FINRA Compliance: Calculating Private Equity IRRs

Now that it is a regulatory requirement, we are working with private equity/venture capital firms to review their IRR calculations and marketing decks to ensure they meet the requirements established in the FINRA 20-21 notice.

In July 2020, FINRA stated “Investment programs such as private equity funds and REITs may have a combination of realized investments and unrealized holdings in their portfolios. Where the program has ongoing operations, FINRA interprets Rule 2210 to permit the inclusion of IRR if it is calculated in a manner consistent with the Global Investment Performance Standards (GIPS) adopted by the CFA Institute and includes additional GIPS-required metrics such as paid-in capital, committed capital and distributions paid to investors.”

In this article, we have included answers to a couple key questions and takeaways from a short case study.

What does it mean for the IRR to be calculated in a manner consistent with the GIPS standards?

The answer is publicly available at  Most of the information needed to ensure compliance with the FINRA 20-21 notice can be found in Section 2, provisions 2.A.28 and 2.A.29.  Note: the GIPS Standards refer to an IRR as an MWR (money weighted return).

From Section 2, provisions 2.A.28 and 2.A.29:

  1. The fund must be valued at least annually and as of the period end for any period for which performance is calculated.
  2. Calculate annualized since-inception money-weighted returns. The calculation must include:
    • Daily cash flows beginning January 1, 2020. If the fund you are showing returns for does not use daily cash flows prior to January 1, 2020, that is acceptable. However, the methodology needs to be changed for performance periods from January 1, 2020 forward.  In the IRR calculation these would be treated as positive cash flows for outflows and negative cash flows for inflows.
    • Stock distributions are accounted for as external cash flows and are valued at the time of distribution.
    • Net returns for the fund are net of all fees. This includes all management fees, administration fees, custodian fees, and carried interest/performance-based fees.

What actually needs to be presented to prospective investors?

The answer to this question is in Section 7 of the GIPS standards, paraphrased below:

  1. Present the since-inception money-weighted return (IRR) through the most recent annual period end.
    • If the fund has less than a year of performance as of the most recent annual period end, then the return must not be annualized. Therefore, firms need to de-annualize the partial period performance.  For an example of how to do this, please click here.
    • If the fund terminates, the firm is required to show the annualized since-inception money-weighted return through the fund’s termination date.
  2. The since-inception money-weighted return for the benchmark must be presented for the same periods as presented for the pooled fund, unless the firm determines there is no appropriate benchmark.
  3. Assuming the fund has committed capital, the firm must present the following items as of the most recent period end:
    • Fund since-inception paid-in capital.
    • Fund since-inception distributions.
    • Fund cumulative committed capital.
    • Total value to since-inception paid in capital (TVPI)
    • Since-inception distributions to since-inception paid in capital (DPI)
    • Since-inception paid-in capital to cumulative committed capital (PIC ratio).
    • Residual value to since-inception paid-in capital (RVPI).

Case Study:  Meeting the requirement in less than a week

Our client was asked by a key institutional representative to get the returns in compliance with the FINRA calculation rules for private equity and was given less than a week to accomplish this for a 5-year track record.  The client was calculating the IRR using daily cash flows; however, the calculations were not including the impact of reinvested distributions.  For the treatment of recycled distributions to be consistent with the FINRA 20-21 notice and the GIPS Standards, the entire distribution must be included in the cash flow. Then whatever part (or all) of the distribution that is recycled would need to be counted as an inflow back into the fund.

Another key revision required for this client included adding the required metrics listed above (3a-3g).  All the data was readily calculated by the client; however, they had not ever included the metrics in the firm’s marketing materials.  We also recommended that they show the fund’s net expense ratio to ensure full transparency.  The good news is that 1) performance went up slightly, and 2) in less than a week, we were able to review the firm’s performance and fee calculation spreadsheets and their marketing materials and provide them the guidance they needed to meet FINRA’s 20-21 notice, so that the client could provide their institutional representative a compliant pitchbook.

What about the GIPS Standards? 

Our client plans to comply with the GIPS Standards in the future, but we made sure they did not mention GIPS compliance in their updated pitchbook.

Firms are not required to comply with GIPS standards to meet the requirements of the FINRA 20-21 notice.  There is a lot of confusion about this.  Firms can utilize the methodology set forth by the GIPS Standards, and present the required metrics, without complying with the GIPS Standards.  However, firms cannot make any claim of GIPS compliance if they are only following the calculation methodology and presenting required metrics.  Compliance with the GIPS standards is on a firm-wide basis not on a fund-specific basis.  A key requirement of being able to claim compliance with the GIPS Standards includes documenting how a firm meets each of the applicable requirements, including policies to ensure that policies and procedures are in fact implemented and maintained firmwide.

For our client, and for other firms not yet ready to adopt the GIPS Standards firmwide, here are our recommendations for additional disclosures for firms that don’t mention the GIPS standards even though the performance has been updated in compliance with the FINRA 20-21 notice:

  1. Fund net returns are calculated using an annualized since inception IRR that uses daily external cash flows. The net returns are net of all fees including but not limited to, management, administration, and carried interest.
  2. The fund is valued using subjective, unobservable inputs.
  3. If there is no benchmark being shown: The Firm is not aware of any market indices that in the Firm’s opinion provide an appropriate basis for comparison to the fund principally because the objective of the investment strategy involves maximizing absolute (as opposed to relative) returns.

If your firm is looking to have performance and marketing materials reviewed to ensure they comply with the July 2020 FINRA notice or if you have any questions, we are here to help.  Cascade Compliance has over 34 years of combined experience working with performance calculations and the GIPS standards, and its 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, let us help you get the regulatory performance piece right.