SEC’s marketing rule FAQ raises more questions than it answers

Extracted performance and attributions causing confusion for PE managers despite the Commission’s recent guidance.

Managers were left with more questions than answers as new SEC guidance on the marketing rule failed to advise on how to calculate net performance, particularly for the extracted performance of one or more assets within a portfolio.

The guidance, in the form of its third FAQ on the rule, was released in January, after months of agonizing by private fund managers over how to comply with the ambiguities and perceived vagaries of the rule.

During FactSet’s recent webinar Demystifying the SEC’s Latest Update to the FAQ of the Marketing Rule, Michael McGrath, a partner at Dechert, said funds are prohibited from presenting any type of gross performance in an advertisement unless net performance is also shown. The requirement applies to total portfolio performance as well as to extracted performance.

But fund managers are struggling with the SEC guidance on whether extracted performance would apply to a subset of investments in a single portfolio, a single asset or grouping of multiple investments from different portfolios.

Julia Reyes, a partner at ACA Group, said the FAQ states that whether a fund manager shows a single investment in the form of a case study or within a narrative that highlights individual investments and their attributed performance over a period of time, the marketing rule considers it a presentation of extracted performance, and managers must provide a net performance number. Many managers had assumed otherwise, McGrath said.

“Funds thought that a single investment wouldn’t be considered extracted performance, so the [marketing] rule wouldn’t apply. But when the FAQ was released in January, it addressed this specific issue and said the marketing rule does apply and net performance needs to be shown,” McGrath explained.

Calculating the net performance of an entire investment fund portfolio is difficult enough, managers have complained – many have reported concocting completely different approaches from their peers. But the FAQ doesn’t address how to calculate extracted performance for a single investment or group of investments from different portfolios. Managers are at a loss for how net extracted performance can be calculated for a case study based on a private equity portfolio that is subject to multiple fee classes and multiple closings.

Private equity managers are going to need to find a way to calculate net performance in these scenarios. As is most often the case with SEC requirements, the key is to be consistent and to document the process, McGrath advised.

CFOs are also grappling with how the SEC wants them to deal with the attribution of performance in a fund to specific assets or assets. Reyes said “attribution” under the rule most likely means showing how active management of certain assets perform against a benchmark.

Fund managers widely questioned whether attribution is considered extracted performance under the rule, and thus requires a net performance calculation. The FAQ ruled that it is, and that the calculation must be made across the same time periods as the attribution assumes, and presented to investors for them to compare.

Fund managers hoping for more specific guidance addressing their concerns over net performance were frustrated by the FAQ, saying it left them with more questions than answers and, in some cases, codified the aspects of the rule they considered most baffling and inappropriate to the asset class.

Some firms are relying on the delta between net and gross performance to provide a net number, some  on their highest projected fee amounts, and others are relying on a more complex calculation involving deal-by-deal IRRs and pro rata expense allocations. Still other fund managers are being conservative and choosing the highest fee they charge in the fund and subtracting that from the extracted performance to arrive at a net figure.

Regardless of the methodology chosen, panelists said firms need to disclose the methodology and warn investors that the results shown are unlikely to be achieved in reality.