US is a radical trend to attract young investors who may invest in more lucrative products further down the line. These drastic fee decreases pose a real challenge to asset managers to find new profitable growth sources.

Creation of local performance fee requirements in Germany, Ireland and the UK

Additional local restrictions on performance fees were recently implemented in Germany, Ireland and the UK, piling more pressure on asset managers. They'll need to urgently adapt their fee models if they wish to keep distributing their products in those countries.

The Central Bank of Ireland (CBI) is moving to reinforce its guidelines regarding performance fee structures, requiring UCITS funds to introduce either a permanent High Water Mark (HWM) or clawbacks.

The German regulator BaFin is also putting additional requirements in place relating to performance fees for UCITS funds in Germany including:

  • a minimum 12-month crystallization period
  • an HWM or a clawback mechanism over at least five years
  • a cap on the total performance fees charged to the fund.

According to The Fitz Partners' Performance Fee Benchmarking report, only 10% of Luxembourg-domiciled funds would technically qualify for German distribution when further performance fee requirements come into place in January 2020.

Nevertheless, the Luxembourg fund industry association ALFI stated that, "it should not be possible to block Luxembourg-domiciled funds from distribution in Germany when changes to regulation take effect in December". They called for the industry to urgently adapt their products and prevent new barriers of entry to local markets.

ESMA guidelines needed to prevent unbalanced treatment of investors across Europe

According to ALFI's legal and tax director Marc-André Bechet, "acceptance by other EU regulators of the extraterritorial effect of national rules would be in violation of the 'passport principle' and would be disruptive to the UCITS framework in general" (Funds Europe). The Association believes that best practice is to follow the principles issued by the International Organisation of Securities Commissions (IOSCO) until ESMA provides further guidelines on that topic.

ESMA consultation on performance fees

A few days ago, ESMA launched a public consultation on performance fees draft guidelines under the UCITS Directive. ESMA stated, "draft guidelines aim to harmonize how performance fees can be charged to the UCITS and its investors while ensuring common standards of disclosure, as current practices vary among EU Member States" (ESMA News).

These guidelines aim to achieve supervisory convergence in the following areas:

  • General principles on performance fee calculation methods.
  • Consistency between the performance fee model and the fund's investment objectives, strategy and policy, in terms of benchmark for example.
  • Frequency of performance fee crystallization and payment, with the minimum crystallization period being consistent with the investors' holding period and one-year minimum.
  • Circumstances in which a performance fee should be payable.
  • Disclosures of performance fee models. For example, new disclosures could be ex-ante, providing concrete examples of how the performance fee will be calculated in the prospectus or ex-post, how performance fees are charged per share class (currently at sub-fund level).

The respondents will give feedback on the proposals and their opinion on whether the scope of the guidelines' principles should be extended to AIFs distributed to retail investors. ESMA will analyze the consultation results in Q4 2019 and plans to finalize the guidelines for publication after this. Our KPMG expert team are eager to share their ESMA feedback in another blog article. In the meantime, you can read our Fund Distribution Alert about the ESMA consultation.

Need for a flexible infrastructure and best-of-suite solutions

Firms can no longer rely on spreadsheets, models or formulas to calculate fees that regulators, investors and themselves cannot clearly understand.

Asset Managers must consider solutions that allow them to respond to these innovative fee structures and changing requirements with agility. It's not only essential for them to provide clear and transparent fee reporting to clients and regulators but they must also understand their costs at a fund, portfolio and share-class level.

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.

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