On February 6, 2024, the SEC’s Division of Investment Management (SEC Staff) released an update to frequently asked questions document (FAQ)1 regarding amendments to rule 206(4)-1.2 The SEC Staff responses to the FAQ’s represent the views of the staff of the Division of Investment Management. The FAQ responses are not a rule, regulation, or statement of the SEC. This FAQ was updated to include a question regarding calculating gross and net performance.
The question posed asks whether gross and net performance shown in an advertisement must always be calculated using the same methodology and over the same time period?
Yes. Although the marketing rule does not prescribe any particular methodology or calculation for performance, the rule requires that any presentation of gross performance be accompanied by a presentation of net performance that has been calculated over the same time period and using the same type of return and methodology as the gross performance. In addition, net performance must be presented in a format designed to facilitate comparison with gross performance.
The FAQ focuses on certain advisers to private funds who:
- present a gross internal rate of return (“Gross IRR”) calculated based on the capital deployed in the investments from the date the investments were made (i.e., the calculation does not reflect the impact of any borrowing under a subscription facility to make the investments), but
- then present the corresponding net internal rate of return (“Net IRR”) calculated based on the date capital contributions were made by investors to fund the investments or pay back the borrowings, as applicable (i.e., the calculation does reflect any borrowing under a subscription facility to make the investments).
In the SEC Staff’s view, if an adviser chooses to exclude the impact of a subscription facility from the fund’s Gross IRR, it cannot then include the impact of a subscription facility in the Net IRR under the marketing rule. The SEC Staff reasoned that it would force the adviser to use two different time periods to compare Gross and Net IRR and result in the use of different methodologies being used for the Gross and Net IRRs (i.e., calculating performance without and with the impact of fund-level subscription facilities). The SEC Staff also indicated that it believes such a presentation would also violate the provision requiring presentations of performance in a format designed to facilitate comparison between net and gross performance.
An adviser would violate the general prohibitions of the marketing rule, the SEC Staff continued, if it showed only 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. Presenting only Net IRR that includes the impact of fund-level subscription facilities, in the SEC Staff’s view, 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.3
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Advisers should review their advertisements that include Gross IRR and Net IRR returns to ensure that the calculations are consistent with the FAQ, and revise the calculations as needed to conform to the FAQ. For additional reference, please see Seward & Kissel’s prior alerts on the Marketing Rule, linked in the footnote below.4