On January 11, 2023, the staff of the Division of Investment Management at the US Securities and Exchange Commission ("SEC Staff") updated their Marketing Rule FAQs. A new FAQ appears to impose the net performance presentation requirement at the investment-level (and not just the portfolio-level) under the amended Rule 206(4)-1 under the Investment Advisers Act of 1940 (the new "Marketing Rule"). This FAQ represents the most significant interpretative position that the SEC Staff has taken publicly since the Marketing Rule's November 4, 2022 compliance date.
Net Performance Requirement and the New FAQ
Rule 206(4)-1(d)(1) requires that any advertisement presenting gross performance must also include net performance (the "net performance requirement"). Due to the definitions of the relevant terms (including "portfolio" and "extracted performance") in the Marketing Rule, many industry participants had interpreted the Marketing Rule as not requiring net performance with respect to the presentation of gross performance of a single investment if it was presented in a "fair and balanced" manner and was not otherwise misleading.
In the FAQ, the SEC Staff stated that the performance presentation of one investment or a group of investments in a private fund is an example of "extracted performance" under the new rule and, if an adviser shows gross performance of such investment(s), it must also show the net performance of such investment(s) with equal prominence and using the same methodology. The SEC Staff also reiterated that an adviser must satisfy the tailored disclosure requirements, which require the performance presentation to be presented in a "fair and balanced" manner and not be misleading.
Challenges With Compliance
The Marketing Rule does not prescribe any particular approach for calculating net performance information at the investment-level, and the SEC Staff has not yet provided any guidance in this respect. Calculating and presenting net performance information of individual investments of private funds that satisfy the tailored disclosure requirements will present significant challenges for private fund sponsors. The calculation of the "actual" net performance at the investment-level is often impractical, if not impossible, particularly due to issues with, among other things, the allocation of fund-level expenses and carried interest, the retroactive calculation of the allocation of investment-level expenses, and the timing issues with such allocations. These challenges suggest that, in many circumstances, an estimated or model fee will be required, which would create separate disclosure issues to prevent the presentation from being misleading.
The SEC Staff justifies the FAQ based on its view that an adviser could "present misleadingly selective profitable performance." However, this risk would appear more directly addressed by the "fair and balanced" presentation requirement — the net performance requirement was justified in the adopting release of the Marketing Rule as helping to convey "to the audience information about the effect of fees and expenses on the relevant performance." The FAQ does not address how this risk exists in the context of the traditional "component" performance presentation — whereby individual investment performance is presented in a table showing the gross performance of each investment as well as fund-level performance (which would include both gross and net performance).
Finally, the timing of this FAQ is problematic for investment advisers. It represents only the third FAQ issued by the SEC Staff in two years following the adoption of the Marketing Rule. The SEC Staff published the FAQ a little over two months after the compliance date on November 4, 2022 but before the SEC Staff has completed its sweep of Marketing Rule-focused examinations. The SEC Staff did not state why it opted not to wait to use information gathered from its examinations to inform the new FAQ or why it did not issue the FAQ prior to November 4, 2022. Further, the SEC Staff did not indicate how it will address advertisements distributed following November 4, 2022 but before the publication of this FAQ.
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