London hedge funds secure victory over pay

Hedge funds are set to benefit from more lenient rules governing pay than originally expected under new draft proposals from the UK regulator.

The Financial Conduct Authority recently published long-awaited guidelines detailing how it plans to implement the Alternative Investment Fund Managers Directive, which aims to curb the buccaneering habits of the alternative fund industry in Europe.

The hedge fund industry was particularly concerned by the potential impact of new pay measures, which will force managers to receive half of their pay in units of their funds and to defer payment over longer time periods.

The directive also requires fund groups to make sure they can subsequently adjust an individual’s pay or claw back some element of pay that has already been awarded.

But, according to draft guidance from the FCA, companies with between £500m and £1.5bn of assets under management in alternative funds may be allowed to opt out of the pay restrictions.

In its consultation paper on the guidance, the FCA says: “We believe that by providing this guidance on proportionality, including setting these thresholds, there should be no significant costs incurred by AIFMs.

“This is because this guidance is likely to provide [alternative fund managers] with greater certainty as to the application of proportionality, and potentially exclude some AIFMs from applying the full regime.”

The proposals have been well received by industry participants, who feared the directive could put the European hedge fund industry at a competitive disadvantage to the US and Asia.

Tim Wright, director of the reward practice at PwC, the professional services firm, says the proposals were pragmatic and demonstrated that the FCA “has a grip on how diverse the industry is, from the largest asset managers in the world to hedge funds operating out of a town house in Mayfair”.

He believes roughly half of hedge fund companies authorised in the UK could fall under the threshold and be exempt from the pay rules.

Groups with more than £1.5bn of assets under management, meanwhile, could also escape the rules if they can prove that their organisational structure is simplistic, such as hedge funds with a high level of assets but that operate in one territory, or those that run non-exotic strategies or have straightforward governance processes.

The existence of the exemptions could create competitive disadvantages for large fund companies that fail to meet the necessary opt-out criteria.

Many hedge funds already impose deferral measures on staff compensation regardless of regulatory requirements to demonstrate alignment of interests with investors. Deferred pay can also serve as an employee-retention tool.

However, the deferral arrangements under AIFMD, which impose a minimum three-year period, are stricter than most existing requirements, which typically involve one to two year periods.

Bill Prew, founder of Indos Financial, the UK-based independent depositary, says “this would make smaller managers potentially more attractive to candidates”.

Mr Wright agrees that the exemptions created the “risk of an unlevel playing field”.

“Fund groups are competing for the same talent pool, and there is a risk that certain firms will be put at a competitive disadvantage,” he says.

Mr Wright adds, however, that the obligation to defer pay into funds could prove more attractive than deferring pay into company shares, a prospect facing banking staff under the Capital Requirements Directive from 2014.

Mr Prew says the guidelines demonstrate that there could also be some flexibility in how hedge fund profits are treated.

Hedge funds that are structured as limited liability partnerships, which account for most hedge funds in the UK, are likely to have their profits characterised as a dividend, rather than as variable remuneration that would be subject to a deferral.

Mr Prew believes that overall the guidelines are a “big relief” for many fund companies, and “probably as good an outcome as the industry could have hoped for”.

The positive news for alternative fund managers echoes similar developments in the mutual fund industry, which has also seen pan-European proposals on pay significantly softened.

Ucits fund managers feared that, unlike the alternative fund sector, they would have bonuses capped at 100 per cent of salary, but the European Parliament narrowly voted against the proposal last July.

The FCA plans to consult with the alternative fund industry over the exact exemption thresholds until November, and final guidelines are expected by the end of the year.

The watchdog’s deadline for complying with the rules has also been extended, allowing fund groups that gain AIFM authorisation by July 2014 another calendar year to comply.

This means that hedge fund companies that are not exempt from the pay rules may still have until spring 2016 to amend how they pay staff.

National authorities across Europe are likely to follow the FCA’s lead in how they apply the AIFM rules, although few will distribute such detailed guidelines, according to Mr Wright.

He says: “I don’t expect many other regulators to come up with formal guidance at all – they will probably tell firms to comply as they feel they should and challenge firms when they think they should.”

He adds that only countries with negligible alternative fund industries were likely to put stricter rules in place that the UK, reducing the risk of regulatory arbitrage across Europe.