Why The SEC's Action Against Misleading Statements is Important to UK Institutional Investors Entering Private Funds
UK institutional investors considering committing to a new private equity, venture capital or hedge fund ( 'Private Funds') read their private placement memoranda ('PPMs') with interest (or instruct their consultants to do so).
PPMs for Private Funds are loosely modelled on prospectuses for public offerings. In addition to the dry material of risk factors, principal terms, and taxes, PPMs display metrics of prior investment performance when the sponsor has a track record with the same strategy.
On close inspection, these presentations of past 'investment performance' have different emphases:
- Is performance computed before or after deducting advisory fees?
- Are all prior vintages of the strategy included in aggregate numbers?
- Are all parallel funds, co-investments and separately managed accounts added to the numbers for the main fund?
Readers, aware that fundraising can be a competitive business, sometimes feel that numbers are being sliced and diced for promotional effect, and wonder which rules militate against sponsors misleading their audience in marketing.
Given the dominance of US-based advisers in the Private Fund industry, it is unsurprising to learn that the presentation of prior performance in many PPMs is governed by the Securities & Exchange Commission's ('SEC') truth-in-marketing rules. Any adviser which seeks to manage the capital of US persons must register with the SEC (upon reaching $100M of AUM, if it is a US-based adviser). If an SEC-registered adviser maintains its principal office and place of business in the United States, it is subject to the SEC’s marketing rules in its dealings with Private Funds wherever they are organised or distributed. Thus, an SEC-registered adviser based in the United States seeking UK investors for a new fund organised in the Cayman Islands will need to comply with the SEC rules on marketing to those UK investors. On the other hand, if the adviser is based outside the United States, its dealings with a Private Fund organised outside the United States are not subject to the SEC’s rules on marketing even if:
- the fund has US investors, or
- the adviser is registered with the SEC for some other reason. Wherever the adviser is based, fundraising from UK investors will also need to comply with the UK’s rules against misleading statements.
To date, the SEC’s guidance on marketing has taken the form of a series of ad hoc advance rulings on specific facts granted by the SEC to petitioning advisory firms, upon which lawyers for Private Funds generally rely when reviewing draft PPMs. There is also a general rule prohibiting advisers, whether registered with the SEC or not, from making fraudulent statements to any potential investors within US jurisdiction. On 5 March, after much consultation, the SEC replaced this patchwork with a comprehensive set of new rules on marketing by investment advisers to both individual clients and Private Funds, which will become effective on 4 May and must be complied with after an eighteen-month transition period.
The new rules’ main goal is to guard against sponsors misleading potential investors by emphasising some elements of past performance over unflattering episodes or ventures (ie, 'cherry-picking'). They implement general principles and provide some specific guidance. Private Funds are distributed only in private placements to sophisticated persons (as variously defined), and the new rules ratchet down some prohibitions when the audience consists of such persons, rather than individual 'retail' clients.
No action is required by UK institutional investors; they will simply benefit from a more straightforward presentation of investment performance in PPMs, probably well in advance of the compliance deadline. Investors in venture capital funds, however, should be aware that these new rules are unlikely to apply directly to advisers, wherever based, of those funds. Furthering its policy of encouraging early-stage capital formation, the SEC does not require advisers to “venture capital funds,” as restrictively defined, to register with it and so exempts them from the new rules. This raises the possibility that the class of venture capital funds will have lower standards when displaying prior investment performance in PPMs. We think it more likely, however, that these funds will eventually adhere to the new, higher market standard.
Set forth below is a summary of selected elements of the new rules.
Gross and Net Performance
Past financial performance must now be presented net of all fees and expenses that investors bore for advisory services. Given the variability and materiality of fees and carried interest in Private Funds, most PPMs already respond to investors’ desire to see net performance figures.
Related Portfolios
The option of excluding some parallel entities of a prior fund, or of some prior vintages of a particular multi-vintage fund strategy, has been curtailed by the new rules. If a sponsor is fundraising for a new Private Fund which shares “substantially similar investment policies, objectives, and strategies” with one or more prior iterations, and wishes to show the performance of one such iteration, it must show that of all of them, either on a portfolio-by-portfolio basis or as a composite aggregation. Thus, for example, if there has only been a single prior iteration of the same investment policy, then the performance of all parallel entities of the prior main fund, and of any separately managed accounts sharing the same policy, must be included. Further, if there has been more than one prior vintage of the same investment policy, then all prior vintages must be taken into account.
During consultation it was argued that advisors should be able to exclude certain earlier vintages which share the same policy as the new fund on the ground that their assets had been smaller, market conditions had changed, or the advisory personnel were no longer in post. The SEC stated that earlier vintages could be excluded on the ground of changed personnel or market conditions only if such change meant that the earlier funds no longer shared the investment policy of the new fund being marketed. This appears to be a high bar for exclusion.
It was further argued that parallel funds, co-investments, or separately managed accounts sharing the same strategy could be excluded from the numbers of the main fund if their fee structures were different. The SEC said that a difference in fee structure alone would not suffice if the investment policies of the two portfolios were substantially similar. On the other hand, the SEC did concede that the results of a 'flagship fund' could be separated out provided that the PPM also displayed the performance of that fund together with all its related portfolios. Also, it is permissible to exclude a particular related portfolio if doing so does not materially flatter the results of the remainder.
It is quite common for PPMs to present the performance of only a subset of prior vintages of the same investment strategy, albeit identifying the excluded vintages in a footnote. It is also common for PPMs to exclude some parallel funds, co-investments, and separately managed accounts from the numbers for the main fund. We think that forcing advisers to include the numbers of all prior iterations of a single investment strategy or none will have a materially positive impact on PPMs.
Extracted Performance
Sponsors sometimes wish to launch a new fund specialising in a subset of opportunities embraced by one of their prior funds, and to break out the past performance of that subset. For example, an adviser might wish to launch a fund solely of fixed-income investments, which it had managed previously as a subset of a multi-strategy fund. PPMs are permitted to separate out actual results of the desired subset of investments made by a prior fund if they provide, or offer to provide promptly, the results of the total portfolio from which the subset was extracted. The same rule applies to the presentation of the results of a particular portfolio company in a prior fund (ie, a case study), which is popular in private equity PPMs. In our experience, PPMs already generally follow this approach.
The SEC, however, is nervous about a sponsor extracting a subset from a composite aggregated from multiple portfolios, rather than a subset of investments from a single portfolio, because it is unlikely to reflect the holdings of any actual investor. In this case, the SEC will demand the additional protections needed for displaying “hypothetical performance” as described immediately below.
Hypothetical Performance
Hypothetical performance means results that were not achieved by any actual portfolio of the adviser, including:
- those derived from a model portfolio (such as a subset extracted from a composite mentioned immediately above)
- those derived by applying a strategy to data from earlier time periods when the strategy was not actually used during those periods (ie, 'backtesting')
- those involving projections for a new Private Fund.
The SEC considers this type of performance advertising to create the biggest risk of cherry-picking, and so requires the highest level of investor protection.
First, advisers will need to adopt policies and procedures in their house manual designed to ensure that this type of advertising is relevant to their intended audience’s “likely financial situation and investment objectives.” Second, they must provide sufficient information in the PPM to enable the audience “to understand the criteria used and assumptions made” in the calculation. Third, they must provide or offer to provide promptly sufficient information to enable an investor to understand “the risks and limitations” of using the hypothetical performance when making investment decisions.
But, understanding the dynamic of customary interactions, the SEC permits sponsors of new Private Funds to discuss hypothetical performance freely in a one-on-one communication with a prospective investor or when responding to an unsolicited request for such information (eg in a Request For Proposal). The investor is sufficiently protected by its ability to question the sponsor in these cases.
Summary
Although past performance is not a reliable guide to the future, the Investment Performance section of a PPM attracts much attention when funds are raised for a further iteration of a strategy. By systematically re-writing its patchwork of rules, the SEC has encouraged this material to be presented in a more systematic and less confusing way, and we anticipate that PPMs will improve steadily in this regard during the transition period. Lawyers for sponsors will be more likely to monitor how this financial information is presented at the drafting stage, and to press sponsors to include the performance of all prior portfolios unless they can document that a particular portfolio does not implement a substantially similar investment policy as that of the new fund. Discussions of hypothetical performance will be conducted only in one-on-one communications or responses to RFPs.