ESMA pay rules still lack clarity

ESMA’s latest remuneration guidelines stick closely to previous guidance, leaving funds still unsure of how to report their carried interest.

Private equity firms are still not exactly sure how carried interest will be treated under remuneration rules released by the European Securities and Markets Authority (ESMA) on Monday. 

The rules detail provisions of the Alternative Investment Fund Managers directive agreed by EU policymakers in 2010 that require firm’s senior management and other key staff to provide a breakdown of their total fixed and variable remuneration. 

The rules state that all payment made by the fund manager, the fund (including carry), and the transfer of the units or shares of fund will fall within the scope of the guidelines. But questions still remain over whether carried interest will be viewed as variable or fixed remuneration, the former requiring deferral of at least 40 percent of the carry for at minimum three to five years (depending on a funds’ life cycle).

The guidelines state that both fixed and variable remuneration may include “remuneration by AIFs e.g. through carried interest models).”
Legal sources tell PE Manager that carry is likely to be seen as part of the total variable remuneration but that certain methods of paying carry, such as advanced drawings that are more akin to a salary, will need to be considered carefully as they may fall within the fixed remuneration bracket.

Another point of confusion is that when carry is paid on a pro rata rate it is not considered remuneration under ESMA's rules, but working out exactly what is pro rata is not always easy, according to one regulatory lawyer. 

According to the lawyer, ambiguity arises when individuals hold nominal amounts of equity in a carry vehicle but are entitled to a disproportionate amount of the return on the investment. 

“I think everything other than something that reflects a pro rata return on the amount they put in will be seen as carried interest and fall within the scope of the guidelines,” said the lawyer, adding that unhelpfully the guidelines don’t give any advice on whether a return is pro rata or disproportionate.

The guidelines, which come into force on 22 July, will apply to all fund managers and their “identified staff” – senior management, risk takers, compliance professionals and any employee whose total remuneration falls into the above brackets or whose duties have a material impact on the risk profile of the fund.

The rules also state that larger firms must create a remuneration committee, a provision detailed in last June’s draft ESMA guidelines. The pan-EU markets watchdog said it wasn't possible to create an airtight definition on what constitutes a “large” firm, but said that firms managing less than €250 million would likely be exempt from the rule.

The latest rules ask firms to consider the “size of funds it manages, its internal organization, the nature, scope and complexity of its activities” when deciding if it would be captured by the rule.

ESMA chairman, Steven Maijoor, said that the guidelines “will help promote prudent risk-taking by fund managers and help align the interests of both fund managers and investors” in a statement.