On February 6, 2024, the SEC staff posted a new Marketing Rule FAQ that will be important to many private equity and private credit managers. The new FAQ addresses the presentation of net and gross IRR by managers of private funds that use subscription credit facilities. In short, the FAQ:
- States that the presentation of (i) gross IRR calculated from the time of a fund's investments, together with (ii) net IRR calculated from the time of LP capital calls violates the Marketing Rule if the fund in question utilizes a subscription credit facility;
- Requires a manager that presents gross IRR calculated from the time of investment to also present net IRR calculated from the time of investment; and
- Requires a manager that presents net IRR from the time of LP capital calls to include either: (i) net IRR calculated from the time of investment; or (ii) disclosure describing the impact of the subscription credit facility on net performance.
SEC staff issued this FAQ to address its concern that a prospective investor will consider the performance experienced by LPs without understanding the leveraging effect of the subscription credit facility. As background, an IRR calculated across a shorter period of time is higher than an IRR calculated across a longer period of time. Use of a subscription credit facility truncates the time that an LP has money at work in a fund compared to the time that the fund holds its investments, and consequently the IRR experienced by an LP is higher than the IRR experienced by the fund. The staff appears to be concerned that the difference could be material in a recent-vintage fund with a short operating history despite the sophistication of private equity investors and notwithstanding that the performance experienced by LPs is likely more relevant to an investor's understanding of its investment results.
The FAQ applies to every communication that is an "advertisement" as defined in the Marketing Rule, including presentation books, relevant portions of PPMs, and standardized RFP responses, among others. To comply with the Marketing Rule as interpreted by the FAQ, a manager that presents gross IRR calculated from the time of investments must also present net IRR calculated from the time of investment "with at least equal prominence to, and in a format designed to facilitate comparison with" the gross performance. Footnote or endnote disclosure generally will not satisfy this requirement. By contrast, a manager that presents net IRR from the time of LP capital calls must include either net IRR from the time of investment or appropriate disclosures describing the impact of the subscription credit facility on the net performance.
Private credit managers will face challenges meeting this standard. Unlike a buyout fund that makes a single investment funded by a subscription line and calls capital for that investment from LPs at a later date, private credit managers that utilize subscription lines typically draw on the line to fund multiple transactions without tying capital calls to specific transactions. Consequently, there is no easy way for private credit managers to calculate net performance based on the time of investments.
The lack of clarity on this topic has not discouraged the SEC staff from citing this issue as a deficiency in examinations, and publication of the FAQ may increase the likelihood that the staff will seek to enforce this interpretation. Managers that utilize subscription credit facilities should assess whether their practices are consistent with the FAQ and consider any necessary steps to adjust current practices.
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