On 1st January 2018, the European Regulation on Packaged Retail Investment and Insurance Based-Products (PRIIPS) entered into force, obliging all fund managers who “manufacture” a product with the objective of presenting an investment opportunity to retail investors to offer these investors a Key Information Document (KID) detailing the risk profile and expected performance of the product.
This Guide covers the main provisions of the law and the latest guidance from the European Commission. The Guide is for the exclusive use of the persons to whom it is addressed and is intended for general information purposes only. It is not intended to constitute legal advice and should not be treated as such.
In this Guide we will refer to the following documents:
- Final PRIIPs Regulation (referred to as “the Regulation”), which sets out the scope and the general requirements
- Commission Delegated Regulation (the “Delegated Regulation”), which details the specific content of each KID)
- Commission Guidelines (“the Guidelines”) and ESAs Q&As (“the Q&As”), which both clarify certain elements of the proposal
What is a KID?
The KID is a short (three sides of A4 sized paper) pre-contractual disclosure document for a retail investor (Article 6 of the Regulation). It contains information, on, inter alia, the product, its potential risks and returns and its costs. As the KID presents information in a standardised format, it is designed to allow an investor to make a side-by-side comparison of a wide range of investments.
What is a PRIP?
A PRIP is an investment where the amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or the performance of one or more assets which are not directly purchased by the retail investor (Art 4.1 of the Regulation). This includes all investment funds, and potentially private equity carried interest and co-investment schemes.
What is a retail investor?
A retail investor is any client that is not a professional client defined in Annex II of MiFID II. The retail category typically includes public sector bodies, local public authorities, municipalities and private individual investors (in particular, individual staff members and high net worth individuals (HNWI)), but not financial market entities or large undertakings.
Certain clients can become professional investors upon request, if they follow the process and comply with the criteria contained in Annex II of MiFID II, point ii: size of their portfolio, professional background (e.g. if they work or have worked in the financial sector for a year), and volume of financial market activity they undertake (based on the average frequency of their transactions); and provided they state in writing they are aware of the consequences of this choice. Member States may also impose their own criteria to determine whether municipalities and local public authorities can be deemed professional upon-request.
When do I have to produce a KID?
The Regulation applies to “manufacturers” of PRIIPs (in most cases, a fund manager, but it can also be the sponsor, the management company or a fund’s board of directors or managers) and persons selling a PRIIP (any person offering or concluding a PRIIP with a retail investor – which may be the manufacturer itself or a distributor).
A fund manager will be deemed a PRIP “manufacturer” as it “packages or wraps together assets so as to create different exposures, provide different product features, or achieve different cost structures as compared with a direct holding” (Recital 6 of the Regulation). In practice, it is the action of providing an investment opportunity subject to risk to a retail investor that triggers the production of a KID.
According to the Guidelines, the Regulation applies to PRIIPs made available to retail investors within the territory of the Union, including entities and persons from third countries. The obligations provided for by the Regulation apply consequently to retail investors within the territory of the Union who decide to subscribe or purchase third country PRIIPs.
Any fund manager that “makes available” a PRIIP to retail investors in the EU must draw up a KID and publish the KID on its website before the PRIIP is made available. The KID must then be provided “in good time before the retail investors are bound by any contract or offer relating to that PRIIP”, unless in very specific circumstances (as defined in Art 13 (3) of the Regulation).
With the exception of those already using UCITS-like KIIDs, there is no grand-fathering for existing products (which are being offered to EU retail investors) or current fund-raisings.
There appears to be no basis for avoiding application of the PRIIPs Regulation where a fund is sold on a purely incidental basis to retail investors. The PRIIPs Regulation may also apply where an interest in a fund is sold on the secondary market to a retail investor.
Should I produce a KID for prior fund-raisings?
A fund operating via commitment agreements and subsequent drawdowns will not have to produce a KID for drawdowns made after 1 January 2018 in the event that the commitment agreement has been signed by the retail investor prior to such date. Should the retail investor however make top-up investments after 1 January 2018 and the underlying terms and conditions change, a KID will have to be produced. Should the underlying terms and conditions however remain unchanged, no KID production will be triggered. Where contractual terms and conditions allow exiting the PRIIP, but that PRIIP is no longer made available to other retail investors after 1 January 2018, a KID is also not required.
Are there situations where I do not have to produce a KID?
The scope of the PRIIPs Regulation is very wide and applies to “all PRIIPs manufacturers and persons advising on, or selling a PRIIP”.
However, the PRIIPs Regulation only applies to products “that are manufactured by the financial services industry to provide investment opportunitiesto retail investors where the amount repayable to the retail investor is subject to fluctuation because of exposure to reference values, or subject to the performance of one or more assets which are not directly purchased by the retail investor”.
There is no legal clarity on the treatment of carried interest or co-investment vehicles, which (arguably) do not fulfil the definition of a PRIP (i.e. no “packaging” element).
What does the KID contain?
The KID is a stand-alone document, containing a summary of the investment and information on risks, performance scenarios and costs. The KID must be short, concise and a maximum of three sides of A4. The Regulation prescribes the contents for the following sections:
- General information (including name of product, manufacturer and, where applicable, a “comprehension alert”)
- What is this product? (covering the nature and main features of the PRIIP, including investment objectives and type of retail investor to whom the PRIIP is intended to be marketed)
- What are the risks and what could I get in return? (including the level of risk (see below), a brief description of the PRIIP’s risk and reward profile and an indication of the possible maximum loss)
- What happens if the manufacturer is unable to pay out? (an indication whether the investor may face a financial loss due to the default of the manufacturer or the default of an entity other than the PRIP manufacturer – unlikely to be relevant in the private equity context)
- What are the costs? (covering costs associated with the PRIIP)
- How long should I hold it and can I take money out early? (including a description of the recommended, or minimum, holding period)
- How can I complain?
- Other relevant information
The Delegated Regulation provides a template.
The KID can be provided on paper or in another durable medium, subject to specific conditions. Marketing communications must indicate that a key information document is available and supply information on how and from where to obtain it, including the manufacturer’s website.
What is the ‘risk indicator’ and how do I calculate it?
The “risk indicator” (on a scale from 1 to 7, 1 being the least risky) is an expression of the product’s market risk and credit risk. The PRIIPs Delegation Regulation (Annex II) prescribes the method for calculating market risk and credit risk.
The market risk measure (a “MRM”) is measured by the annualised volatility corresponding to the value-at-risk (a “VaR”) of the amount invested over the “recommended holding period”. PRIIPs or underlying investments of PRIIPs which are priced on a less regular basis than monthly, or which do not have an appropriate benchmark or proxy, will be classified as “Category 1” PRIIPs (with a deemed VaR equivalent volatility of 30%-80%), and will not need to calculate their volatility. It is thought that most private equity funds will be classified as “Category 1” PRIIPs, although firms should make their own determination.
The credit risk measure (a “CRM") is calculated where the return of the PRIIP or its underlying investments depends on the creditworthiness of the manufacturer or other party which is bound to make payments directly or indirectly to the investor. Funds are taken to present no credit risk in themselves, whereas their underlying investments may present a credit risk. According to the ESAs’ Q&A (Question 18), equity holdings in companies do not carry credit risk. For a fund which makes investments that entail credit risk (such as loans to portfolio companies), the credit risk is assessed in relation to the credit risk of the underlying investments or exposures. The CRM is calculated based on the credit rating assigned to the underlying investment by an external credit assessment institution certified or registered with ESMA or (in the absence of this type of credit rating) a default credit rating.
Once the MRM and CRM have been determined, the Single Risk Indicator ("SRI" - c.f. point 52. of Annex II of the Delegated Regulation) is determined according to this table.
It is important to note that a fund which is a “Category 1” PRIIP will automatically have a MRM of 6 and as a result a risk indicator of 6. The CRM will make no difference to this measure but firms will be required, according to the Q&As (Question 19), to include a brief explanation of the product classification in the narrative explanation. As this explanation may differ depending on the CRM classification, the CRM still needs to be calculated.
The risk section also needs to contain a specific warning if the product has a materially relevant liquidity risk or is illiquid. Closed-ended private equity funds will generally be considered as illiquid.
What are the four “performance scenarios” of my product and how do I calculate them?
The PRIIPS KID does not show past performance. Instead, the KID models possible returns based on four scenarios: a stress scenario, an unfavourable scenario, a moderate scenario and a favourable scenario (Annex IV of Delegated Regulation).
The scenarios must be calculated for various specified periods within the product’s recommended holding period as follows:
- Unfavourable scenario is value at 10th percentile
- Moderate scenario is value at 50th percentile
- Favourable scenario is value at 90th percentile
- Stress scenario is the value of the PRIIP according to a set methodology for “Category 2” or “Category 3” PRIIPs. There is no set methodology for “Category 1” PRIIPs
Performance is calculated net of costs and presented in monetary (based on a notional EUR 10,000 investment) and percentage terms (as the average annual return of the investment). In a private equity context, performance in percentage terms is expected to be internal rate of return, although this is not prescribed by the PRIIPs Regulation.
For “Category 1” PRIIPs (see section 8 above), firms must make a reasonable and conservative best estimate of the expected values for the various performance scenarios at the end of the various holding periods. For new funds without a track record, firms could look to other funds or peer funds when estimating performance.
For any product with a recommended holding period longer than 3 years, the four scenarios will need to be shown in the cases where the investor wants to cash in after 1 year, after half of the recommended holding period and at the end of the recommended holding period.
In total, 12 performance scenarios must be given to the investor and presented in monetary and percentage terms.
What are the costs of the product and how do I calculate them?
The KID must disclose the following costs (Annex VI of Delegated Regulation):
- One-off costs (entry or exit costs which are either paid directly by the retail investor or deducted from a payment received from or due to the retail investor), such as distribution fee, constitution costs, marketing costs and subscription fees incl. taxes.
- Recurring costs (payments deducted from the fund’s assets that represent expenses in the fund’s operation, including transaction costs), such as management fee, custody and depositary fees, audit and legal fees, distribution costs (state maximum of possible known), financing costs related to borrowing, payments to third parties to meet costs incurred in connection with the acquisition or disposal of assets in the fund’s portfolio (transaction costs), the value of goods or services received by the manager in exchange for placing orders with dealers and earnings from efficient portfolio management techniques.
- Incidental costs (performance related fee or carried interest).
Transaction costs must be calculated on an annualized basis, based on an average of the transaction costs incurred by the PRIIP over the previous three years. The aggregate transaction costs are summed and converted into a percentage by dividing by the average NAV of the PRIIP over the same period.
Actual transaction costs (for any type of “transferable security”) are calculated as follows: for each purchase, subtract the net realized execution price from the price of the instrument at the time the purchase order is transmitted to another person for execution (the “arrival price”) and multiply by number of units purchased (vice versa for each sale). The net realized execution price is the price at which the transaction was executed, include all commissions and taxes. The arrival price is the mid-market price of the investment at the time when the order to transact is transmitted to another person. This may generate a negative figure. For private equity, the calculation could include in particular the use of best estimates adopting as proxies either a comparable PRIIP or a peer group.
For new PRIIPs that have been operating for less than 3 years, transaction costs are calculated either based on an estimate of the portfolio turnover in each asset class (using a methodology based on reference indices) or an average of the actual costs incurred during the period of operation.
Carried interest is calculated based on historical data or (where the fund is new) using the return of a comparable fund or peer group. The manager may state that no carry is paid below a preferred rate of return. If no carried interest is taken during the recommended holding period, the manager should indicate that a payment of a defined percentage of the final return will take place at the end of the life of the fund if, and only if, the fund achieves results above the preferred rate of return.
The KID includes a “Costs over time” table, which estimates the impact of costs on return of the fund for three different holding periods, assuming an investment of EUR10,000, showing total costs and impact on return as a percentage. It also includes a “Composition of costs” table, which shows the impact each year of the different types of costs on the investment return the fund might get at the end of the recommended holding period.
How often should I update the KID?
The KID should be updated at least annually and on an on-going basis where the “manufacturer” becomes aware of something that might affect its accuracy, such as new market data becoming available or a change in investment strategy. In these circumstances, the KID must be reviewed “without delay”. The KID must be published on the PRIIP manufacturer’s website within 5 days of its finalisation.
If the product is closed to new investors, it appears that it is no longer necessary to maintain the KID, even in circumstances where investors make changes to their commitments provided they are subject to the same contractual terms and conditions. Article 15 of Delegation Regulation states that “PRIIP manufacturers shall establish and maintain adequate processes throughout the life of the PRIIP where it remains available to retail investors”.
What are the consequences of not complying?
The PRIIPs Regulation states that the “manufacturer” will not incur liability on the basis of the KID unless it is misleading, inaccurate or inconsistent with the underlying documentation or with the contents specified in the PRIIPs Regulation. The PRIIPs Regulation also states that a retail investor who demonstrates loss resulting from reliance on a key information document under these circumstances may claim damages from the PRIIP manufacturer for that loss in accordance with national law.
This is saying, on the one hand, that there will be liability for the “manufacturer” for producing a misleading KID; on the other hand, that any liability is governed by local law (such as negligence or fraudulent misrepresentation). It is not currently clear whether the PRIIPs Regulation gives investors a claim that they would not otherwise have under local law.
There will also be liability to the relevant regulator. The PRIIPs Regulation sets out the minimum sanctions that must be imposed by member states for breaches.