New Marketing Rule Performance Net Return Calculation Methodologies
As we approach the November 2022 deadline for implementation of the U.S. Securities and Exchange Commission (SEC’s) new Marketing Rule, many private fund advisers are concerned about the general prohibition of gross-only performance. The Marketing Rule prohibits any presentation of gross performance without the inclusion of net performance with at least equal prominence, calculated for the same time period, and using the same type of return and methodology as the gross performance. It is important to note that gross performance is defined as the “performance results of a portfolio or portions of the portfolio that are included in extracted performance, if applicable, before the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser’s advisory services to the relevant portfolio.”
This is a general requirement and applies to all performance, including extracted and hypothetical performance. For many private fund advisers, this will require the analysis of all performance currently shown on a gross-of-fees basis to understand the implications of this change and determine the appropriate response. Per the Adopting Release text, where advisers show gross extracted and hypothetical performance, they will be required to calculate and present a corresponding net return.
Extracted Performance in the new Marketing Rule is defined as “the performance results of a subset of investments extracted from a portfolio.” Common types of extracted performance include deal-level, sector, geographic, and realized and unrealized aggregations. Where extracted performance is shown, performance of the entire portfolio must be provided or offered to be provided promptly.
There has been (and will likely continue to be for the foreseeable future) increasing debate around whether deal-level (singular) performance is considered extracted performance under the new Marketing Rule. One notable argument, eloquently dubbed the S-theory, suggests that performance of a singular deal from within a portfolio would not be considered extracted performance under the new rule as the rule refers to a subset of investments (plural), which, by definition, must include more than one investment.
The S-theory has been met with opposition by those who read the Adopting Release’s statement that “net performance applies not only to an entire portfolio but also to a portion of a portfolio that is included in extracted performance.” The term “portion of a portfolio” seems to encompass all deals, singular and plural. Further, in the context of discussing case studies and the Marketing Rule’s restrictions on referencing specific investment advice, the Adopting Release also states that “case studies that include performance information also will be subject to the final rule’s restrictions and requirements for performance advertising.” Only time will tell how the SEC staff will view single deal-level performance. Whatever stance an adviser makes based on their own assessment of the risks, the rationale for the decision should be documented, and any related policies, procedures, and disclosures are clear and robust.
Common types of hypothetical performance include target returns for new funds, projected returns (e.g., projected exit returns for unrealized investments), and any composite (aggregation) of the performance of a select group of deals extracted from multiple portfolios (e.g., a fund manager presenting the aggregate performance of all energy sector portfolio investments made by Funds I-IV in the context of marketing a private fund focused on energy investments).
The Marketing Rule conditions the presentation of hypothetical performance on the adviser adopting certain policies and procedures and requires that advisers provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating the hypothetical performance. Where hypothetical performance is permissibly advertised under the Marketing Rule, net performance should reflect the fees and expenses that “would have” been paid if the hypothetical performance had been achieved by an actual portfolio. The definition of net performance refers to the deduction of all fees that an investor “has paid or would have paid” in connection with the services provided.
When advertising hypothetical performance, the new Marketing Rule requires a private fund manager to provide – or if the intended audience is a private fund investor, to provide, or offer to provide promptly – sufficient information to enable the intended audience to understand the risks and limitations of using the hypothetical performance in making investment decisions.
Calculation Methodologies for Extracted and Hypothetical Performance
Under the final rule, presentation of “net performance” in advertisements may reflect the deduction of a model fee when doing so would result in performance figures that are no higher than if the actual fee had been deducted. Private fund managers may consider calculating net returns for extracted and hypothetical performance using either an actual fee or model fee calculation methodology.
Allocating actual fees and expenses applied on a pro-rata basis to specific deals with relevant carried interest calculations may be difficult for many advisers. Books and records requirements for calculation support may also be difficult to maintain depending on the length of any track record. Where records are sufficient, when calculating an internal rate of return (IRR), advisers should reflect the fees as dollar amounts within the IRR stream of cash flows. As the IRR is not additive, reducing gross returns by geometric or arithmetic means is mathematically incorrect.
When applying model fees (which, historically, has been the common approach the industry has taken for hypothetical performance), an adviser generally should apply a model fee that reflects either the highest fee that was charged historically or the highest potential fee that it will charge the investors or clients receiving the particular advertisement.
For composites of extracts that may be relevant to a new fund, advisers should assess the impact of fees and expenses intended to be charged by the relevant fund. For example, if management fees are charged on committed capital and carried interest earned on a hurdle rate, then the model fee should apply the highest relevant fee rates. When expenses are not captured in the gross performance results, firms may identify an appropriate model rate to reduce the gross hypothetical track record.
Target and projected returns should also be reduced by the highest anticipated model fees and expenses that are likely to be incurred with respect to any portfolio or to the investment advisory services with regard to securities offered in the advertisement.
The SEC’s new Marketing Rule introduces some new concepts that have not applied to private fund managers under current regimes. It’s important for advisers to consider the type of performance shown and implement practices that are achievable for the firm to maintain consistently.
How we help
ACA is the only governance, risk, and compliance firm that offers both compliance and performance expertise, including a deep understanding of the intricacies of complex performance calculation methodologies – such as the ones outlined in this blog post. This issue is one that is causing a great deal of questions in the industry as firms look to make this substantive change. We are assisting firms with this change in many ways including:
- Assisting clients with 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 with documenting the policies and procedures associated with the chosen calculation methodology and ensuring the methodology is appropriately disclosed
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