United States: SEC Marketing Rule FAQ's Unexpected Impact On Investment Performance Presentations

On January 11, the staff of the SEC's Division of Investment Management (the “Staff”) released new guidance with respect to the current version of Rule 206(4)-1, adopted under the U.S. Investment Advisers Act of 1940 and amended in late 2020 (the “Marketing Rule”).¹ This new guidance, which came in the form of an update to the Staff's FAQs for the Marketing Rule, appears to require private fund sponsors to include “net performance” with any presentation of a subset of an investment portfolio, including “deal-by-deal” returns or “deal studies.” This interpretation is a departure from how many industry participants thought the Marketing Rule would apply to individual investment-level presentations and will require sponsors to consider how to provide such information going forward and whether providing it with gross performance on an investment-level basis is still practical.

Net Performance Requirement for Individual Investment Presentation

The Marketing Rule prohibits any presentation in an advertisement (broadly defined) of gross performance unless the advertisement also includes a presentation of “net performance.”² Gross performance is defined as performance results “before 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 advisory services to the relevant portfolio.” According to the Marketing Rule, where performance results are provided for a subset of investments of a portfolio, both net and gross performance for such “extracted performance” must be shown with equal prominence and calculated over the same time period, using the same methodology.³ Such a presentation must also satisfy the general prohibitions of the Marketing Rule, which among other things prohibit the presentation of information other than in a “fair and balanced manner.”

The text of the new Marketing Rule was unclear, however, as to whether a presentation of certain individual investments – such as a deal study or deal-by-deal presentation – would constitute “extracted performance.” Many private fund sponsors calculate all fees, carried interest, and certain expenses only at the fund or portfolio level and allocating all fund fees and expenses to individual investments could present significant challenges. Nevertheless, in the FAQ the Staff takes the position that including net performance helps demonstrate “to the audience information about the effect of fees and expenses on relevant performance” and the failure to provide such information would be considered “misleading under the final rule ….”⁴

Compliance Required

Showing net performance of individual investments will most likely require the adoption by many private fund sponsors of methodologies to attribute such amounts to individual portfolio holdings. Disclosure of such methodologies and any corresponding assumptions, and consistent application to similar portfolios, will be necessary to comply with the general prohibitions of the rule. Given the fact that the compliance deadline for the new Marketing Rule was November 4, 2022, investment advisers and fund sponsors should waste no time reviewing their offering and marketing material and developing methodologies for allocating fees and expenses across individual investment presentations. Offering and marketing materials distributed in reliance on the industry's understanding of the rule's application before this FAQ update will likely need to be supplemented or amended. 

Conclusion

The guidance released by the Staff is only the third provided since the Marketing Rule was adopted two years ago. The SEC has begun conducting Marketing Rule sweep examinations to determine compliance by advisers and private fund sponsors, but no results should be expected for a while. Industry standards with respect to the methodologies and models for allocation will continue to develop, but it will remain to be seen which the SEC examiners and Staff will find acceptable. 

Seyfarth's institutional investor, private fund and SEC enforcement attorneys will continue to keep you updated as the SEC's interpretations continue to evolve and are available for more information and any questions you may have about the Marketing Rule and newly issued guidance.

Footnotes

1. Release No. IA-5653, Dec. 22, 2020 (“Release”).

2. See Release, section II.E.1; Rule 206(4)-1(e)(7) and (10).

3. See Release, section II.E.5; Rule 206(4)-1(e)(6).

4. See id (discussing extracted performance).

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