Tag Archive for: GIPS Compliance

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.

Selecting a Verifier

Three Crucial Considerations When Selecting a Verification Firm: People, Process, and Fees

Every year, around this time, budget reviews for the upcoming year often prompt firms to review long-term service providers. While firms meticulously scrutinize their budgets, verification providers are also assessing fees for the following year to determine if an increase is justifiable. If you haven’t yet evaluated your current verifier, the CFA Institute’s verification questionnaire offers valuable questions for your consideration. In addition to the CFA Institute’s questionnaire, this article provides supplementary insights that may prove beneficial as you evaluate your existing verification firm or search for a new one.

People

People constitute the most pivotal component of any verification process. The firm you engage and the individuals they enlist for your verification must possess experience, knowledge, and a strong commitment to the task. Furthermore, it’s essential to consider how a verification firm plans for the future. Over the past decade, we’ve observed several mergers and acquisitions among verification and compliance firms. Strangely, one of the most important questions, not included in the CFA Institute’s questionnaire, is related to succession planning: “What is the succession plan for the firm?” As the owners of verification firms approach retirement, this question is often overlooked, leading to inadequate succession planning or the sale of firms to competitors.

Another vital question to ask is, “What caliber of staff will be working on the engagement?” Verification firms typically assign one senior-level person and one junior-level person to their engagements. Sometimes, the junior-level team member may have less than a year of verification experience and ends up doing most of the work. Understanding your engagement team is crucial for a successful and efficient verification process. [Do we want to add a sentence here, similar to the Fees section, that addresses Cascade’s difference? “At Cascade, partners are involved in the regular communications/emails/phone calls before during and after the verification, and even our junior-level staff working with clients have more than 5 years of GIPS compliance verification experience.”]

Process

It’s imperative to inquire “Does the verification firm consider regulatory requirements beyond the GIPS Standards when reviewing your marketing materials.” With the SEC Marketing Rule now in full effect, this question holds greater importance than ever. Some verification firms choose not to comment on any aspect of the SEC Marketing Rule. However, we believe this approach is misguided. Verification firms often position themselves as performance experts, making the SEC Marketing Rule an important part of any RIA’s GIPS compliance process. As a client, you shouldn’t hesitate to seek their insights on the performance aspects of the SEC Marketing Rule.

An additional aspect to evaluate is “How frequently does the verification firm communicate before, during, and after the verification process?” Effective communication during the verification process significantly impacts its timeliness. Questions to consider include whether you will have timely email follow-ups and regularly scheduled weekly, bi-weekly, or monthly calls during the verification, and how the verification firm stays informed and keeps your firm informed about industry-specific regulatory changes.  At Cascade, clients receive timely call summaries for every regularly scheduled call that keep your entire team informed on key issues and next steps, and your entire verification team—including partners—participates in those calls and call summary communications. Frequent communication from your verifier ensures that your firm receives the information it needs for a successful compliance program.

Fees

With the SEC Marketing Rule considerations impacting GIPS Reports this past year, it’s important to know what guidance is or isn’t included in your verification fees:  “Do verification fees encompass consulting regarding the performance aspects of the SEC Marketing Rule?” This question could be a determining factor in your decision to hire a specific firm. Some verification firms charge additional fees for consulting on performance requirements of the SEC Marketing Rule, while others include this service as an integral part of their offerings. Recognizing that investment management firms often have external compliance providers to assist with regulatory disclosures and documentation, verification firms have the expertise to provide valuable insights on the performance aspects of the rule.

Firms could do well to ask about fee increases: “Does the verification firm enforce automatic fee increases and how are increases communicated to their clients?” Some firms have implemented substantial fee hikes without adequate client communication. At Cascade Compliance, we take a different approach: when you become a client, we freeze your fees for the initial two years and guarantee a fee increase cap moving forward. As a 100% employee-owned company, we have the autonomy to control pricing and manage costs and competitive staff retention packages, offering our clients the peace of mind of working with the decision-makers.

In conclusion, selecting a verification firm is a critical decision that should be made after careful consideration of people, processes, and fees. By asking the right questions and evaluating these three key components, you can make an informed choice that aligns with your firm’s needs and expectations. Remember, choosing the right verification partner can have a substantial impact on your organization’s success and compliance program.

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.

Verifier Independence

Verifier Independence drew dozens of attendee inquiries and comments at the 25th Annual GIPS Standards conference this year.  The growth of virtual service offerings during the pandemic, more automation, and M&A activity in the compliance and verification provider space all require a fresh look at verifier independence.

Overview

The 2020 GIPS Standards, for both Firms and Asset Owners, added to the Fundamental requirements that recipients of a verification must gain an understanding of the verifier’s policies for maintaining independence and consider the verifier’s assessments of independence. What does this mean?

Verifiers are required to conduct their work independent of their clients in an unbiased manner, because the verification opinion is relied on by potential investors and other market participants and stakeholders.  Verifiers cannot examine their own work, function in decision making roles, serve in an advocacy role or have mutual or conflicting roles with clients, and the GIPS Standards require verifiers to document their policies on independence at both the firm and employee level. Requesting and reviewing your verifier’s policies on independence is a way to determine if any potential independence issues exist.

Determining Independence

To determine if an independence issue exists, firms/asset owners should consider other services provided by the verifier. If the verifier does not offer any other services or you do not and will not engage in other services, then you need to consider if the verifier is involved in compliance decisions to the extent they are verifying their own work.

Many verifiers provide pre-verification consulting services where they provide templates and consult with verification clients on how to document policies or comply with the GIPS Standards.  Verifiers can provide useful insight on considerations for the creation of meaningful composites and education on industry practices for including GIPS Reports with prospective client communications. In these cases, whether or not verifier independence issues exist would depend on the verifier’s level of involvement.

Frequently Asked Verifier Independence Questions, 2021 GIPS Standards Conference

  1. What does testing their own work mean?

A verifier would be testing their own work if, for example, they compile your account data in a composite calculation spreadsheet or create your firm’s GIPS standards policy manual, and then verify your firm. Any documents that the verifier directly creates on behalf of the firm would fall into this category of testing their own work if the same verifier was engaged for verification services. However, if your verifier provides templates that your firm populates and the verifier reviews, this is not considered testing their own work.

  1. Most, if not all, verifiers provide spreadsheets to their clients if they need a tool to calculate composite performance. They then turn around and verify that calculation. Isn’t this “testing their own work”?

CFA Institute provides examples of services that are unlikely to create an independence issue. These examples include, formulas and calculation examples, example policy language and GIPS compliance checklists. If the verifier provides a tool that your firm uses to calculate performance but does not actually input the values on behalf of the firm, there is likely no independence issue.  See more examples of services a verifier can provide without violating independence here.

  1. We hired a consultant to start our GIPS compliance program. They wrote our P&Ps, drafted our GIPS Reports, and created/maintain our composites based off initial & ongoing feedback from our SMEs. This was signed off on by the CCO. Can they now Verify us since we made the mgt decisions? Is there an independence issue, and if so, how much time must pass before the verifier is considered independent?

This situation would be considered a violation of verifier independence if the same consultant was used to verify the firm. The consultant would be testing their own work based on the information provided above.  See more examples of situations where other services lead to an independence issue here.

There is no set amount of time that must pass before the verifier is considered independent again. This was answered during the 2021 GIPS Conference and the panelists agreed that if an independence issue such as this exists, it will exist indefinitely. This is because the consultant set up the firm’s policy manual and created the firm’s composites.  The firm should consider other verification firms if pursuing verification.

  1. Our verifier has a division that offers composite software. It is a completely different business line from the verification business. If our firm utilized their composite software, can the verifier still be considered independent?

This was also answered at the 2021 GIPS Conference, and the panelists agreed that if the verifier has another division that offers composite software, there would be an independence issue if the firm chose to use the verification division for GIPS verification.  When firms are considering hiring a verification firm, they should be considering the options that are above reproach.  If there is doubt about whether the verifier is independent due to engaging other services, then it might be best to look to another provider. 

At Cascade, we provide our policies on independence to each client upon signing a contract and provide an updated copy annually.

Access our Verifier Independence Checklist

Cascade Compliance’s checklist is a starting point when considering the independence of a verification firm.  We also recommend reviewing the Guidance Statement in its entirety.

Navigating Actual vs. Model Net-of-Fee Performance

One of the more common questions we get asked by firms is whether they should use model or actual fees to calculate net-of-fee composite returns.  With the soon-to-be-implemented SEC Marketing Rule requirements for net-of-fee composite performance calculations, many firms will need to reconsider their current calculation methodology to make the best decision going forward.

Read more

2020 GIPS® Standards Q&As

This is a comprehensive list of Q&A’s released as part of the GIPS standards Newsletter, organized by subject matter.  As CFA Institute continues to add Q&As through the GIPS Standards Newsletter, we will continue to update this page.

GIPS 2010 Transition to GIPS 2020

Pooled Funds

Composite Management/Policies

Input Data and Portfolio Calculation

Read more

Fundamentals of Compliance