SEC Marketing FAQ: Net IRR Guidance for Private Funds

February 13, 2024

What happened?

On February 6, 2024, the SEC updated its Frequently Asked Questions page for the new Marketing Rule. The page now has four questions and four answers. The first dealt with the compliance date of November 4, 2022, and an adviser’s ability to comply early. The second addressed the prescribed time period requirement and conditions on the use of interim performance information for up to one month after the most recent calendar year-end. The third specifies that presenting the performance of one investment or a group of investments in a private fund, such as performance of a case study, is extracted performance and must include a presentation of net performance. Below, we discuss the fourth question, its answer, and implications for advisers.

Presentation of Gross and Net Performance: Private Funds

The Rule: “An investment adviser may not include in any advertisement:

• Any presentation of gross performance, unless the advertisement also presents net performance:
  • With at least equal prominence to, and in a format designed to facilitate comparison with, the gross performance; and
  • Calculated over the same time period, and using the same type of return and methodology, as the gross performance.”

The Question: “Must gross and net performance shown in an advertisement always be calculated using the same methodology and over the same time period?”

The Answer: Yes. “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’) 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. 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 SEC added two examples of such performance presentations that would violate the Marketing Rule:

Example 1: “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.”

• Why:
  • This practice would cause IRR calculations to be made across different time periods, since the calculations would be made for “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 cause Gross and Net IRRs to be calculated using different methodologies, since Gross IRR would not reflect fund-level subscription facilities, while Net IRR would.
• Solution:
  • The SEC indicated that a possible solution could be to show Net IRR calculated from the same time as Gross IRR (i.e. before capital commitments are called, and including the effect of fund-level subscription facilities in its calculation).
• Footnotes:
  • Fund-level subscriptions facilities include “any subscription facilities, subscription line financing, capital call facilities, capital commitment facilities, bridge lines, or other indebtedness incurred by a private fund, or on its behalf, that is secured by the unfunded capital commitments of the private fund’s investors”
  • An IRR example, from the SEC staff, is “the discount rate that causes the net present value of all cash flows throughout the life of the private fund to be equal to zero.”

Example 2: “An adviser would violate the general prohibitions (e.g. Rule 206(4)-1(a)(1) and Rule 206(4)-1(a)(6)) if it only showed 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.”

• Why:
  • Only presenting Net IRR that accounts for fund-level subscription facilities may be misleading, since it implies that “the fund’s advertised performance is similar to the performance that the investor has achieved from its investment in the fund alone.”

What does this mean for me?

The SEC’s last two additions to its Marketing Rule FAQ clarify how the Commission expects advisers to private funds to prepare and present net performance. This fourth question and answer offers additional guidance on how advisers to private funds may calculate gross and net performance and comply with the general prohibitions. While the marketing rule allows firms to calculate net performance any one of three ways—using actual performance, creating model performance that is not higher than actual, or using the highest fee tier to model performance—net performance calculations must still satisfy the general prohibitions and net performance requirements. This update to the FAQ drives home the fact that performance must not be misleading and gross and net must be calculated to allow for an apples-to-apples comparison.

If you are an adviser to private funds and use performance information in your advertising, consider reviewing your performance calculation procedures to make sure fund-level subscription facilities are properly accounted for in your firm’s calculation of gross and net fund performance.

Fairview provides comprehensive and ongoing compliance services, including comprehensive marketing and advertising review and complete examination support. Contact us today for additional information about maintaining your compliance program in an ever-changing regulatory environment.