The Financial Industry Regulatory Authority’s (FINRA) release of Regulatory Notice 20-21 (RN 20-21) on July 1, 2020, as previously reported, includes clarified guidance for calculating and presenting internal rates of return (IRR) for use in retail communications by FINRA member firms. The notice allows the use of IRR for investments or funds that have been fully realized but further requires utilizing the calculation methodologies of the Global Investment Performance Standards (GIPS®) for investment programs/funds that include both realized and unrealized holdings. Since the guidance applies to private placements conducted by FINRA member firms including third-party prepared materials, as addressed in Regulatory Notice 10-22 (RN 10-22), both private placement issuers as well as placement agents that are FINRA members involved in the creation and distribution of the retail communication should be familiar with the nuances of the notice.
IRR for Realized Investments/Funds
For a fully realized investment (or fund), the total investment and proceeds are known, and the IRR can be calculated using the actual cash flows to/from the investment or fund. Since the investment/fund has been fully realized, there is no subjective valuation of the illiquid investments as of any given point in time that impacts the IRR. As noted in RN 20-21, FINRA interprets Rule 2210 to permit retail communications to include IRR for completed investment programs.
IRR for Ongoing Funds with Unrealized Investments
In many situations, an issuer or placement agent may wish to present returns for predecessor funds, some of which may have ongoing operations resulting in a combination of realized and unrealized investments. For these funds, the IRR is significantly impacted by the period-end net asset value, which is derived from the fair value of unrealized investments. As these investments are potentially illiquid and valued using subjective inputs, the actual realized value when eventually sold may differ (sometimes materially) from the value derived at any point in time. RN 20-21 allows the inclusion of IRR for investment programs with realized and unrealized investments “if it is calculated in a manner consistent with the Global Investment Performance Standards (GIPS) adopted by the CFA Institute and includes additional GIPS-required metrics such as paid-in capital, committed capital and distributions paid to investors.”
Calculation Methodology vs. Compliance with GIPS Standards
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 trace their history back to the mid-1990’s but 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.
However, several issues arise that issuers and broker dealers should consider:
- Avoiding inappropriate references to the GIPS standards: RN 20-21’s requirement to “calculate consistent with the GIPS standards” might infer that a specific fund, track record, or even a calculation methodology could be considered “GIPS compliant.” Statements referring to a calculation methodology as being “in accordance,” “in compliance,” or “consistent” with the GIPS standards, or similar statements, are prohibited. Compliance with the GIPS standards can only be at the “firm” level, so while calculation methodologies associated with the GIPS standards are being required by RN 20-21, firms should ensure they are not inappropriately referencing the GIPS standards in any outward communications. Inappropriate/misleading claims of GIPS compliance in advertisements are also a frequent finding within SEC examinations, as indicated in a prior SEC Risk Alert. Many firms are making a full transition to compliance with the GIPS standards in order to both comply with FINRA rules and also avoid the risk of false or misleading information with regard to the status of the firm.
- Gaining internal comfort – documenting and testing calculation methodologies: For firms that claim compliance with the GIPS standards, the vast majority undergo third-party verification, providing additional assurance on the calculation methodologies and associated policies and procedures. In the absence of firm-wide GIPS compliance and third-party verification, firms may need to consider additional review and testing of not only the IRR itself but also the “additional GIPS-required metrics such as paid-in capital, committed capital and distributions paid to investors,” as referenced in RN 20-21.
The GIPS standards include specific calculation requirements for IRR, including but not limited to:
- the use of fund-level cash flows rather than investment level.
- the use of daily cash flows for periods on or after January 1, 2020. Frequency varies by asset class prior to January 1, 2020.
- reducing net IRR by management fees, carried interest, and other fund expenses.
- calculating IRR “with” and “without” the impact of subscription lines of credit, unless only used for short-term purposes with additional criteria being met.
- treating recalled capital as additional paid-in capital for investment multiples (i.e. no “netting” of recallable distributions).
- Providing external comfort: Fund managers/issuers should consider what level of due diligence is expected from placement agents or other broker dealers utilized in the offering. Firms may also consider what types of representations may be requested on the use of GIPS standards calculation methodologies especially given RN 20-21’s clear reminder that FINRA member firms can be held responsible for Rule 2210 violations when distributing or using noncompliant retail communications prepared by a third party.
How ACA Can Help
ACA offers GIPS compliance verification and other investment performance services to investment managers across the globe. Our performance division is the largest team of professionals solely dedicated to GIPS compliance verification and investment performance services.
ACA’s in-house regulatory and performance experience is leveraged to help your firm understand the broader picture of compliance. We draw from our experience and regulatory insight to help your firm understand industry best practices and the range of compliance issues that your peers face today.
Whether a firm is considering GIPS compliance for the first time, is GIPS compliant but considering expanding the firm definition, or just needs assurance that the firm’s IRR calculations abide by RN 20-21, ACA assists firms through:
- GIPS standards feasibility studies to quantify the scope and effort to become GIPS compliant
- GIPS compliance consulting and verification to provide internal and external assurance
- Ad hoc performance consulting and certifications.
Join ACA for a complimentary webcast discussing the main areas of impact to broker-dealers, FINRA member placements agents, private placement issuers, and fund managers, including:
- Overview of FINRA Notice 20-21 focusing on IRR guidance
- Key differences between realized and unrealized IRRs and the impact of FINRA Notice 20-21
- Overview of the GIPS standards, what they entail, and how they impact IRR calculations based on FINRA Notice 20-21
- Emerging trends in issuer due diligence
- Impact on compliance, finance, and performance departments
Are you a broker-dealer or FINRA member placement agent? Register here for the November 17 webcast.
Are you a private placement issuer or fund manager? Register here for the November 19 webcast.
For more information or questions, please reach out to your ACA consultant or contact us below.