Net performance metrics of private equity firms in the spotlight

May 2024  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

May 2024 Issue

The US Securities and Exchange Commission (SEC) has always taken a close look at performance metrics of registered investment advisers during SEC examinations. With the adoption of new rules and the publication of recent guidance, however, investment advisers registered with the SEC, including private equity (PE) firms, now have to comply with prescriptive rules when calculating and reporting their net performance returns.

In December 2021, the SEC adopted a substantial overhaul to the marketing rule governing registered investment advisers’ marketing materials, and the compliance date for the marketing rule was 4 November 2022. One component of the rule prohibits the use of gross performance information (performance before the deduction of fees and expenses of the fund or account), unless the advertisement also presents net performance “with at least equal prominence to, and in a format designed to facilitate comparison with, the gross performance; and calculated over the same time period, and using the same type of return and methodology, as the gross performance”.

The requirement to show net performance applies to all different types of performance under the rule, including what is called ‘extracted performance’ (or performance of a subset of a portfolio).

It is common for PE firms, and other types of advisers, to show performance information of individual portfolio companies in marketing materials. It was not clear to the industry whether, if they showed gross performance of individual investments in their marketing materials, the rule meant that they had to show performance results of individual investments also on a net basis. In other words, it was not clear whether an individual investment’s performance was ‘extracted performance’.

Shortly after the compliance date of the marketing rule, the staff of the SEC issued guidance in the form of an FAQ stating that if an adviser showed performance information of individual investments on a gross basis (e.g., in a case study), it would also have to show net performance information of those investments because such performance information was in fact ‘extracted performance’ under the marketing rule.

In this guidance, however, the staff of the SEC did not explain how advisers were supposed to calculate net performance information of individual investments, as the fees and expenses of a fund (i.e., management fees, carried interest and other expenses) are calculated at the fund level, not at the individual investment level.

Following this FAQ, the industry scrambled to figure out how it was going to update its marketing materials with case studies and other performance information of individual investments to show net performance information. Some advisers now calculate net performance information based on estimated investment-level cash flows, applying a fee and expense assumption and the fund’s carried interest percentage.

However, we typically see advisers calculate a ratio of the fund-level net performance to the fund-level gross performance information and apply that ratio to the investment-level gross returns. They then disclose how they are calculating this net number. The application of this ratio can create unexpected outcomes in certain circumstances (e.g., in particular with negative internal rate of return numbers), and advisers have come up with disclosure solutions in those circumstances.

Then, in August 2023, the SEC adopted broad-sweeping new rules affecting advisers to private funds, and one of the new rules is the requirement for registered investment advisers to private funds to prepare and distribute to the investors in the private funds a quarterly statement. The quarterly statement must include performance information about each fund it advises.

In particular, for ‘illiquid’ funds (i.e., closed-end funds like most PE funds), the quarterly statement rule requires an adviser to show the fund’s gross and net internal rate of return (IRR) and multiple on invested capital (MOIC) as well as gross IRR and MOIC for the realised and unrealised portions of the illiquid fund’s portfolio. The quarterly statement rule requires advisers to calculate and show performance measures for each illiquid fund with and without the impact of fund-level subscription facilities (typically, the net IRR calculation is based on the contribution and receipt of proceeds by investors, and because investors contribute proceeds later with a fund-level subscription facility, it generally has the effect of increasing net returns compared to investor contributions at the time the transaction is closed).

For performance measures without the impact of fund-level subscription facilities, this means advisers must calculate performance as if the fund called investor capital, rather than drawing down on fund-level subscription facilities (for which advisers would have to exclude associated fees and expenses).

This last requirement – the requirement to show performance measures with and without the impact of fund-level subscription facilities – is worth pausing on and comparing to the requirements under the marketing rule. While the quarterly statement rule requires advisers to calculate and show performance metrics for each illiquid fund with and without the impact of fund-level subscription facilities, the new marketing rule does not explicitly require performance to be shown without the impact of fund-level subscription facilities.

However, in February 2024, the staff of the SEC published a new FAQ that stated that, because net performance information needs to be calculated over the same time period as gross performance information, when an adviser advertises its fund’s performance in terms of gross IRR and net IRR, presenting gross IRR that is calculated without the impact of fund-level subscription facilities (i.e., at the time the fund makes its investment) compared only to net IRR that is calculated with the impact of fund-level subscription facilities (i.e., at the time that capital is called from investors) would violate the marketing rule.

Conversely, if an adviser shows only net performance (without gross) in an advertisement, and such performance reflects the impact of fund-level subscription facilities (i.e., net performance is calculated based on the date that investors actually contributed capital, rather than the earlier date on which the fund made the investment), then the adviser must either show ‘comparable performance’, which the staff of the SEC defines as pro forma net returns without the impact of fund-level subscription facilities, or include appropriate disclosures describing the impact of such subscription facilities on the net performance shown.

Calculating and showing returns without the impact of fund-level subscription line borrowing (in addition to returns with the impact of fund-level subscription line borrowing) is the approach that the SEC has mandated for private fund quarterly statements from registered investment advisers under the quarterly statement rule, so advisers were going to have to do these pro forma net calculations in any event, and this guidance brings the marketing rule requirements more in line with the quarterly statement requirements. This guidance is particularly relevant for PE funds, which regularly utilise subscription lines to make investments in lieu of calling capital.

It is worth noting that the levered net IRRs are actually consistent with the returns that the investors received because it reflects what an investor actually experienced based on the amount and timing of investor contributions, and an unlevered pro forma net IRR is a hypothetical net return that is distinct from the returns the investor received. That said, we believe that many advisers will continue to show the ‘true’ net levered returns in addition to unlevered pro forma net returns.

In summary, the practical impact of both the quarterly statement rule and the guidance under the marketing rule is that advisers may have to calculate new pro forma net returns for both individual investments and unlevered returns, to the extent they have not been doing so already.

We recommend that advisers confirm that their performance metrics are consistent with the requirements under the quarterly statement rule and the marketing rule – and pay particular attention to their net performance metrics – and adjust or supplement their performance metrics accordingly, including by calculating pro forma net returns.

 

Jason Brown is a partner and Colleen Meyer is counsel at Ropes & Gray LLP. Mr Brown can be contacted on +1 (617) 951 7942 or by email: jebrown@ropesgray.com. Ms Meyer can be contacted on +1 (415) 315 6366 or by email: colleen.meyer@ropesgray.com.

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Jason Brown and Colleen Meyer

Ropes & Gray LLP

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