Caught up in the Marketing Rule’s net

With additional reporting by Tom Auchterlonie

The November 4 compliance date for the SEC’s Marketing Rule has passed, but private equity firms are still working out the best methodology for calculating net performance in the absence of any guidance from the commission.

Whether firms are relying on the delta between net and gross performance to provide a net number, relying on their highest projected fee amounts or relying on a more complex calculation involving deal-by-deal IRRs and pro rata expense allocations, they are simply trying to reach a net number they are comfortable presenting to potential investors – and that would be accepted by the SEC.

It’s a previously unthought-of figure in the private equity market – one CFO cursed the idea at PEI’s CFOs & COOs Forum West in San Francisco in September, saying no one even knows what it is.

And to the extent they understand what the SEC wants in a net performance number, CFOs say the figures can nonetheless be misleading. They are calculated based on non-existent circumstances – such as fees that have not yet been incurred – and are not a return any investor can reasonably expect, since fees may not be the same for all investors, and the figure may only capture a specific timeframe, rather than the entire lifecycle of an investment, for example.

But some disagree. Igor Rozenblit, managing partner with Iron Road Partners, says he doesn’t think that net performance numbers are any more misleading than the current practice of showing gross performance based on interim valuations.

“Both are inherently imprecise, but both tell investors an important story – valuations tell a story about investment acumen, while net performance numbers tell a story about the cost of that acumen,” he explains.

Pop quiz

Molly Diggins, general counsel at Monument Group, says many firms are hoping that the SEC recognizes and acknowledges that they haven’t given a lot of guidance on net performance calculations, and that makes it tough to complete compliance with every facet of the rule.

“Although the Marketing Rule is essentially a compilation of old No-Action letters on marketing practices, there is room for interpretation,” she says. “The rule simply is not crystal clear as to how everyone should be and computing everything in terms of a net performance number.”

That is worrisome for some GPs, since the SEC has said it will be conducting sweeps exams on Marketing Rule compliance.

“No one wants to be the first firm that gets in trouble for violating a new rule,” a CFO/COO/CFO of a lower mid-market PE firm in New York posits. “We’re all trying to come up with figures we’re comfortable with, using the limited guidance we’ve been given, documenting everything and just hoping that’s enough for the SEC examiners when they come in.”

What the SEC thinks ‘net performance’ is

The Marketing Rule prohibits any presentation of gross performance without the inclusion of net performance with at least equal prominence, calculated for the same period, and using the same type of return and methodology as the gross performance.

The rule defines “net performance” as the performance results of a portfolio “after 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 investment advisory services to the relevant portfolio.”

Before the Marketing Rule was adopted, the SEC’s ICI No-Action letter allowed advisers to use gross-of-fees performance in one-on-one presentations to wealthy individuals, pension funds, universities and other institutions as long as specific disclosure was included regarding fees. This practice will no longer be allowed under the new Marketing Rule, which prohibits any presentation of gross performance unless the advertisement also presents net performance.

And this focus on net performance calculations is delaying firms’ readiness for compliance with the Marketing Rule, says Iron Road Partners analyst Zakary Neal.

“I think a lot of firms are ready, or they would be ready, for the compliance date of the new Marketing Rule, but they’re kind of scrambling to figure out how to calculate net performance in a perfect manner,” he says. “And I think some are focusing too much on the details of the calculations and ignoring other portions of the rule.”

Bigger is not better

Iron Road’s Rozenblit believes larger private equity firms are having the most trouble complying with the net calculations requirement because of the increased complexity of their fund structures.

“They also have a significant amount of marketing materials making this task even more daunting,” he adds.

The CFO of a large private equity sponsor agrees calculating net performance is a harder exercise for larger or firms that have been in business for a long time, have multiple products and invest across several sectors.

“We have multiple products, and we know that we will continue to expand those products, which means these net calculations will have to be re-run on a regular basis. So, we need to come up with something that we could easily explain to an investor,” the CFO explains. 

Keep it simple 

Since the Marketing Rule was implemented last year, private equity executives have been speaking with their peers to see how each firm was planning to calculate net performance to find a method that worked for their firm as well.

“There was a ‘safety in numbers’ belief, so if the SEC had a problem with one methodology it could be pointed out that other firms are relying on that same methodology and hoping that would be enough to, at least temporarily, prevent an enforcement action,” notes the lower mid-market private equity CFO/COO/CFO.

Neal says Iron Road has been advising clients to keep things simple and really make a best effort, reasonable calculation.

“Do not complicate things too much. There is really no way of knowing if the results from the complex calculations are any more accurate,” Neal says.

Different approaches

Some firms are relying on model fees when calculating net performance. The model fees used in the calculations are most often based on the highest fee that would be charged to investors.

Diggins says that some firms are being more conservative in their calculations and are using the highest possible fee for the funds in coming up with a net number.

The lower mid-market PE CFO/COO/CFO says his firm is taking this conservative approach. “We’re hoping that that is at least clear enough and it’s a valid methodology to the SEC,” he notes.

Another option for firms is to simply take the delta between gross and net performance for each fund and use that percentage in marketing materials.

The large PE firm CFO says her firm takes this approach. “We calculate a ratio of net-to-gross on a deal-by-deal basis and then apply that to the portfolio using a weighted average,” she explains. “In talking to our peers with similar businesses, this seemed to be the best approach.”

April Evans, CFO of Monitor Clipper Partners, says her firm calculates net returns by using the dates of the capital calls and distributions for LPs. The capital-call dates are used for determining net IRR, she explains.

Evans notes that net asset values in LPs’ capital accounts at the ends of quarters are also factors. The cashflow dates approach factors carry and expenses paid to the fund, she says.

And Blinn Cirella, CFO of Saw Mill Capital, explains that her firm is coming up with net returns data going deeper than the fund level, by calculating net IRR and net MOIC for each portfolio company.

She explains that all the expenses will be allocated pro rata to each deal based on their percentage of costs in the overall portfolio. Saw Mill then replicates this allocation method on the carry side.

Next, the firm subtracts its portfolio companies’ actual realized carry from the figure. Finally, it comes up with an ending net asset value, she says, with fair market value considered. Cirella notes that her firm is being cautious with compliance by also including net returns for portfolio companies.

“We just decided to take the most conservative approach to it,” she says. Saw Mill also produces fund-level net IRR and net MOIC, which entails “just the flows to and from the LPs and the fund.”

A challenge with the pro rata approach that Cirella outlines is it involves taking costs that are incurred at the fund level and assigning them to portfolio companies, however.

Golden rule: Write it all down

Regardless of the method used to calculate net returns, Diggins reminds firms to document everything.

“Especially with firms taking different approaches, it’s really important to document your methodology and substantiate the data you are relying on in your calculations,” she says. “You must maintain everything that would substantiate the actual calculations and how you came up with your figures on every net figure used in your marketing materials.”

Documentation and substantiation of your process will be helpful as things progress and the industry figures out what works and what doesn’t, perhaps resulting in more guidance from regulators and industry groups on how to approach net calculations, Diggins notes, so firms can compare their practices with what is recommended and accepted.

Sweep exams are coming 

The SEC will be focusing on compliance with the Marketing Rule in sweeps exams.

The commission’s Division of Examinations warned in a September Risk Alert that it will be looking at firms’ policies and procedures for the new rule. The expectation is that the sweep exams will be a fact-finding mission by the SEC and will help the commission issue clarifications or additional guidance on issues such as calculating net performance.

Rozenblit thinks the SEC’s upcoming Marketing Rule sweep will be very structured, wherein the examiners may examine for the existence of net performance – and associated footnotes – without necessary spending a lot of time analyzing the pros and cons of any specific calculation methodology.

But he says it is unlikely the SEC will pursue an enforcement action against a manager simply for not displaying net returns every time a gross return a displayed.

“However, this does not mean that the SEC will accept whatever interpretation the manager has of the rule. Instead, the SEC will gather everyone’s interpretations and make their own informed decision about expectations. This will likely be communicated in a risk alert or FAQ at a later date.”