Private Fund Quarterly Statement Rule Breakdown - Performance Disclosures

New Rule 211(h)(1)-2 was adopted by the U.S. Securities and Exchange Commission (SEC) on August 24, 2023, along with the rest of the Private Fund Adviser Rules. This Quarterly Statement Rule requires SEC-registered private fund advisers to prepare and distribute a quarterly statement that includes information regarding fees, expenses, and performance to the private fund’s investors. The goal of the new rule is to provide clear and simple disclosures to existing investors, so investors better understand their private fund investments.

Our previous article, Private Fund Quarterly Statement Rule Breakdown, details the required components of Rule 211(h)(1)-2 (the Quarterly Statement Rule). However, in the months since the release of the final rule, we continue to dig further into the practical implications of these required disclosures and the impacts on private fund managers’ current reporting structure. We are finding that many illiquid fund managers may face significant changes to conform with the performance requirements of the new Quarterly Statement Rule.

Below is an excerpt from the rule on the required performance components for an illiquid fund:

(A) The following performance measures, shown since inception of the illiquid fund through the end of the quarter covered by the quarterly statement (or, to the extent quarter-end numbers are not available at the time the adviser distributes the quarterly statement, through the most recent practicable date) and computed with and without the impact of any fund-level subscription facilities:

1. Gross IRR and gross MOIC for the illiquid fund;
2. Net IRR and net MOIC for the illiquid fund; and
3. Gross IRR and gross MOIC for the realized and unrealized portions of the illiquid fund's portfolio, with the realized and unrealized performance shown separately.

(B) A statement of contributions and distributions for the illiquid fund.

Illiquid funds

Illiquid funds are defined as a private fund that:

1. Is not required to redeem interests upon an investor's request
2. Has limited opportunities, if any, for investors to withdraw before termination of the fund

Illiquid funds will be required to report internal rates of return (IRR) and multiple of invested capital (MOIC) for the fund. While the IRR and MOIC are commonly calculated metrics already, the methodologies prescribed may cause advisers to rethink current practices.

Gross IRR

Gross IRR is defined as the internal rate of return calculated before all fees, expenses, and performance-based compensation borne by the fund.

Currently, a private fund is generally calculated using investment-level cash flow information (e.g., acquisition and disposition amounts). However, the Quarterly Statement Rule now requires that the Gross IRR be calculated using fund level cash flows (e.g., capital calls and distributions). This represents a categorical shift across the private fund industry as the newly required methodology has seen minimal adoption historically.

It is important to note that while private funds will be required to report performance using the newly prescribed methodology, advisers are not prohibited from providing information to supplement the standardized fund-level performance.

Considerations will need to be made that such additional information complies with the other requirements of the final rule.

Net IRR

Net IRR calculated at the fund level will typically be the same Net IRR that advisers are already calculating and disclosing.

The Quarterly Statement Rule defines net as the internal rate of return after all fees, expenses, and performance-based compensation borne by the fund. The use of limited partner (LP) capital calls and distributions with the LP Net Asset Value is the commonly shown IRR in the industry. This will be the required calculation methodology for the new rule as well.

Unlevered IRR

IRR without the impact of the fund-level subscription facilities (i.e. "unlevered" IRR)  will be required for funds on a gross and net basis.

Subscription facilities are defined as “any subscription facilities, subscription line financing, capital call facilities, capital commitment facilities, bridge lines, or other indebtedness incurred by a private fund, or on its behalf, that is secured by the unfunded capital commitments of the private fund’s investors.”

These facilities often provide another source of cash to make investments and allow the fund to delay capital calls. This process shortens the time period of the IRR resulting in a higher return with varying impact.

The adopting release notes that the levered IRR alone has the potential to mislead investors and now requires the unlevered IRR to be disclosed. This concern aligns with the recently received FAQ on the SEC’s Marketing Rule.

Although we have seen a slight shift in some markets to show an unlevered IRR, this new Quarterly Statement Rule requirement will pose a dramatic shift for many advisers. The more common approach for advisers is to disclosure the existence of a line of credit and to disclose that the line of credit could have an impact on the performance of the fund.

The premise of this calculation is to show returns as if the fund had called capital from investors rather than drawn on the subscription facility to fund all investments.

The IRR is greatly influenced by the timing of cash flows. As the subscription facility allows for capital calls from investors to be delayed, the time period measured by the IRR is compressed and, accordingly, the resulting IRR is amplified.

MOIC

MOIC must be calculated as:

• The sum of all distributions from the fund plus the Net Asset Value; and
• Divided by total capital contributed by investors.

Additionally, capital which has been distributed to investors and subsequently recalled from investors must be counted as both distributions and additional contributions.

Illiquid fund performance information that does not treat such recalled distributions as additional contributions may be misleading.

For funds where investment proceeds are reused within the fund (i.e., not distributed to investors) those advisers will need to understand and assess how to treat recallable and recycled capital.

Realized and Unrealized Gross IRR and MOIC

Realized and unrealized gross IRR and gross MOIC for the respective portions of the illiquid fund’s portfolios must be shown separately. Based on a strict interpretation of the language contained in the rule, these metrics will technically be required both with and without the impact of a subscription line though questions remain on the practical application of a levered return.

Unlike the Gross and Net IRR, the adopting release does not provide a detailed methodology for these calculations and notes that the inclusion of realized and unrealized performance information serves chiefly to provide a comparison between the two and provide a check against adviser’s exaggeration of unrealized performance at the fund-level.

Determining whether an investment is realized or unrealized may also be challenging for some advisers. However, the adopting release provides for advisers to have some discretion in determining whether an investment has been realized for purposes of the Quarterly Statement Rule based on the specific facts and circumstances, provided that their methodology is properly documented.

It is also important that advisers remain consistent in how they determine realized and unrealized investments and that they provide sufficient disclosure to investors about the methodology and criteria they use to achieve consistency in their determinations.

Statement of contributions and distributions

Statement of contributions and distributions is defined as a listing of:

• The dates and amounts of all capital inflows and outflows of the private fund; and
• The net asset value of the private fund as of the end of the reporting period.

While additional particular information beyond the above is not prescribed, advisers may wish to consider also providing other details they believe would be "critical information” to investors in the statement of contributions and distributions.

One challenge many advisers have faced here is the determination of how much information to include in this quarterly statement compared to the minimum floor of information required. The volume of cash flows necessary to calculate the Fund Net IRR is significantly lower than the volume of cash flows necessary to calculate the Fund Gross IRR without the benefit of the subscription facility.

While a fund may have only a few investor cash flows, there could be hundreds of cash flows on the subscription facility since inception of the fund. Advisers have considered whether to include this additional relevant information in the Quarterly Statement deliverable or to provide outside of the statement to help support the recalculation of all performance metrics provided in the Quarterly Statement.

How we help

The Private Fund Adviser Rules require substantial implementation efforts with varying deadlines, the implications of which private fund advisers should begin considering and planning for now.  

ACA is the only governance, risk, and compliance firm that offers both compliance and performance expertise, including a deep understanding of the intricacies of complex performance calculation methodologies – such as the ones outlined in this blog post. Our people, processes, and technology can help simplify this task and help address the new rules with:

• Private Fund Adviser Rule Readiness Assessment: Our tailored solution is designed to evaluate your firm's compliance program and investor reporting for alignment with these new rules.
• Quarterly Statements Solutions: Our tailored quarterly statement solutions help you navigate the complicated process and specifics around what is shown on these statements and how it must be calculated.
• ACA Signature: Our customized solutions combine compliance advisory, innovative technology, and managed services to provide expert solutions to assist firms with rule interpretation as well as modification and implementation of a firm’s compliance program.

Reach out to your ACA consultant or contact us to find out how we can help your firm comply with these rules.

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