New SEC Marketing Rule FAQ: IRR Calculations When Using Subscription Lines

On February 6, 2024, Securities and Exchange Commission (SEC) staff issued frequently asked question (FAQ)[1] guidance with respect to registered investment advisers’ obligations under Rule 206(4)-1 (Marketing Rule) of the Investment Advisers Act of 1940 (Advisers Act).  The FAQ describes, among other things, how gross and net internal rates of return (IRRs) should be presented under the Marketing Rule when a fund uses subscription lines and other borrowing arrangements.

The Marketing Rule requires the presentation of gross performance to be accompanied by a presentation of net performance that has been calculated over the same time period, and using the same type of return and methodology as the gross performance.  Further, the staff noted, net performance must be presented in a manner designed to facilitate comparison with gross performance.

Calculating and Presenting Gross and Net IRR

The SEC noted that certain advisers to investment funds that utilize leverage or subscription facilities present gross IRR figures that are calculated from the time an investment is made, as opposed to the time when the investors contribute capital to repay those borrowings (i.e., gross IRR calculations that exclude the impact of borrowing) and also present net IRR that is calculated from the time investor capital has been called to repay such borrowing (i.e.,net IRR that does reflect the impact of borrowing).  The staff took issue with this form of presentation.  Specifically, the FAQ provides:

• Consistent Timing and Methodology when Presenting Gross and Net IRR Together.  If an adviser chooses to exclude the impact of fund-level borrowing from the fund’s gross IRR, it cannot then include the impact of such borrowing in the Net IRR (i.e., if the impact of borrowing is excluded from one metric it must be excluded from the other and vice versa);

In the SEC’s view, such inconsistencies would violate the Marketing Rule because the differing timing and methodologies would prevent investors from being able to compare the gross and net performance metrics.

• Rules Only for Net IRRs.  Furthermore, it is a violation of the Marketing Rule’s general prohibitions[2] to show net IRR with the impact of fund-level borrowings without either:
  • showing comparable net IRR without the impact of fund-level borrowing; or
  • providing appropriate disclosures describing the impact of such borrowing on the net IRR.  (The FAQ did not provide any guidance on what the SEC considers “appropriate disclosure.”)

In the SEC’s view, presenting only net IRR figures that include the impact of fund-level borrowing, could mislead investors by suggesting that the fund’s advertised performance is similar to the performance that the investor has achieved from its investment in the fund alone.

The Marketing Rule does not require advisers to show gross performance if only net performance is shown.  Accordingly, advisers can present net IRR including or not including the impact of fund-level borrowing without being required to display the gross IRR with the same methodology; provided, however, the net IRR that includes the impact of fund-level borrowing is subject to the additional requirements discussed above.

Private Fund Adviser Rules

Under one of the recently adopted “private fund adviser” rules (Rule 211(h)(1)-2),[3] quarterly statements of illiquid funds will be required to present both gross IRR and net IRR with and without the impact of fund-level subscription lines.  The FAQ appears to be an attempt by the SEC to align Marketing Rule requirements with the “private fund adviser” rules.

Action Items

Private fund advisers should review their marketing materials (e.g., pitch decks, PPMs, etc.) that include gross IRR and net IRR metrics to ensure calculation methodology, time periods, and presentation are consistent with the FAQ.

Please contact your Foley Fund Formation and Investment Management client team for more information and assistance with navigating these Marketing Rule obligations.

[1] Available at:  https://www.sec.gov/investment/marketing-faq.

[2] Specifically, Rules 206(4)-1(a)(1) and 206(4)-1(a)(6) under the Advisers Act.

[3] See Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Investment Advisers Act Release No. 6383 (August 23, 2023) (available at: https://www.sec.gov/files/rules/final/2023/ia-6383.pdf).