Almost ten years in the making, in January 2018, the Packaged Retail and Insurance-based Investment Products (PRIIPs) regulation came into effect. Its aim is to help retail investors to better understand and compare the key features, risks, rewards and costs of different PRIIPs through access to a Key Information Document (KID), to encourage efficient EU markets.
What are KIDs and PRIIPs?PRIIPs is an EU regulation that aims to protect retail investors who have invested in products that are not typical Undertakings for the Collective Investment of Transferable Securities (UCITS) retail funds. (UCITS is a regulatory framework of the European Commission that creates a harmonised regime throughout Europe for the management and sale of mutual funds.)
PRIIPs regulation covers investments where, irrespective of the legal form of the investment, the amount repayable to the retail investor is subject to fluctuations because of exposure to the performance of one or more assets, which are not directly purchased by the retail investor.
The principal way of protecting investors under the regulation is to help retail investors better comprehend and then compare the key features, risks, rewards and costs of a PRIIP investment by providing them with a key information document (KID) prior to investment.
Why were KIIDs introduced? Key Investor Information Documents (KIIDs) as a concept is fairly well established in the world of UCITS retail funds. They detail key facts about the way each fund works and its investment risks and assist customers in making an informed investment decision.
However, KIDs will eventually replace any remaining KIIDs by 1 January 2020.
A main benefit of a KID is that it is produced in the same format and with the same structure – so in theory, an investor can pick up KIDs for a range of funds and easily compare them at a glance.
What are KIDs supposed to achieve? KIDs are designed to increase transparency for retail investors and allow them to better compare products; this, in turn, is designed to aid investor protection and competition among managers.
How do KIDs and PRIIPs relate to each other? The KID, and the obligation on a fund manager to produce a KID, is one of the key components of the PRIIPs regulation.
How has MiFID II changed KIDs and PRIIPs? The main change arises because of how definitions are used in the two pieces of legislation.
PRIIPs regulation states that a KID has to be produced and supplied for any fund that is not a UCITS fund and that it is ‘made available’ to retail investors. This phrase is undefined in the PRIIPs regulation. The logical conclusion is that if any retail investor can subscribe for an interest in the PRIIP, the PRIIP has been made available to retail investors.
The definition of retail investors is taken across from the Markets in Financial Instruments Directive II (MiFID II), and MiFID II introduces a tightening up of this definition. The definition now catches anyone who is not a professional client, such as high-net-worth individuals, sophisticated investors (such as staff, family and friends of a fund manager) and certain public authorities (for example, municipalities and local authorities).
Under MiFID II, investors that are not automatically considered ‘professional clients’ must meet certain requirements set out in two tests (a qualitative test and a quantitative test) in order to elect to be able to be treated as ‘elective professional clients’ and not as retail investors. However, these tests are quite stringent. This means that many fund managers might be surprised to find out that their traditional high-net-worth investors, and even staff members, cannot pass the two tests and become an elective professional client. They are therefore de facto a retail client for the purposes of the PRIIPs rules and a KID now needs to be produced for the fund in question.
What is the methodology behind the information quoted in KIDs?There are a number of different areas that need to be covered in the KID. In particular, the KID has to cover:
- Performance scenarios: the average return per year after costs for future performance, presented in four scenarios (unfavourable, moderate, favourable and stress). These scenarios must be presented midway between and at the recommended holding period for a product, which will generally be one year.
- Costs: all direct and indirect costs incurred by the investor must be included and presented by their impact on returns, averaged over the holding period. This includes transaction costs (calculated on an annualised basis on an average of the costs over the previous three years), and implied costs such as opportunity costs. Transaction costs must be calculated according to a prescribed methodology set out in regulatory technical standards, which accompany the PRIIPs regulation.
- Risk indicator: managers will need to assign a summary risk indicator to the PRIIP by giving it a number on a scale from one (being the lowest risk) and seven (being the highest risk). The methodology to determine the relevant number is based on detailed market risk and credit risk calculations. Most illiquid and riskier fund products, such as private equity and hedge funds, will tend to be on the riskier side of the scale.
Are they appropriate for UK investors?
About the expert
Christopher Good’s practice focuses on private funds, advising sponsors on global fundraisings and investor negotiations, spin-out arrangements, incentive structures, together with primary and secondary fund transactions.
He is also regularly asked to advise a number of UK and international institutional investors on their primary investment programmes, co-investments and management arrangements with fund sponsors.
Christopher has previously spent time on secondment in the legal teams at both Legal & General Asset Management (2013-2015) and Goldman Sachs Asset Management (2009). He is a member of the Association of Partnership Practitioners and sits on Invest Europe’s working group on legal and regulatory affairs.KIDs will be useful to UK investors but, given that PRIIPs regulation covers all fund types other than UCITS, this usefulness will vary depending on the fund structure and context. For example, a UK retail investor investing into a complex fund might find a KID very useful, whereas staff members investing into their own company’s co-invest or carried interest vehicle will not derive much or any benefit from the KID.
What aspects of post-MiFID II KIDs have attracted criticism from the big fund management companies?The key criticism is that the ‘one size fits all’ approach means that some managers will be forced to produce a KID for fund products where the participants are, by definition alone, ‘retail’ investors, but, in the context of the actual investment, are highly knowledgeable (such as repeat investors or staff members investing into a fund managed by their employer).
What are some other issues that have arisen from the KIDs and PRIIPs implementation? One of the main issues for managers is that they need to comply with some quite strict details set out in the PRIIPs regulation, with the requirement to create a KID that is fair, clear and not misleading.
For example, following the methodology in the PRIIPs regulation on how to forecast performance or how to calculate costs may not reflect what the manager does in practice (particularly in relation to strategies that focus on buying illiquid assets) and lead to over or understatement of the actual figures. Alternatively, a manager may not be able to get all the information on underlying costs or charges from underlying fund investments, because those investments are outside of the EU and do not themselves produce KIDs.
Are they overall a good thing? While the intention of increasing transparency for retail investors is admirable, the scope of the PRIIPs regulation means that the same sets of rules have to apply to managers running open-ended equity products that routinely take in retail investors, or managers operating hedge funds or carried interest schemes where the only individual investors who participate are ‘sophisticated’.
Further clarity and guidance on when KIDs do not have to be produced (for example, for internal staff schemes) or relaxations for certain of the prescribed calculations would help managers, as would more tailored rules that recognise differences in different types of fund product.
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