Does the New SEC FAQ Impact Your Fund Calculations?

In February, the SEC published another Q&A pertaining to the 2022 marketing rule.

For CCOs working with private funds at firms that don’t claim compliance with the GIPS Standards, you’ll want to check the performance calculation input for the start date of the IRR and make certain the same date is used for both gross and net performance.  You will also want to check and make sure your disclosures are adequate in describing the methodology used.

Calculations

Most IRR calculations are in Excel so the start date for performance is typically the first date referenced in a stream of valuations. Image 1 and 2 below are from publicly available calculation tools from CFA Institute®, located on the gipsstandards.org website. Image 1 shows the inception date input, and Image 2 shows the impact of showing net performance with and without subscription lines of credit included. The most important variable in the differences in returns in Image 2 is the inception date of fund performance given the subscription line of credit.

Image 1

Image 2

If your firm doesn’t utilize fund-level subscription lines of credit, then the start date will likely be the same for both gross and net performance, and typically either the date capital is first called or the date the first investment is made.

Firms claiming compliance with the GIPS standards who utilize subscription lines of credit for periods of 120 days or longer are already required to show performance both with and without the impact of the subscription line of credit.  Net performance with and without the impact of the line of credit is also required if principal is used for a distribution.  However, even if your firm utilizes subscription lines of credit for shorter periods, this Q&A underscores the SEC’s position that only showing returns that include the impact of the subscription line of credit has the potential to be misleading.  Comparable returns (both with and without) is best practice even for shorter periods of time.

Disclosures

If your firm is currently showing net returns with subscription lines of credit, and doesn’t include comparable net returns without the impact of the line of credit, this FAQ does note that the general prohibitions may be met with “appropriate disclosures describing the impact of such subscription facilities on the net performance shown.”  Based on the current FAQ and the amended PF Rule, we believe that the best practice is to show returns that reflect gross and net performance both with and without the subscription lines of credit.

The GIPS Standards require the periods presented to be clearly labeled and include disclosure of the inception date of the fund. Additionally, if subscription lines of credit are used for 120 days or more (or if principal is used to fund distribution), firms must show both types of net returns and must disclose if composite returns do or do not reflect the subscription line of credit; the size and purpose for using the subscription line of credit; and the amount outstanding as of the most recent annual period end.

The SEC marketing rule has no “within 120 days” exception and also requires firms to disclose how returns are calculated. We recommend firms utilizing lines of credit include both inception date and descriptions of lines of credit in any marketing materials that include performance, whether you claim GIPS compliance or not.

Transparency in investment performance reporting has always been good form, and now is a good time to consider the value of GIPS compliance and verification. Or maybe, it’s enough to have your firm’s performance calculations and disclosures reviewed by an independent third party that specializes in investment performance.  Either way, we’d love to be a resource.

From SEC.gov:

Q: Must gross and net performance shown in an advertisement always be calculated using the same methodology and over the same time period?

A: Yes. Although the marketing rule does not prescribe any particular methodology or calculation for performance, the rule requires that any presentation of gross performance be accompanied by a presentation of net performance that has been calculated over the same time period and using the same type of return and methodology as the gross performance.[4] In addition, net performance must be presented in a format designed to facilitate comparison with gross performance.[5]

The staff understands that certain advisers to private funds may wish to present gross internal rate of return (“Gross IRR”) that is calculated from the time an investment is made (without reflecting fund borrowing or “subscription facilities”)[6] and then present net internal rate of return (“Net IRR”) that is calculated from the time investor capital has been called to repay such borrowing.[7] In the staff’s view, if an adviser chooses to exclude the impact of such subscription facilities from the fund’s Gross IRR, it cannot then include them in the Net IRR that is presented to comply with section (d)(1) of the marketing rule. In other words, when an adviser advertises its private fund’s performance in terms of Gross IRR and Net IRR, presenting Gross IRR that is calculated without the impact of fund-level subscription facilities compared only to Net IRR that is calculated with the impact of fund-level subscription facilities would violate the marketing rule. The staff believes that such a presentation would result in IRR calculations being made across different time periods (e.g., Gross IRR calculations beginning when funds initially use their lines of credit to acquire investments, and Net IRR calculations beginning only once all capital commitments are called and the lines of credit are retired).

This practice would also result in the use of different methodologies being used for the Gross and Net IRRs (i.e., calculating performance without and with the impact of fund-level subscription facilities). Such a presentation would also violate the provision requiring presentations of performance in a format designed to facilitate comparison between net and gross performance.[8] Accordingly, in the staff’s view, if an adviser were to include in an advertisement the Gross IRR of a private fund calculated from before capital commitments are called, then it would need also to show the Net IRR calculated from the same time before capital commitments are called (i.e., including the effect of fund-level subscription facilities in its calculation).

Further, in the staff’s view, an adviser would violate the general prohibitions (e.g., Rule 206(4)-1(a)(1) and Rule 206(4)-1(a)(6)) if it showed only Net IRR that includes the impact of fund-level subscription facilities without including either (i) comparable performance (e.g., Net IRR without the impact of fund-level subscription facilities) or (ii) appropriate disclosures describing the impact of such subscription facilities on the net performance shown. The staff believes that presenting only Net IRR that includes the impact of fund-level subscription facilities could mislead investors by suggesting that the fund’s advertised performance is similar to the performance that the investor has achieved from its investment in the fund alone.

Cascade Compliance has over 45 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.

SEC Marketing Rule – Hypothetical & Extracted Performance

Hypothetical performance and extracted performance are a key point in the SEC Marketing Rule set to take effect on November 4, 2022.  Firms that have previously used model, targeted, projected, and back tested performance need to take special care when presenting such performance to prospective clients.  The new rule is a significant change from what a lot of firms have been previously allowed to do.

Hypothetical performance will only be allowed after November 4, 2022, if the advisor takes specific steps to address its potentially misleading nature. The SEC’s goal with this portion of the rule is to ensure that advertisements containing hypothetical performance are only distributed to investors who have the financial expertise and resources to interpret the data and understand the risks and limitations of these types of presentations.

There is no distinction between retail and non-retail investors in the new rule when considering the sophistication of the audience receiving the hypothetical performance). The only exception to the hypothetical performance rule is one-on-one communications provided in response to unsolicited investor requests or provided to a private fund investor.

What is considered hypothetical performance?

Hypothetical performance is defined as performance results that were not achieved by any portfolio of the investment advisor. Hypothetical performance includes, but is not limited to: model performance, backtested performance, and targeted or projected performance returns.

Model performance includes performance where the advisor applies an investment strategy that is similar to an actual investor account but makes slight changes to the model to accommodate different investor objectives. Computer generated models are included in the definition of model performance. This type of performance was originally described in the Clover Capital No Action Letter.

Backtested performance is performance that has had a strategy applied historically to market data from prior periods when the strategy was not actually used. This includes scenarios where an advisor could backtest performance based on current strategy data and apply it historically either because the manager doesn’t have actual portfolios during the period, or because the manager doesn’t have access to portfolio books and records for the past period.

Targeted and Projected performance reflects an advisor’s aspirational performance goals. These returns reflect an advisor’s performance estimates, often based on historical data and assumptions. Projections of general market performance or economic conditions are not subject to the provision on presentation of hypothetical performance.

What’s New

  1. The advisor must create and implement policies and procedures designed to ensure the performance information provided is relevant to the financial situation and investment objectives of the intended audience of the advertisement. These policies do not need to address each specific recipient’s circumstances but rather the likely investment objectives and financial situation of the advertisement’s intended audience. Being thoughtful in your establishment of policies and procedures that connect your firm’s hypothetical performance as a useful tool for your typical clients is a key step in being ready for November 2022.

What’s Familiar

  1. The performance being presented must be net performance—just like all actual performance beginning November 2022.
  2. An advisor must provide sufficient information to the intended audience to enable them to understand the criteria and assumptions used in calculating the performance. Sufficient information includes details about how the hypothetical performance is calculated and describes any assumptions used.
  3. An advisor must provide (or offer to provide if the audience is a private fund investor) sufficient information that enables the intended audience to understand the risk and limitations of using hypothetical performance in making investment decisions. Risk information should include reasons why the hypothetical performance might differ from actual performance of a portfolio. An example of this would be external cash flow timing. Simply disclosing the possibility of loss is not enough to satisfy this requirement.

Hypothetical Performance Example

Below is sample disclosure language pertaining to risk information for prospective clients and investors to understand the hypothetical performance shown.  Much of the sample language is straight from rescinded SEC no-action guidance, and we expect such guidance to live on in the implementation of the new Marketing Rule.  While there are familiar disclosures below, we encourage firms to be thoughtful in considering the variety of reasons that their hypothetical performance may differ from actual performance.

The presented performance represents hypothetical model results during the measurement time period. As such, these results have limitations, including, but not limited to, the following:

  • model performance may not reflect the impact that material economic conditions and market factors would have had on the adviser’s decision making or on individual clients, or the impact of the timing of actual client cash flows into or out of an actual portfolio;
  • results do not reflect actual trading by specific clients, but were achieved by [describe calculation methodology and material objectives or strategies used to obtain results];
  • model performance does not reflect brokerage commissions, custodian fees, taxes, or any other expenses a client would have paid, and as such, actual investment returns would be lower;
  • how (if) model performance reflects investments that differ from advisory services currently offered; and
  • hypothetical past performance [just like actual past performance] is no guarantee of future results.

One final note on hypothetical that bridges both policies and disclosures pertaining to hypothetical performance: with the new requirement to show related account performance for actual accounts, now more than ever, it is important to have policies and procedures for reviewing actual portfolio performance to results portrayed in a model.  Results that are materially similar will lend credibility to the usefulness and relevance of the hypothetical/model performance.  Alternatively, we recommend firms reconsider using model performance where model results materially differ from the actual results of related accounts, nor can firms use model results as a replacement for doing the difficult work of aggregating related account performance histories.

Extracted Performance

Extracted performance is defined as performance results of a subset of investments extracted from a single portfolio. This type of performance is commonly known as a “carve-out” to firms that comply with the Global Investment Performance Standards (GIPS®). Additional requirements will apply to advisors who present this type of performance.

The advisor must provide, or offer to provide promptly, the results of the total portfolio from which the extracted performance was derived. This is intended to prevent advisors from cherry-picking certain performance results.

Performance that is extracted from a composite of multiple portfolios is not considered extracted performance because it is not a subset of investments extracted from a single portfolio. This type of performance (including carve-out composite performance that complies with the GIPS Standards) is considered hypothetical and will be subject to the hypothetical requirements discussed above.

The final rule does not require a specific treatment for cash allocation in extracted performance. However, it would be considered misleading to not disclose the allocation of cash and the effects of the cash allocation, or the absence of a cash allocation. When crafting disclosures to meet the SEC rule, it’s important to consider the intended audience. For firms claiming compliance with the GIPS Standards,  cash allocations and additional disclosures are required.

With the SEC Marketing Rule, please remember that when performance is shown, firms must show performance as net of fees.  Firms can also show gross of fee performance however, net must be shown in equal prominence.

Read our blog on SEC portability and predecessor performance here.

If you have any other questions regarding the marketing rule, contact us here.

Cascade Compliance has over 34 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.

 

SEC Portability Predecessor Performance

Money Can’t Buy You Love – Or Your Manager’s Predecessor Performance

A portfolio manager’s track record is an important asset and key pillar of evaluation by institutional investors/asset owners.  Ensuring that a portfolio manager’s performance can—or whether it should—go with her/him/the team to a new firm is of critical concern for planning or evaluating any transition.

At a high level, the new or acquiring firm must:

  • Make sure the strategy stays intact, with no break in performance –
  • Bring the entire team primarily responsible for investment decisions –
  • Secure books and records to support substantially similar management and “not materially higher” performance –
  • And now, with the SEC’s new marketing rule – make sure no one responsible for the predecessor performance ever retires, dies, or decides to do something different.

With portfolio managers leaving firms, and mergers and acquisitions happening frequently, the latest regulatory update on what predecessor performance can and can’t be advertised will impact the current published performance of any firms with acquired track records where key decision makers have since moved on.

Let’s say you are evaluating Firm B, which acquired a Team from Firm A with a great ten-year track record in 2018.  The Team was with Firm B for three years and advertises a 13-year track record through 2021, with a disclosure that the performance results prior to 2018 were achieved by the Team at another firm.  Then, the key portfolio manager moves on to Firm C (or buys a yacht and sets off to sail around the world).  A strict interpretation of the SEC’s new rule leaves Firm B with a three-year track record, and disclosure of the departure of a key portfolio manager in 2022.

– Whatever Firm B paid to acquire that great ten-year track record goes out the door with any key person responsible for achieving it –

What about Firm A?   Firm A can continue to show the performance of the Team from 2009 through 2018, linked to its ongoing performance, with disclosure of the departure of key personnel in 2018.

What about Firm C?  If only one member of a two-person team goes to Firm C, Firm C gets the portfolio manager, but not the predecessor performance.  If Firm C is acquiring a strategy managed by a single portfolio manager with the books and records to support the entire history, Firm C can advertise the previous performance for the full 13 years, but only as long as the portfolio manager stays at Firm C.

This strict interpretation of the SEC’s Marketing Rule, which goes into effect this November, dwarfs the nuanced differences between the SEC’s requirements and the Global Investment Performance Standards (GIPS®) portability requirements. But should the new rule be interpreted so narrowly?

Two next-level considerations that will impact predecessor performance decisions going forward:

  • Manager knowledge transfer
  • The transitive property (of equality) on books and records

Manager Knowledge Transfer:

The GIPS Standards take the position that performance belongs to the firm.  Once the Team left Firm A to join Firm B in 2018, if all the requirements were met to link the ten-year predecessor performance from Firm A, Firm B can advertise that performance. Period.

During the three years that the Team is part of Firm B, investment professionals may come and go, research analysts are trained and promoted to portfolio management, and after three years, the Team has left an imprint on Firm B, even if a key portfolio manager moves on in 2022.  According to the GIPS Standards, Firm B can continue to advertise the 13-year performance record.  CFA Institute staff has communicated in every presentation on this topic that they hope the SEC will consider manager knowledge transfer in its interpretation and enforcement of the latest predecessor performance requirements.

How long does knowledge transfer take?  Many solo portfolio managers move from one financial institution to another, without training a team, and in those cases, Firm B shouldn’t continue showing the performance of a manager no longer managing accounts there, no matter how much time has passed.  What if Firm B acquires the Team from Firm A, and after just a few weeks/months, the key portfolio manager leaves?  Can the rest of the Team remaining at Firm B carry the knowledge transfer forward?  Stay tuned – the industry is eagerly anticipating the SEC’s answers to these questions.

The Transitive Property (of Equality) on Books and Records:

We all learned in grade school that if a = b, and b = c, then it follows that a = c.

This is good news for new or acquiring firms that don’t claim compliance with the GIPS Standards: essentially, if all accounts are managed similarly, then a subset of composite performance should be substantially similar to the composite.  This is the heart of an ongoing nuanced difference between SEC requirements and the GIPS Standards: the SEC only requires books and records to support that the historical performance is for “substantially similar” managed accounts and that results are “not materially higher” than the performance of all accounts managed in that strategy.

If the Team’s strategy at Firm A was block traded, with substantially similar performance for 100 accounts, Firm B doesn’t need custodial statements or portfolio accounting records for all 100 accounts to advertise the Team’s performance from Firm A.  If 25 of the accounts follow the Team to Firm B, it’s likely Firm B could obtain statements for just those 25 accounts and support advertised predecessor results that are “not materially higher.”

If Firm B does claim GIPS compliance, the Team will need to bring books and records for all accounts to advertise and link performance from Firm A. If Firm A claimed compliance with the GIPS Standards, policies for input and calculation methodologies and composite maintenance are also important for the Team to bring to Firm B.

More predecessor performance questions before we get to the other side of November 2022?

Cascade Compliance has over 34 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at team.cascade@cascadecompliance.com.

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