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Hedge Fund Industry Requests Exemptions for Fund Advisers from Proposed UK Remuneration Code

By Jim Hamilton

Citing fundamental structural differences between hedge fund advisory firms and other financial firms, the hedge fund industry asked that the firms be exempted from some provisions of the proposed UK Remuneration Code. In a letter to the Financial Services Authority, the Managed Funds Association also requested an appropriate transition period for hedge fund advisers since the timelines for implementation, which begin as early as January 1, 2011, do not provide sufficient time to allow firms to implement changes that may be required as a result of the Code. While strongly supportive of the Code?s goal of developing compensation policies that promote effective risk management, the MFA pointed out that the significant management ownership in the funds managed by the adviser ensures that an adviser and its senior employees seek long-term profits and discourages excessive short-term risk taking.

Unlike many financial institutions, hedge fund advisers are typically privately owned and, therefore, do not have public shareholders. Moreover, the principals who own the hedge fund adviser are also typically the adviser?s senior management with primary responsibility for the portfolio management activities and oversight of other adviser employees. Thus, unlike financial institutions with public shareholders, the management and ownership of hedge fund advisers is integrated, not separated, thus ensuring an alignment of interest providing a strong incentive to manage risks.

Because the structure of hedge fund advisers promotes alignment of interests between management and ownership, the MFA believes that hedge fund advisers do not need to be subject to those provisions in the Code that are designed to achieve the same result. The association also believes that payments tied to a person?s ownership stake in a hedge fund adviser should not be treated as remuneration and should thus be deemed outside of the scope of the Code. In the MFA?s view, the treatment of these types of payments as remuneration under the Code would unfairly subject the owners of one type of business structure to restrictions on their ownership interests.

Similarly, the MFA noted that the revenue model for hedge fund advisers is distinct from that of other financial firms since hedge fund advisers generate profits by receiving management and performance fees for successfully managing client assets as distinct from trading their own. Moreover, because hedge fund adviser fees are generally not subject to claw-back, profits earned for the adviser are not subject to the risk of future loss. Further, because the principals of the hedge fund adviser typically have significant amounts of their own capital invested in the funds they advise, and because the performance fees earned by the adviser typically are subject to high-water marks, the fee structure for advisers is designed to encourage long-term profits and to discourage excessive short-term risk taking.

The FSA proposal seeks to include the senior management and primary risk takers within the scope of the Code. The MFA fears that the definition of ?Code Staff? is overly broad in two key respects. First, the reference to risk takers in the definition and the related guidance potentially includes junior persons within a hedge fund adviser as well as persons who do not make material risk judgments on behalf of the adviser. The association urged the FSA to provide further guidance on the types of persons intended to be included in the term ?risk taker,? which should provide flexibility based on the different types of business models and structures of firms subject to the Code. Second, the MFA is concerned that there are global hedge fund advisers who have registered personnel within their international groups with the FSA as approved persons performing significant influence functions who appear to fall within the definition of ?Code Staff? even when they are not employees of the UK firm and do not receive any remuneration from the UK entity.

In the MFA?s view, employees of a non-European parent entity of a UK entity should not be deemed Code Staff unless they receive remuneration from the UK entity. This is the appropriate treatment even if that person is registered with the FSA as an approved person performing a significant influence function.

Because hedge fund advisers earn annual fees not subject to claw-back or other future adjustments, the MFA believes that Code requirement to defer 40 to 60 percent of variable remuneration over a period of at least three years should not be applicable to hedge fund advisers. The association is also concerned that the deferral requirements could have adverse tax implications on senior employees of hedge fund advisers. Because these senior employees are also likely to be owners of the adviser, said the MFA, much of what may be deemed variable remuneration is related to their ownership stake. As a result, the deferral requirements of the Code could result in these senior employees having tax liabilities in excess of the amount of cash they are permitted to earn under the Code in a given year.

Another Code provision on the payment of 50 percent of variable remuneration in shares
is not practicable for hedge fund advisory firms with no active market for the ownership interests in the adviser. This creates complications if those interests have to be used as remuneration for employees. Moreover, employees that receive those interests would be extremely limited in their ability to dispose of them at a future date.

Finally, the MFA cautioned that the Code?s ratio provisions requiring hedge fund advisory firms to contractually pay their employees a higher percentage of fixed remuneration would have the unintended consequences of restricting the firm?s ability to limit total remuneration in difficult times when many hedge fund advisers face severely reduced bonuses and of limiting the firm?s flexibility in periods of underperformance. Higher fixed remuneration would also disrupt the alignment of interests among the advisory firm, its employees and the adviser?s clients that results from the current revenue and remuneration structures of hedge fund advisers.

Full post as published by Jim Hamilton's World of Securities Regulation on October 16, 2010 (boomark / email).