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.
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.
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.
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.
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. In addition, net performance must be presented in a format designed to facilitate comparison with gross performance.
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”) 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. 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. 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 email@example.com.