On February 6, 2024, Securities and Exchange Commission (SEC) staff issued a new Frequently Asked Question (FAQ) under the SEC’s Marketing Rule on “Calculating Gross and Net Performance.” The FAQ identifies two new requirements under the Rule for advisers’ marketing materials:
- Materials advertising a fund’s performance using gross and net internal rates of return (IRRs) must calculate both IRRs using a methodology that treats fund subscription facilities equivalently.
- Materials advertising a fund’s performance using only net IRR must include either (i) comparable performance without the impact of subscription facilities, or (ii) appropriate disclosures regarding the impact of subscription facilities on the performance shown.
Below, we summarize the FAQ and its impact on compliance obligations under the Marketing Rule. At a minimum, it is reasonable to assume that the SEC staff will begin looking at whether fund managers are complying with the requirements of the new FAQ in upcoming examinations and, as such, it is advisable that managers review and, if necessary, revise their marketing materials to ensure compliance.
Overview of Gross and Net IRR Disclosures Under the Marketing Rule
The SEC’s Marketing Rule modernizes and consolidates the framework governing investment advisers’ advertisements and payments to solicitors under the Investment Advisers Act, which had formerly been established in the SEC’s 1961 Advertising Rule, 1979 Solicitation Rule, and associated guidance. It is intended to provide a comprehensive framework for advisers’ marketing communications, establishing general prohibitions on misleading advertisements and specific limits or disclosures regarding testimonials, endorsements, third-party ratings, presentations of prior performance, and estimates of hypothetical performance. The Marketing Rule was issued in December 2020 and became effective in May 2022, with a final compliance deadline of November 4, 2022.
The Marketing Rule contains several provisions that limit an adviser’s use of performance information, including IRRs, in advertisements. For instance, advisers may not include any presentation of gross performance in an advertisement unless the advertisement also presents net performance (i) with equal prominence to, and in a format designed to facilitate comparison with, gross performance, and (ii) calculated over the same time period as gross performance, using the same type of return and methodology. Many of the Marketing Rule’s general provisions also limit advertisements in ways that may restrict the presentation of performance information, including prohibitions on omitting material facts that are necessary to make an advertisement not misleading, including information that would be reasonably likely to cause an untrue or misleading implication or inference to be drawn, or including or excluding performance results in a manner that is not fair and balanced.
What does the FAQ Address?
1. Treatment of Subscription Lines Should Not Affect Comparisons Between Gross and Net IRR
The FAQ clarifies that the Marketing Rule’s prohibition on using different methodologies to calculate gross and net IRRs applies when an adviser advertises a fund’s gross IRR calculated without the impact of subscription facilities together with a net IRR calculated taking into account the effect of subscription facilities. While some advisers have historically included gross IRRs calculated based on the date an investment is funded and net IRRs based on the later date that the subscription line used to fund the investment is repaid from investor capital calls, the FAQ clarifies that the principle of calculating gross and net IRRs using the same methodology requires treating fund-level borrowing or subscription the same under both calculations (either both with, or both without the impact of such facilities or borrowings).
2. Treatment of Subscription Lines Should Be Clear if Net IRR Presented on Standalone Basis
The FAQ also states that reporting only a net IRR that includes the effect of fund-level subscription facilities would violate the Marketing Rule’s prohibitions on material misstatements or omissions and presentation of performance results in a manner that is not fair and balanced unless accompanied by either (i) comparable performance, such as a net IRR without giving effect to fund-level subscription facilities, or (ii) appropriate disclosures describing the impact of subscription facilities on the net performance shown. The FAQ does not clarify what such “appropriate disclosures” would entail.
Impacts of the Proposed FAQs
The new FAQ reflects continued attention by SEC staff to advisers’ implementation of the Marketing Rule. SEC-registered advisers that include net IRRs calculated using the impact of fund-level subscription facilities should promptly ensure that their marketing materials meet the standards described in the FAQ. We expect the SEC staff to continue to develop its interpretation of the Marketing Rule as it comes to better understand advisers’ practices in implementing the rule and will provide additional updates as warranted.