On Wednesday evening, the SEC Staff published two new FAQs relating to the presentation of gross and net performance under the Investment Advisers Act Marketing Rule, the sweeping 2022 overhaul of the advertising and endorsement restrictions applicable to registered investment advisers (“RIAs”).  Both FAQs provide significant relief from prior Staff interpretations of the Marketing Rule and will dramatically reduce compliance burdens for RIAs in the areas of performance of individual investments and certain performance “characteristics” of portfolios and investments.  The limited open questions raised by new FAQs pale in comparison to the issues RIAs faced with the prior interpretations.

Marketing Rule Requirements and Prior FAQs

The Marketing Rule prohibits the presentation of gross performance (returns without deductions for fees and expenses) without presenting net performance (returns reflecting the deduction of fees and expenses).  The net performance must be shown with equal prominence to the gross performance, calculated with the same methodology and time period, and shown in a format designed to facilitate comparison with the gross performance.  Prior FAQs required RIAs to apply this requirement when showing the performance of one investment or a group of investments from one portfolio or a group of similar portfolios (defined as “extracted” and “composite” performance, respectively).  As a result, RIAs have had to develop and document methodologies for calculating pro forma net performance of individual investments, which was not market practice before the Marketing Rule and which has presented significant operational issues relating to, among other things, the fact that a significant portion of a fund’s fees and expenses are charged at the fund (and not investment) level, and such fees and expenses are often not easily allocatable to underlying investments. 

In addition, the Marketing Rule does not contain a definition of “performance,” leading to ambiguity for RIAs about whether certain characteristics of portfolios or investments, such as coupon rate, yield, contribution metrics and ratios, were captured by the Marketing Rule’s gross and net performance requirements.  As a result, RIAs had to make subjective judgments and risked hindsight criticism during SEC examinations or investigations.

New FAQ on Extracted and Composite Performance

The first new FAQ reverses the prior FAQ’s position on the presentation of gross and net performance for individual investments.  The new FAQ expressly permits showing gross performance of extracted and composite investment performance without net performance as long as both fund level gross and fund level net performance accompanies the extract or composite, and meets the following other conditions:

1. The extracted/composite performance must be clearly labeled as gross performance;
2. The gross and net performance of each fund reflected in the extract or composite must be presented consistent with the Marketing Rule;
3. The fund level gross and net performance must be presented with at least equal prominence to, and in a manner designed to facilitate comparison with, the extracted or composite performance; and
4. The fund level gross and net performance must be calculated over a time period that includes the entire time period over which the extracted or composite performance is calculated. 

The SEC Staff acknowledged that the time periods for extracts and composites may not easily align with the Marketing Rule’s required time periods, and so the FAQ permits extracted and composite performance to be calculated over a single, clearly disclosed period.  The FAQ also permits the first condition to be satisfied with disclosure that the extract or composite does not reflect “the deduction of all fees and expenses that a client or investor has paid or would have paid” and refers the reader to the fund level gross and net performance to understand the overall effect of fees.

Notably, the FAQ provides that the total fund gross and net performance does not need to be on the same page as the extract or composite.  It does not provide guidance on how far from the extract or composite is permissible, but stated that the fund level performance could be prior to the extract/composite to help facilitate comparison.  A question remains as to whether fund level performance coming after the extract/composite, such as in an Appendix or in the full track record, with disclosure on the page with the extract/composite referring the reader to that later presentation, would be sufficient.

Finally, the FAQ reminded RIAs that a composite of investments from multiple portfolios may be considered hypothetical performance, and those requirements, as well as the other Marketing Rule requirements, will still apply to composites.

New FAQ on Portfolio or Investment “Characteristics”

The second new FAQ acknowledged that by not defining “performance,” the Marketing Rule left RIAs unsure of whether certain characteristics are subject to the performance requirements in the Marketing Rule.  The FAQ provided the following examples: yield, coupon rate, contribution to return, volatility, sector or geographic returns, attribution analyses, the Sharpe ratio, and the Sortino ratio.  The FAQ expressly permits showing gross performance without net performance for these characteristics as long as the following conditions are met:

1. The gross characteristic is clearly identified as being calculated without the deduction of fees and expenses;
2. The gross characteristic is accompanied by a presentation of fund level gross and net performance presented consistent with the Marketing Rule;
3. The fund level gross and net performance is presented with at least equal prominence to, and in a manner designed to facilitate comparison with, the gross characteristic; and
4. The fund level gross and net performance is calculated over a time period that includes the entire period over which the gross characteristic is calculated.

The SEC Staff noted that this FAQ does not take a position on whether any particular characteristic is “performance” under the Marketing Rule, and that to the extent a characteristic is not performance, the presentation of such characteristic would not be subject to the performance requirements under the Marketing Rule.  Accordingly, where an adviser has already determined that particular characteristics are not “performance” under the Marketing Rule, including those in the examples listed in the FAQ, we believe that the adviser does not need to comply with the FAQ.  However, advisers should document and validate those conclusions, and some advisers may decide to follow the FAQ as a matter of prudence.  The FAQ did, however, identify the following characteristics that do not benefit from the FAQ’s new position: return on investment (ROI), internal rate of return (IRR), multiple on invested capital (MOIC), and Total Value to Paid in Capital (TVPI), regardless of how such metrics are labeled.  While some of these are consistent with market practice, there may be others that RIAs had treated as not “performance” but will now need to conform in order to comply fully with the Marketing Rule. 

This FAQ applies the same guidelines as the first FAQ for the time period shown, disclosure as to the gross performance condition, and what constitutes “equal prominence” within an advertisement.