The FSA Remuneration Code has raised barely a ripple among UK investors. It is just a dry run for the real thing. Shayla Walmsley reports

The FSA Remuneration Code that came into effect at the beginning of 2011 barely raised cheers or sneers from UK fund managers. It isn't that piece of regulation they're worried about. Where there's any excitement at all over the code, it's because it's a dress rehearsal for the AIFM Directive.

Aimed at banks, the FSA code now covers fund managers and real estate, too. Senior managers and fund managers - as well as investment research managers - are among those targeted by remuneration strictures designed to penalise (or at least not to reward) risky behaviour. They include a three-year deferral on parts of bonuses, a mandatory non-cash element in bonuses, and an end to guaranteed bonuses for existing staff.

If anything might strike fear into the heart of the average real estate fund manager, it is this, from a note on the code issued issue in February by law firm Nabarro: "Pay in the European Union is now the most severely restricted in the world and the UK leads the pack."

So are property fund managers worried? Not especially.

Meekhal Hashmi, legal counsel at Old Mutual, doubts that most fund managers will come within the purview of ‘code staff' - the material risk-takers, the risk analysts. Those who might be understood as subject to the code, who were interviewed by IP Real Estate, believed they would be contained within the tier 4 carve-out, which will effectively allow them not to apply parts of the code. MIFID-exempt firms will escape the code altogether.

Just because they've been carved out of the code, fund managers should pay it some attention, according to Alistair Woodland, a partner at law firm Clifford Chance - on the one hand, because exemptions are not automatic, and on the other, because there's worse to come.

Woodland argues that the FSA code is effectively a dry run for the EU Alternative Investment Fund Managers (AIFM) Directive scheduled for transposition into UK law in 2013. That's why fund management firms need to ensure they identify the right people internally: because the people identified as ‘code staff' now will be the same group of employees caught by the remuneration provisions in the AIFM Directive.

"This means that firms should think about how they document the decision to take advantage of those exemptions," he says. "If an employer casts the net too widely now, it may get stuck with applying the AIFM Directive rules to those identified as code staff."

David Brown, head of Deloitte's real estate funds practice, says the real issue is that when the AFM Directive comes in, it will be difficult for the FSA to carve out tier 4 institutions. Although the FSA hasn't thought through how it will apply the code to asset managers, the latter should know it's "a temporary reprieve" before the AIFM Directive.

You might assume that fund managers are inherently hostile towards the AIFM Directive. But they aren't necessarily. Adrian Benedict, investment director at Fidelity, describes it as a "fantastic step forward" - with a few caveats.

"Many people have forgotten what the AIFM Directive was supposed to achieve," he says. "It provides an EU passport to market products across Europe. It's incredibly important to the alternatives sector not covered by UCITs."

He adds: "As with any other piece of regulation, there are things we like, things we don't like, and things we are ambivalent about - but at least it means we don't have to go to regulators in the UK, France, and Spain to market a European product."

The issue is not whether those things should be happening but about whether it's for the regulators to make them happen. Benedict points to long-standing open discussions about gearing, risk management and how fund managers do business.

"We're comfortable with the regulation on those issues," he says. "Clients are giving us money to invest, and they have a right to that information."

Benedict compares the new rules on disclosure to long-required disclosure standards for equities and bonds. "It's a step towards getting the same level of disclosure and frequency of disclosure in real estate," he says. "In the crisis, investors say the good managers alerted them early and came up with solutions. It's not about bad times but about how you deal with problems in bad times."

He adds: "I'm not suggesting real estate should copy equities, with daily pricing. But this should be one standard valuation methodology."

Not that he'll be drawn on which methodology that should be. "I'd like to see harmonisation," he says. "There is a role for the market and a role for policymakers. Over-regulation isn't healthy, but neither is an unfettered market."

For Benedict, regulation, including the FSA Remuneration Code, is a good thing because it will further encourage investors to focus on risk as well as reward. Another consequence, intended or unintended, will be to bring real estate up to speed with other asset classes.

"Our cousins in equities and bonds talk about return but also about the volatility of return," says Benedict. "We're already seeing on the ground that risk is a talking point for investors coming from overseas."

He cites a recent IP Real Estate webcast on risk that attracted record registrations. "It is a hot topic," he says.

Perhaps in the end it's not so much fund managers anticipating investors on one side and regulators on the other. Perhaps it's rather a case of all of them facing the same direction.

Benedict says it would be a mistake to underestimate the importance of corporate governance to investors, as well as regulators. Between 2007-10, the priority was fixing problems. Now the market has stabilised, alongside performance investors are talking about governance, portfolio transparency and communication.

"It's more of a live issue for pension funds as an audience but it's not exclusive to them [as a group of investors]," he says. "These are topics we're hearing more and more about from investors in the Nordics, in Korea, and in the Middle East."

Pension funds care about manager pay, too, and in a more individual way than before, according to PwC real estate partner John Forbes. Although few funds have been raised over the past three years, now the market is coming back it's clear that investors are looking at individual remuneration of fund managers. "Now that fund managers are starting to go out looking for capital, it is apparent that investors are serious about it," he says.

Whereas before some fund managers were focused on the carry and co-investment, others were focused on the management house. Now the focus is on the individual fund manager.

"More people are incentivised according to alignment of interest," says Forbes. "They want reward structures that mirror what investors want - and investors want a return for investors. That includes rewarding individual fund managers over the life of the fund." Investors are also paying more attention to detail - focusing, for example, on catch-up fees.

"If you're a fund manager and you think regulation is a big problem, you don't know how far investors have moved," he says.

Forbes attributes the change not to regulation but to industry organisations such as INREV, especially that body's due diligence guidelines, which have given investors more traction by sharing knowledge. Likewise Harry Humble, investment director at Hunter Property Fund Management, reckons badly burnt investors had wanted performance-based valuations before regulators stepped in. "The industry will expect this from managers whether the regulatory framework says you have to do it or not," he says.

"Investors can dictate terms at the moment. Those allocating can make their voices heard. When that changes, managers will be in a stronger position. We're pretty sanguine about it here - but it's probably easier to implement if you're a niche, manager-owned business."

According to Nabarro, UK financial services will find it difficult to recruit and retain top talent and they'll find themselves at a competitive disadvantage as a result. But if, say, the absence of pure cash bonuses were to drive top talent out of the UK, where would they go? Not to mainland Europe, where AIFMD can still get them. So the US - or Asia?
It's unlikely. Targeting real estate managers is like shooting fish in a barrel: it's too local a business to allow much by way of transfer of personnel or skills.

"I doubt that will lose talent outside of Europe," says Will Anderson, property finance director at Henderson Global Investors. "It's not easy for a real estate professional to relocate. These are not transferable skills in that sense and local knowledge is important in this industry."

In any case, in the UK there have already been plenty of reasons to move, according to Brown. "There is insufficient cause in this for real estate fund managers to move elsewhere. Besides, there are competing disincentives. In fact, among our global clients, US fund managers are considering moving to Europe. They'd rather be under the AIFM Directive than Dodd-Frank."

Like we care
It's hard to see this hands-up approach to regulation as anything other than bowing to the inevitable. Anderson says he endorses the principles of the regulation because clients want to know how the firm remunerates managers and being open about pay does the firm no harm.

"If I'm a pension fund and I invest £20m [€22.7m], I want to understand what makes the manager tick," he says. Likewise the FSA's bonus stipulations, which he claims will improve alignment between fund managers and investors.

But the fact that all three - fund managers, investors and regulators - are fixated on the same issues doesn't mean that there is necessarily an alignment of interest between investors and regulators. "I'm not sure they care," says Anderson. "Is it something investors want or need? I'm not sure the answer is yes."

What it will do, say some property fund managers, is align real estate fund managers with fund managers in other asset classes. "The property industry needs to play by the same rules, even if the background to the regulation - the financial crisis - meant that the property industry got carried along with a primary focus on hedge funds and private equity," says Anderson of the AIFM Directive.

He points out that up to now parts of the property fund business haven't been regulated. Most of Henderson's pooled property funds are regulated in Jersey or in Luxembourg, for example, but the funds it manages from the UK are not regulated by the FSA because they aren't retail funds.

"We're part of a larger house and there are standards we're expected to follow, says Anderson. "But it's possible that other funds would not be following similar standards."

He describes it as "an anomaly" that alternatives are not regulated to the same extent as mainstream asset classes. If smaller fund managers will find it uneconomic to pay the additional compliance costs and consolidate with larger fund management houses, that's so much more opportunity for the latter.

What creates uncertainty among fund managers is not the content of the regulations themselves but the sheer volume of it due over the next couple of years.

Solvency II will require insurers to scrutinise the market risk of their investments, including those in real estate. The AIFM Directive - described by Nabarro in its February note as "a messy compromise" - though designed to cover hedge funds and private equity, will bring real estate fund managers directly into the mix. European Market Infrastructure Regulation (EMIR) regulation covering over-the-counter derivatives will include out-of-the-money interest rate swaps often used by real estate investors, including pension funds.

In other words, 2013 will be a hard year. "I'm remarkably unsentimental about it," says Forbes. "Fund managers need to be planning how they get through 2012. Those who don't will face a very sweaty time."