An investment adviser’s investment track record is an important resource when raising capital from prospective investors. However, investment advisers, particularly registered investment advisers or emerging fund managers, must be aware that they are subject to specific limitations under the Investment Advisers Act with respect to the presentation and portability of their performance data.
Presentation of Performance
Advertising rules for investment advisers are tied to statutory anti-fraud restrictions. Section 206(4) of the Investment Advisers Act (the “Advisers Act”) prohibits an investment adviser from engaging in any act, practice or course of business that the Securities and Exchange Commission (“SEC”), by rule, finds fraudulent, deceptive or manipulative. Rule 206(4)-1(a)(5) under the Advisers Act provides that it is a fraudulent, deceptive or manipulative act to directly or indirectly distribute any advertisement that contains any untrue statement of material fact or that is otherwise false or misleading.
Registered investment advisers are also subject to other advertising-specific requirements. Under SEC rules and no-action letters (notably The TCW Group, SEC No-Action Letter (Nov. 7, 2008) and Franklin Management, Inc., SEC No-Action Letter (Dec. 10, 1998)), a registered investment adviser’s advertisement may not:
- Refer to past, specific recommendations made by the adviser that were profitable, unless the advertisement includes a list of all recommendations made by the adviser within the preceding period of not less than one year, and meets other specified conditions;
- Represent that any graph, chart or formula or other pictorial device can, in and of itself, be used to determine or assist a prospective investor in deciding which securities to buy or sell (or when), unless the limitations of that device and reliance on it to make investment decisions are prominently disclosed, and
- Represent that any report, analysis or other service will be provided without charge, unless the report, analysis or other service will actually be provided without any obligation whatsoever.
Under Rule 204-2, registered investment advisers must maintain copies of their advertisements and other communications in their records for review during an SEC examination.
In addition, a registered investment adviser looking to use data to advertise its past performance may only do so if the advertisement meets certain conditions. In particular, an advertisement using performance data must disclose all material facts as needed to avoid any incorrect inferences. An advertisement must (i) disclose the effect of material market or economic conditions on the results advertised, (ii) disclose whether and to what extent the advertised results reflect the reinvestment of dividends or other earnings, and (iii) not suggest or make claims about the potential for profit or potential for loss. Furthermore, an investment adviser may not, except in limited circumstance, use performance data that does not reflect the deduction of fees, carried interest and expenses a client would pay unless the adviser includes net performance information in an equally prominent manner.
Portability of Performance
Emerging fund managers looking to raise their first fund may, given the possible dearth of recent performance data, be tempted to leverage their track record from work at a prior firm. Similarly, that prior firm may want to use that record in ongoing advertisements. The SEC generally takes the position that an investment advisory firm’s performance data belongs to the firm, not the investment professionals or subsidiaries the data tracks, and has developed guidance regarding “portability of performance”. These rules developed from the Horizon Asset Management, LLC SEC No-Action Letter (Sept. 13, 1996), where Horizon Asset Management, LLC, a registered investment adviser, included in its advertisements performance data reflecting the performance of its wholly-owned subsidiary, also a registered investment adviser.
The SEC staff views the use of predecessor performance as not, in and of itself, misleading, provided that:
- The person or persons who manage accounts at the successor adviser were also those primarily responsible for the prior performance results;
- The accounts managed at the predecessor adviser are so similar to the accounts currently under management that the performance data would provide relevant information to prospective clients;
- All accounts that were managed in a substantially similar manner are advertised unless the exclusion of such account would not result in a materially higher performance;
- The advertisement is consistent with staff interpretations with respect to the advertisement of performance results; and
- The advertisement includes all relevant disclosures, including that performance results were from accounts managed by another entity.
As discussed, discussions of specific recommendations or investments, in lieu of the collective performance of a pool of investments, are discouraged and subject to restrictions, and investment advisers must retain copies of advertising materials in their records. Note that while the SEC’s advertising rules apply to registered investment advisers, the SEC’s guidance on this matter falls under the general anti-fraud provisions of Rule 206(4), and is therefore equally applicable to exempt reporting advisers relying on the venture capital or other exemption from registration.
Improper usage of performance data, particularly with respect to emerging fund managers, may not only prompt SEC enforcement action but may also give rise to private cause of action. Additionally, opaque or exaggerated marketing materials may lead experienced prospective investors and their counsel to believe that the manager is not fully aware of its other fiduciary obligations under the Advisers Act. Before releasing a slide deck or making an investment pitch involving the use of performance data, investment advisers should consider engaging fund formation counsel to ensure their marketing efforts are in compliance with applicable securities laws and industry standards.