Clamping down on comp?

For some time now European private equity managers have been expecting significant reforms to their compensation models following passage of the Alternative Investment Fund Managers (AIFM) directive. Since 2010, when the directive was first introduced, PE Manager has reported that the bill will bring about a number of sweeping changes to how the industry operates, including its pay structures. 

Yet, there remains a lack of clarity on certain items in the recently released AIFM remuneration guidelines, such as how to classify carry. While that’s got a number of insiders worried, one lawyer suggested the guidelines pretty much just mandate what most private equity firms already do: control risk-taking, ensure investor alignment and limit rewards to investments proven to be successful.

That’s largely because fund managers are only awarded a performance bonus (carried interest) after investors are first awarded a preferred return. And a ‘clawback mechanism’ on carry ensures GPs are never paid too much should a buyout fund later turn sour. Those agreements are precisely what regulators had in mind when originally writing remuneration rules for bankers, but which have now made their way to the private equity industry under AIFM.

To its credit, the European Securities and Markets Authority (ESMA) has acknowledged this much by saying certain GPs will not need to defer carry payouts – as is required for other types of variable remuneration under the guidelines. However, to enjoy this exemption, GPs will need to adopt a distribution ‘waterfall’ that provides investors all of their capital contributions, plus a preferred return (typically of about 8 percent) before the GP can start collecting carry – a waterfall distribution model already popular in Europe.  

At any rate lawyers are advising GPs to map out their current remuneration practices and work out what they need to change in order to meet the directive’s requirements, including thinking about whether the firm’s size and complexity warrants a remuneration committee. Most likely, they’ll find that not too much work needs to be done. 

The risk moving forward  will be how EU sovereigns interpret the guidelines when implementing the directive into national law over the coming months as ESMA has provided some wiggle room for national regulators to ‘gold plate’ the rules. It will be at that time that GPs will really feel the effects of Europe’s grand scheme to create a harmonized marketing and regulatory regime for private fund managers.