Updated FAQ About the SEC Marketing Rule Performance Requirements
The U.S. Securities and Exchange Commission's (SEC's) Division of Investment Management released updated Frequently Asked Questions (FAQ) on January 11, 2023 clarifying requirements around gross and net performance obligations for one investment or a group of investments (i.e., extracted performance). The full Q&A is included at the bottom of this alert.
The opinion expressed in the FAQ indicates “the staff believes that displaying the performance of one investment or group of investments in a private fund is an example of extracted performance under the new marketing rule. Accordingly, an adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment.”
As we noted in our Private Markets Quarterly Update: Q3 2022, 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. Although the guidance may run contrary to what some advisers chose to implement, the FAQ will help to provide clarity around a topic where we have noted divergences in the adoption of practices related to deal-level net performance.
With this clarification from the Division of Investment Management, advisers should begin to incorporate fee and expense assumptions into the calculation of extracted performance and report gross and net returns when presenting the performance of one investment or a group of investments extracted from a private fund. While the FAQ used the example of a case study when formulating its question, the rationale for considering those returns extracted and the requirement to present net returns alongside gross returns should be considered for all instances where an adviser is showing extracted performance.
Many fund managers have expressed concerns around the complexity, nuances, and even appropriateness of calculating net returns for individual investments and extracted performance broadly. Several of the common methodologies that we have observed in the marketplace are the use of actual fees or model fees. While each of these methodologies have their challenges and benefits, firms should ensure they are incorporating the appropriate management and performance-based fees, and that all fees and expenses relevant to the prospective investor are incorporated into the calculation.
How we help
The issue of performance calculations required by the Marketing Rule is causing a great deal of questions in the industry as firms look to make the substantive changes required by the rule. We are assisting firms with this change in many ways, including:
- Explaining various options to calculate net return (including helping firms assess whether the actual fee or model fee approach makes the most sense for their firm)
- Providing outsourcing resources to create or edit your firm's performance templates to include such net return calculations
- Reviewing the calculation to ensure the methodology was applied consistently and in-line with the rule and industry best practices
- Assisting 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 about how we can assist with this component of the new rule, or any other area of the Marketing Rule. Please contact us here to learn how we can help.
Q. When an adviser displays the gross performance of one investment (e.g., a case study) or a group of investments from a private fund, must the adviser show the net performance of the single investment and the group of investments?
A. Yes. The staff believes that displaying the performance of one investment or a group of investments in a private fund is an example of extracted performance under the new marketing rule.1 Because the extracted performance provision was intended, in part, to address the risk that advisers would present misleadingly selective profitable performance with the benefit of hindsight, the staff believes the provision should be read to apply to a subset of investments (i.e., one or more). Accordingly, an adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively. In addition, the adviser must satisfy the other tailored disclosure requirements as well as the general prohibitions, including the general prohibition against specific investment advice not presented in a fair and balanced manner, when showing extracted performance.
Extracted Performance is defined as “the performance results of a subset of investments extracted from a portfolio.”2 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. Below are some considerations for how that performance can be calculated.3
1 Extracted performance means “the performance results of a subset of investments extracted from a portfolio.” Rule 206(4)-1(e)(6). See section II.E.5 of the adopting release.
2 The rule prohibits any presentation of gross performance in an advertisement unless the advertisement also presents net performance. See section II.E.1 of the adopting release. The gross and net performance requirement applies to not only an entire portfolio but also to any portion of a portfolio that is included in extracted performance. See sections II.E.1(a) and (b) and the definitions of gross and net performance in rule 206(4)-1(e)(7) and (10) (“Net performance means the performance results of a portfolio (or portions of a portfolio that are included in extracted performance…”)). The adopting release also states that the rule requires that advisers that show extracted performance must show net and gross performance for the applicable subset of investments extracted from a portfolio. See section II.E.1.a. of the adopting release (discussing gross performance).
3 The adopting release states that “advisers should evaluate the particular facts and circumstances that may be relevant to investors, including the assumptions, factors, and conditions that contributed to the performance, and include appropriate disclosures or other information such that the advertisement does not violate the general prohibitions…or other applicable law.” See section II.E.1 of the adopting release (discussing the net performance requirement). In addition, it would be considered “misleading under the final rule to present extracted performance in an advertisement without disclosing whether it reflects an allocation of the cash held by the entire portfolio and the effect of such cash allocation, or of the absence of such an allocation, on the results portrayed.” See section II.E.5 of the adopting release (discussing extracted performance).