Performance Precision: SEC's New FAQ Sharpens Focus on Gross and Net IRR Obligations
On February 6, 2024, the Securities and Exchange Commission’s (SEC) Division of Investment Management released a new Frequently Asked Question (FAQ) clarifying requirements around gross and net performance obligations for Internal Rates of Returns (IRR) often seen in the private markets space.
The FAQ addressed two key points. The first point covers the prohibition that an advertisement includes gross performance unless net is also shown “(i) with at least equal prominence to, and in a format designed to facilitate comparison with, the gross performance; and (ii) calculated over the same time period, and using the same type of return and methodology, as the gross performance.”
A common practice for private fund managers when showing an IRR is to present a fund’s Gross IRR using investment level cash flows, and a Net IRR using fund level cash flows. The investment level Gross IRR starts at the time of investment which would not capture any impact of a fund’s subscription line.
Net IRR at the fund level starts with the fund’s first capital call and includes the impact of a fund’s subscription line. This distinction matters because the start date of those Gross and Net IRRs will be different, particularly when a fund utilizes a subscription line of credit to assist with the purchase of investments, delaying the need to call capital from investors.
The position expressed in the FAQ states “…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 FAQ goes on to state, “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."
The solution offered in the FAQ is that when an investment level Gross IRR (without sub line) is shown, an investment level Net IRR (without sub line) also be shown with equal prominence. This would be the baseline needed to comply with the written text of the Marketing Rule and the FAQ.
The practical implications of this may be that advertisement still includes some level of Fund Level Net IRR (with the impact of the subscription line). An adviser may wish to further include with equal prominence Fund Level Gross IRR. The result would be four sets of returns with and without the impact of subscription line both gross and net.
If you get this far you can see that the FAQ starts to align with the recently released Private Fund Advisers Rule for Quarterly Statements. The Quarterly Statement Rule requires investors to receive Fund Level Gross and Net returns both with and without the impact of the subscription line of credit. The main distinction advisers will need to navigate is that while the Marketing Rule does not dictate the method used to calculate a Gross and Net IRR — provided it is shown at a minimum without the impact of the subscription line of credit — the Private Fund Adviser Rule does prescribe methodologies required to calculate returns. The practical challenge will be in the operational alignment needed to comply with both rules.
The second, and perhaps more important, point of clarification is around the practice of only showing a Fund Level Net IRR that includes the impact of a subscription line.
The FAQ states “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.”
Those firms that attempted to keep advertisements simple with the inclusion of only a Fund Level Net IRR with the impact of a subscription will now find that further work is required. The most straightforward approach would be to also include the corresponding Net IRR without the impact of a subscription line. For those advisers that wish to include disclosure, assurance that those disclosures provide sufficient detail to meet the “appropriate” description of the impact for the fund will need to be considered.
This FAQ reinforces staff views on providing a complete picture of the performance earned for a particular strategy when subscription lines are used. Now is a good time to look back at some of those decisions made early in the adoption of the Marketing Rule and identify potential changes to existing practices.
How we help
We are the only GRC firm that offers both regulatory compliance advisory and performance expertise, including a deep understanding of the intricacies of complex performance calculation methodologies – such as the ones outlined in this alert. The calculation of Gross and Net IRRs as described in the FAQ will cause a great deal of questions in the industry as firms look to make this substantive change. We assist firms with this change in many ways, including:
- Gap Analysis: Conducting a gap analysis to help assess the impact of the new FAQ on your firm’s presentation of investment performance and providing recommendations on how to calculate and present such performance.
- Implementation Support:
- Providing resources to create or edit your firm’s investment performance templates to include required performance calculations.
- Assisting the firm with documenting the policies and procedures associated with the chosen calculation methodology and ensuring the methodology is appropriately disclosed.
- Focused Review: Review of the calculation to ensure that the methodology was applied consistently and in-line with the SEC marketing rule.
We would be happy to speak with your firm to provide assistance on this component of the rule, or any other area of your compliance program, as it pertains to the SEC Marketing Rule, and Private Fund Advisers Rule.
Download our whitepaper, The Private Equity Managers Path to Compliance With the GIPS Standards which outlines how an adviser may calculate a return without the impact of a subscription line for private equity firms.