The SEC’s Staff Issues A New Marketing Rule FAQ On Net Performance Requirements – Securities

On Jan. 11, 2023, the staff of the U.S. Securities and Exchange
Commission’s Division of Investment Management
(“Staff”) issued an FAQ update (“FAQ”),
excerpted below,¹ stating the Staff’s belief that
Investment Advisers Act Rule 206(4)-1 (“Marketing Rule”)
prohibits registered investment advisers from disseminating
advertisements showing the gross performance of one investment or a
group of investments in a private fund without showing, with equal
prominence, the net performance of such single investment or group
of investments. This FAQ addresses a key point of ambiguity and
market divergence, and comes over two months after the Marketing
Rule’s compliance date on Nov. 4, 2022.

Background on the Net and Gross Debate

The Marketing Rule prohibits any presentation of “gross
performance” in an advertisement unless accompanied by
“net performance” that is shown with equal prominence,
calculated over the same time period and uses the same type of
return and methodology. Gross and net performance are both defined
as relating to the “performance results of a portfolio (or
portions of a portfolio that are included in extracted performance,
if applicable).”² Prior to the FAQ, the Staff had
not formally indicated whether it views “extracted
performance”, which is defined as a “subset of
investments extracted from a portfolio”³ (and is
inherently plural), as including the performance of a single
investment.

What the Staff Said in the FAQ

In the FAQ, the Staff articulated its belief that presenting the
performance of one investment or a group of investments in a
private fund is an example of extracted performance under
the Marketing Rule, and such performance must be shown on a net
basis.

The Staff cites as its rationale the risk that advisers
“would present misleadingly selective profitable performance
with the benefit of hindsight.” The FAQ reminded advisers to
ensure that their presentation of net extracted performance
complies with other applicable disclosure requirements (i.e., the
requirement to provide or offer to promptly provide the performance
results from the total portfolio from which the performance was
extracted). The Staff also noted that such performance is subject
to the Marketing Rule’s general prohibition against referencing
specific investment advice in a manner that is not fair and
balanced.

What the Staff Didn’t Say in the FAQ

The FAQ does not address why the presentation of net performance
is necessary to address the identified risk of presenting
“misleadingly selective profitable performance” when the
Marketing Rule already prohibits presenting individual investments
in a manner that is not fair and balanced, and it does not detail
how the requirement to show net performance would address that
problem.

The FAQ also did not specifically address several critical
points, including:

• What methodologies are acceptable for calculating net
  performance for individual investments or groups of
  investments;




• The level of disclosure required in order to ensure that net
  performance calculations are not themselves misleading;




• Timing expectations for managers switching to comply with the
  FAQ’s guidance; and




• Whether comprehensive presentations of each individual
  investment or category of investments (e.g., schedules of
  investments; attribution reports), when shown alongside the
  fund’s net and gross performance, can be treated differently
  because such presentations show the entire portfolio and do not
  raise the same concerns about selective performance cited in the
  FAQ.

Key Takeaways for Private Fund Managers

Private fund managers should be prepared to support on
examination the approach they have taken to presenting performance
in advertisements, including how that approach addresses the
Marketing Rule, the SEC’s adopting release,⁴ and the
Staff’s FAQ.

Attribution Reports and Schedules of Investments. The
FAQ does not specifically address the common practice of showing,
in close proximity to the fund’s overall gross and net
performance, the performance of (i) each of a fund’s individual
investments (e.g., schedules of investments) or (ii) each aspect of
a fund’s portfolio grouped into categories (e.g., an
attribution report). Nonetheless, the FAQ should be considered when
preparing such materials and assessing the risks associated with
presenting gross performance in those contexts.

Calculation Methodology. The Staff has not articulated
a specific calculation methodology for preparing net performance of
single investments or sections of a fund’s portfolio where fees
and expenses are taken at the fund level. Several methodologies
have evolved through market practice, each of which has limitations
and requires fulsome disclosures of the methodologies, assumptions
and limitations of such performance calculations in order to comply
with the Marketing Rule’s general prohibitions. Some examples
of common items we have observed requiring consideration in the
preparation of such returns include: the impact of a hedge
fund’s “high water mark,” the operation of different
waterfall carried interest structures, how to incorporate clawbacks
(if applicable), the impact of hedging and leverage, the timing of
investment dispositions and how to determine an appropriate expense
allocation for an investment or attribution category.

Footnotes

1. The SEC’s FAQs relating to the Marketing Rule can
be found here.

2. 17 C.F.R. § 275.206(4)-1(e)(7),
1(e)(10).

3. Id. at 206(4)-1(e)(6).

4. Investment Adviser Marketing, 86 Fed. Reg. 13024
(March 5, 2021). The adopting release can be found here.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.