Industry Insights on Deal Level Net Performance

This past month the CFA Institute and ACA Group co-sponsored an in-person roundtable discussion on the topic of Deal Level Net Performance Methodologies. We invited private fund managers in the New York area for a closed-door meeting seeking insights on methodologies currently in use to derive deal level net returns as required by the SEC’s Marketing Rule and subsequent FAQ’s. This topic has garnered significant industry interest and we enjoyed the collaboration that a small gathering can cultivate.  Below are some insights that may prove helpful as others look to examine the potential solutions around deal level net performance. 

General sentiment: No one was asking for this!

Setting aside conversation around whether deal level net returns are inherently misleading, much of the room agreed that limited partners have not seemed to be concerned with these results and that requests for this information in the past were sparce to non-existent. While some posited that investors may still be working to understand the new regulatory requirements, others felt that investors were already requesting and receiving sufficient access to data, in general, to understand the impact of fees and expenses on the fund performance.  

Most used Methodology: Ratio method is the most used

We identified several methodologies for deriving deal level net returns in our previous Q&A. The final rule provides for the calculation of net performance using an actual fee or model fee methodology.¹ As the Rule has been digested and interpreted across the industry, the ratio method was broadly accepted and implemented across the industry. Among the 18 attendees, only three were using a methodology other than the ratio method.  

There is a certain comfort in numbers. Following the crowd, especially regarding regulatory concerns, usually helps avoid uncertainty. It came as no surprise when we found that amongst the attendees, the prevalence of the ratio method came down to simplicity of both the calculation and the disclosure. It was also noted that very few assumptions were required in this calculation. Where there is a known fund-level net return, which is net of all actual fees, and a known comparable gross return, the ratio is found as net divided by gross and the resulting percentage can generally be multiplied by the gross investment level returns to derive net investment level returns.  Absent clarification from the SEC, there is comfort in that simplicity from a calculation perspective and for explaining to investors. 

The room did acknowledge challenges around the ratio method.  One example is where the portfolio-level gross return is lower than the fund level net return.  This can be due to the timing difference between investment in a deal and capital being called from investors.  When the ratio is greater than one net performance will be greater than gross performance. The solutions proposed included adjusting the calculation or identifying an historical or averaged ratio to use in place of the current spread. There were a few other corner cases mentioned, but overall we encouraged firms to fully disclose and document any deviations in calculations methodologies for these edge cases.  

Several participants mentioned that in cases where deals are aggregated together for the purposes of illustrating a historical track record for a new fund or strategy, fees and expense assumptions for the new fund have been layered into the firm’s internal fund models to calculate the projected gross and net IRR of the fund. Using this projected methodology, the ratio of the projected net returns to the projected gross returns seems to give a reasonable indication of the effect of fees and expenses that a prospective investor may expect to incur. However, the additional steps required to make the relevant projections may require additional disclosure and documentation to substantiate the assumptions used. The benefits to this approach are that the highest fees and expenses may be used to reduce the projected gross returns and that the same ratio may be applied through time rather than updating quarterly or annually. 

Sentiment around other methodologies: Just too much! 

Too complicated with too many assumptions

Conceptually, allocating actual fees incurred by a fund to the individual deals should be easy. In practice though, a number of assumptions must be made to implement this methodology. Participants expressed concern that assumptions around timing of expenses would be necessary given the actual mechanism by which management fees are incurred. As early periods in the life of a fund generally experience greater fee loads in relation to later periods in the fund’s life, the concern was that without additional assumptions to smooth out the effect of the fees, the net returns of early deals may be understated while the net returns of later deals would be overstated.  

One solution to this would be to use since inception expense information and reallocating quarterly or annually to each of the deals. The drawback would be that approach would be the level of detail required when disclosing the methodologies and assumptions used in the calculation. The more complex the calculation and the more extensive the assumptions, the more detailed the disclosure narrative must be in order to fully explain the methodologies. In most cases, it seemed the group was in agreement that the number of assumptions necessary for this calculation made the results too complex to be effectively disclosed given the need to describe and disclose the assumptions used in the calculation. 

Too time consuming

Other participants were concerned with the time necessary to develop, implement, and maintain the additional books and records to allocate actual fees. Since these calculations have not historically been commonplace in the industry, there are few technologies noted that are readily able to handle these allocations and administrators appear to be reluctant to provide resources to aid in the calculation.  

The same issues were raised for model fees.  An IRR model fee is generally only applied by inserting dollar values representative of expenses within the stream of cash flows from the investment. While this methodology is relatively straightforward on the surface, significant time and consideration are necessary to identify, test and implement fair and accurate assumptions. This, accompanied by the lack of pressure from LP’s on the topic, has created a reduced appetite for expending too many resources on the topic.  

When would it be reasonable to use another methodology: New fund launch and use of hypothetical track records 

One silver lining for the model fee approach was the group’s opinion on the use of this methodology in the specific scenario where a firm is fundraising for a new strategy in which the firm has previously invested but has not offered as a standalone strategy (e.g., historic buyout equity firm launches a credit fund or an ESG fund). Using a model to illustrate the impact of fees and expenses that are intended to be charged by the new fund seemed to be logical in this instance.  

Final thoughts: Absent interest from investors, advisers may continue to see this as a regulatory exercise and not look for further investment in other solutions

While much of the industry has gravitated towards one or more of the particular methodologies that were discussed during this conversation, there continue to be examples where thoughts and methods may diverge. In some ways, this may be a net positive for investors as the industry continues to consider and understand the implications of one methodology over another. In other ways, without relevant and functional guidance from either regulators or industry groups the topic of deal level net performance will likely continue to cause uncertainty around best practices in this regard.  

While we only touched on this point briefly during our conversation, firms should consider the recommendation to document the firm’s policies for defining input data and calculation methodologies. Documentation of specific policies and procedures for calculating investment performance have long been an industry leading practice in the traditional asset management world. In most cases, performance policies should be straightforward to adopt when the same methodology may be used across the board. However, as we covered above, there may be a use case where a firm may deviate from the standard calculation.  Acknowledging that possibility and structuring a framework for how and why the adviser will manage exceptions can be helpful to the team doing the calculations and regulators looking to understand your practices.

How we help

ACA is the only governance, risk, and compliance (GRC) firm that offers both compliance and performance expertise, including a deep understanding of the intricacies of complex performance calculation methodologies. As noted, this issue is one that is causing a great deal of questions in the industry as firms look to make this substantive change in light of the new rule. 

ACA can assist firms in many ways, including: 

• Providing consulting to assist in understanding options for how to calculate the net return (including helping firms to assess whether the actual fee or model fee approach makes the most sense for their firm). 
• Once the net return is calculated, reviewing the calculation to ensure the methodology was applied consistently and in line with the SEC Marketing Rule and industry best practice. 
• Assisting the firm with documenting the policies and procedures associated with the chosen calculation methodology and ensuring the methodology is appropriately disclosed. 

We would be happy to speak with your firm to provide assistance on this component of the new rule, or any other area of your compliance program, as it pertains to the SEC marketing rule. Contact us here to learn more.

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¹ Final rule 206(4)-1(e)(10)