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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