Regulatory Changes Force Private Fund Managers to Re-Focus on IRRs or Face Fundraising Hurdles

Private fund managers, fund raising through intermediaries, such as placement agents, bank-platforms, or other types of registered broker-dealers, must be aware of a new hurdle that they might face while engaging with these intermediary channels. Such channels, in some cases, are requiring a legal representation for internal rate of return (IRR) calculations to be consistent with the Global Investment Performance Standards (GIPS®) and to include additional GIPS-required metrics (discussed in further detail below).

This request from intermediaries comes on the heels of FINRA Regulatory Notice 20-21 (RN 20-21). Under the notice, the marketing of an IRR for a portfolio investment and/or fund that has realized and unrealized returns is permitted only if it is calculated in a manner consistent with the GIPS standards and includes additional GIPS-required metrics such as paid-in capital, committed capital, and distributions paid to investors. 

This has caused confusion for private fund managers who calculate IRRs but do not comply with the GIPS standards. In this blog we will try to address how fund managers can overcome this fundraising hurdle, and some key misconceptions. 

Utilizing GIPS methodologies vs. GIPS compliance

It is important to note that RN 20-21 focuses on the use of IRR calculation methodologies that are consistent with the GIPS standards and the inclusion of additional GIPS-required metrics. This is a subset of what is required if a firm wishes to claim compliance with the GIPS standards, as shown below.  

Calculating IRRs consistent with GIPS standards

Though working with multiple fund managers to assess the impact of RN 20-21 and the associated legal representations that are being requested, ACA’s experience is that several misconceptions have arisen related to utilizing “GIPS methodologies”:

Misconception #1:  Generally Accepted Accounting Principles (GAAP) dictates the IRR calculation methodology, and the IRR in GAAP financials is consistent with the GIPS standards.

Not necessarily. While it is true that certain elements of GAAP are consistent with the GIPS standards, such as the use of fair valuation of investments and accrual accounting, the GIPS standards also include additional calculation requirements such as for the treatment of fees & expenses, timing assumptions for capital calls/distributions, and prescriptive treatment for recallable distributions, among others. Fortunately, in ACA’s experience, the inputs and calculations that many firms are already utilizing to calculate fund-level net IRRs can often be made fully consistent with the GIPS standards with minimal adjustments.      

Misconception #2: It is easier/safer to only show fully realized deals/funds rather than trying to utilize methodologies and metrics consistent with the GIPS standards to continue showing unrealized or partially realized deals/funds.  

While it may seem like hyperbole that a firm would just omit the presentation of performance for ongoing funds and/or unrealized investments from a firm’s fundraising efforts, ACA has heard this as an option from multiple firms. However, it likely is not an ideal option for many firms and it seems to overestimate the work entailed with calculating “GIPS-compliant” IRRs. Additionally, only presenting IRRs for realized funds and/or aggregations of only realized investments may also present issues related to the existing “Fair and Balanced” expectation of FINRA and the new SEC marketing rule. It may also cause issues related to the extracted performance requirements from the marketing rule. 

Misconception #3: The GIPS standards are not relevant or relatable to private fund managers. 

The GIPS standards are ethical standards for calculating and presenting investment performance based on the principles of fair representation and full disclosure. The GIPS standards were largely focused on traditional asset class structures until the recent release of the 2020 GIPS Standards, which greatly expanded and standardized the use of IRR and the overall applicability of the GIPS standards to private funds. 

Misconception #4: The relatively narrow scope of RN 20-21 is reflected in the representations being requested by bank platforms.  

As mentioned previously, the use of GIPS methodologies and inclusion of GIPS metrics is included within the safe harbor related to presenting IRRs for funds with ongoing operations within retail communications. Since fully realized predecessor funds would fall outside of this scenario (as they no longer have unrealized holdings), firms may initially assume that there is no need to assess whether the methodologies utilized for realized fund/investment IRRs are consistent with the GIPS standards.   

In practice, ACA has seen fund managers receive a variety of requested representations from bank platforms/broker-dealers as a result of RN 20-21. While some closely mirror the facts and circumstances outlined above from RN 20-21, others are requesting broader representations that all IRRs are consistent with the provisions of the GIPS standards. Ultimately, ACA recommends that fund managers be prepared to explain and demonstrate the assumptions and methodologies for all performance metrics utilized in marketing materials.  

Misconception #5: If we represent that our calculation methodologies are consistent with the GIPS standards, we face potential backlash from the SEC.  

The safe harbor provided within RN 20-21 does not require any type of disclosure within the marketing materials indicating the use of methodologies consistent with the GIPS standards nor any specific reference to the GIPS standards. Further, inappropriate / misleading claims of GIPS compliance in advertisements are frequent deficiencies from SEC examinations, as indicated in a prior SEC Risk Alert.   

If a firm is not already claiming compliance with the GIPS standards on a firmwide basis, any new references to the GIPS standards included in marketing materials as a result of RN 20-21 should be reviewed carefully to ensure they are allowable and appropriate.  

Defining the additional GIPS-required metrics

In addition to requiring the use of “GIPS-compliant” methodologies, the safe harbor provided within RN 20-21 for IRRs of funds with ongoing operations also requires the inclusion of “additional GIPS-required metrics”. While RN 20-21 includes three examples of additional GIPS metrics (paid-in capital, committed capital, and distributions paid to investors, the GIPS standards have subsequently indicated the following seven metrics are required:

As dollar amounts:  

• cumulative committed capital, 
• since-inception paid-in capital, 
• since-inception distributions

As a ratio or multiple:

• TVPI (total value to since-inception paid-in capital) aka investment multiple or MOIC
• DPI (since-inception distributions to since-inception paid-in capital)
• RVPI (residual value to since-inception paid-in capital)
• PIC (since-inception paid-in capital to cumulative committed capital)

Firms that are GIPS compliant and prepare GIPS Reports would already have these metrics calculated. For those that are not GIPS compliant, most already calculate some of these statistics, such as TVPI (aka MOIC) and DPI.  

How ACA can help

For firms that do not want to fully comply with the GIPS standards, ACA offers the following service to assist them in ensuring they are able to meet the FINRA 20-21 requirements: 

• Focused Performance Review: ACA provides consulting on what it means to be consistent with the GIPS standards with respect to IRR calculations as well as insights on GIPS-required metrics and the associated calculation methodologies. ACA consultants will conduct calculation methodology reviews on the IRRs and multiples to make sure firms meet the RN 20-21 requirements which will result in a findings report. 

For firms choosing, or considering, a full transition to the GIPS standards, ACA offers: 

• GIPS Feasibility Study: GIPS standards feasibility study to quantify the scope and effort to become GIPS compliant. This service assists a firm in identifying the gaps to GIPS compliance.
• GIPS Compliance and Verification: GIPS compliance consulting and verification to provide internal and external assurance. 

Additional resources on meeting FINRA 20-21 requirements

• FINRA IRR Requirement and the 2020 GIPS Standards for Alternative Managers (ACA Spring 2021 Conference Session)
• FINRA Leverages the GIPS Standards for Standardizing Private Placement Performance Marketing
• FINRA Requires Unrealized Fund IRRs to be Presented in Accordance with the GIPS Standards (Issuers and Fund Managers)
• FINRA Amends Rules 5122 and 5123 Filing Requirements to Include Retail Communications that Promote or Recommend Private Placements

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