What do the Rules provide?

The principles set down in Annex II to the Directive cover matters such as the rationale behind such policies; who is to set, review and be responsible for the implementation of the policies and the annual review of same; distinctions between control functions and senior officers within the risk management and compliance functions; principles regarding performance related remuneration and guaranteed variable remuneration; the balance between fixed and variable components of total remuneration; limitations on termination payments (golden parachutes); the potential composition of variable remuneration; as well as principles regarding pensions.

Dillon Eustace | 92 8.4.1 High Level Principles

The remuneration policy is required to be consistent with and promote sound and effective risk management and not encourage risk taking inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs managed.

In addition, the policy should be in line with the business strategies, objectives, values and interests of the AIFM and the AIFs it manages or the investors of such AIFs and should include measures to avoid conflicts of interest.

8.4.2 Adoption / Review / Implementation

Broadly speaking, the remuneration policy should be adopted by the management body of the AIFM (i.e. its board) which should periodically review the general principles of the policy and be responsible for its implementation. How it is implemented should, at least on annual basis, be subject to central and independent internal review for compliance with the adopted policies and procedures. These procedures are addressed at length in the Guidelines. 8.4.3 Different Staff Positions

The remuneration of senior officers within the risk management and compliance functions should be directly overseen by the AIFM’s remuneration committee. Staff engaged in control functions should be compensated in accordance with the achievement of the objectives linked to their functions, independent of the performance of the business areas they control.

8.4.4 Performance Related Remuneration

Where remuneration is performance related, Annex II to the Directive indicates that the total amount of remuneration should be based on a combination of the assessment of the individual’s performance and that of the business unit or AIF concerned and of the overall results of the AIFM. Financial as well as non-financial criteria should be taken into account when assessing individual performance.

It also indicates that the assessment of performance should be set in a multi-year framework appropriate to the life cycle of the AIFs managed and explains that the rationale behind such a requirement is to ensure that the assessment process is based on longer-term

performance and that the actual payment of performance-based components of

remuneration is spread over a period which takes account of the redemption policy of the AIFs managed by the AIFM and their investment risks.

8.4.5 Fixed and Variable Components

Fixed and variable components of total remuneration should be appropriately balanced, with the fixed component representing a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration components, including the possibility to pay no variable remuneration component.

The Directive does not impose a strict limit as to variable compensation versus fixed compensation in an absolute sense. Instead, one of the principles to be adhered to in formulating a remuneration policy is that"fixed and variable components of total

remuneration are appropriately balanced and the fixed component represents a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy, on variable remuneration components, including the possibility to pay no variable remuneration component." There is no strict limit as to the ratio between the two.

The Directive is more prescriptive in the case of the make-up of the variable remuneration itself, as discussed below under “Composition of Variable Remuneration”.

There is no limit on fixed compensation and Annex II to the Directive envisages the

possibility of paying no variable remuneration at all. AIFMs and their affected delegates will however still need to look at the general principles, being that the remuneration policy is consistent with and promotes sound and effective risk management / does not encourage risk taking which is inconsistent with the risk profile, etc.

Guaranteed variable remuneration should be exceptional and occur only in the context of hiring new staff and be limited to the first year of employment.

The principles also indicate that performance measurement used to calculate variable remuneration or pools of variable remuneration should include a comprehensive adjustment mechanism to integrate all relevant types of current and future risks.

8.4.6 Contractual provisions regarding Early Termination

Payments related to early termination of a contract should also reflect performance achieved over time and be designed in a way that does not reward failure.

“Golden parachute” arrangements for staff members who are leaving the AIFM and which generate large payouts without any performance and risk adjustment should be considered inconsistent with the principles. Any such payments should be related to performance achieved over time and designed in a way that does not reward failure. This should not preclude termination payments in situations such as early termination of the contract due to

Dillon Eustace | 94 changes in the strategy of the AIFM or of the AlFs it manages, or in merger and/or takeover situations.

8.4.7 Composition of Variable Remuneration

Where the legal structure of the AIF and its rules or instruments of incorporation allow, the Annex indicates that a substantial proportion, and in any event at least 50% of variable remuneration, should consist of units or shares in the relevant AIF or equivalent ownership interest or share-linked instruments or equivalent non-cash instruments except where the management of AIFs accounts for less than 50% of the total portfolio managed by the AIFM in which case that minimum 50% figure does not apply.

Appropriate retention policies designed to align with the interests of the AIFM and the AIFs managed and the investors in AIFs should be applied and Member States are given some flexibility in this regard at least in so far as they may be able to restrict (or ban) the types of instruments which may comprise variable remuneration.

8.4.8 Deferral of Variable Remuneration

At least 40% of the variable remuneration component should be deferred over a period appropriate to the life cycle and redemption policy of the AIFs concerned and be aligned with the nature of the risks of the AIFs in question. Unless the lifecycle of the AIF concerned is shorter, the period of deferral should be at least 3 to 5 years with vesting limitations also being imposed. It is important to note the additional principle from Annex II which indicates that the total variable remuneration shall generally be considerably contracted where subdued or negative financial performance of the AIFM or the AIF concerned occurs when taking into account both current compensation and reductions in payouts of amounts previously earned, including throughmalusorclawbackarrangements.

8.4.9 Pensions

In the case of discretionary pension benefits, as part of the variable remuneration, a staff member should not retire or leave the AIFM with such benefits vested, with no consideration of the economic situation of the AIFs that the AIFM manages or risks that have been taken by the staff member in the long term. In order to align this specific kind of pension benefits with the economic situation of the AIFs that the AIFM manages, discretionary pension benefits, where legally possible according to the relevant pension legislation, should be paid in the form ofinstruments.

Where a staff member leaves the AIFM before retirement, the discretionary pension benefits should not be vested before a period of five years and should be subject to performance assessment and ex post risk adjustment before pay out. Where the employee reaches

retirement, pensions benefits vested to that employee must be subject to a 5 year retention policy.

8.4.10 Dividends

In relation to the issue of dividends received by an owner of a delegate investment manager, paragraph 17 of the Guidelines states that:"Consideration should also be given to the position of partnerships and similar structures. Dividends or similar distributions that partners receive as owners of an AIFM are not covered by these Guidelines, unless the material outcome of the payment of such dividends results in a circumvention of the relevant remuneration rules, any intention to circumvent such rules being irrelevant for such

purpose."

In other words, the rules do not apply to dividends paid but if, irrespective of what the intention is, the "material outcome" (which is not defined in the Guidelines) of the payment of dividends results in a circumvention of the rules, then there is an issue. Clearly the

dividends are paid to the partners as owners of the firm rather than as employees.

Although not entirely free of doubt, it does not seem that the dividend related rules apply to delegates.

8.4.11 Anti Avoidance

The Annex also indicates that variable remuneration should not be paid through vehicles or methods that facilitate the avoidance of the requirements of the Directive and that staff are required not to undertake to use hedging strategies or remuneration and liability related insurance to undermine the risk alignment effects embedded in the remuneration arrangements.