Private fund advisers that are registered with the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940 (the “Advisers Act”) are subject to certain rules governing their use of investment track records and performance data. The Advisers Act Marketing Rule (the “Rule”) applies to all “advertisements”—which are broadly defined to include most marketing materials, including portions of a fund’s private placement memorandum, slide decks, and certain information provided in response to due diligence questionnaires—and imposes specific conditions on presenting performance information and using testimonials, endorsements, and third‑party ratings in these materials.[1] Although the Rule does not strictly apply to exempt reporting advisers (ERAs),[2] ERAs are “investment advisers” under the Advisers Act and thus are subject to the Act’s antifraud standards, which prohibit investment advisers from engaging in any fraudulent, deceptive, or manipulative conduct.[3] Given that the SEC believes that the marketing and solicitation activities covered by the Rule are inherently misleading, it is best practice for an ERA to ensure that its marketing practices adhere to the principles of the Rule to avoid running afoul of the antifraud standards. This article highlights some of the guardrails imposed on private fund advisers when they are presenting their track records and related performance information in a fund’s offering documents.

1. Gross vs. Net Performance

The Rule prohibits registered investment advisers (including private fund advisers) from presenting only gross performance in an advertisement. The SEC has historically viewed this practice as misleading because such performance does not reflect the actual performance results that an investor achieves. Under the Rule, an investment adviser may not include in an advertisement any presentation of gross performance, unless the advertisement also presents net performance:

• With at least equal prominence to, and in a format designed to facilitate comparison with, the gross performance, and
• Calculated over the same time period, and using the same type of return and methodology, as the gross performance.[4]

A private fund adviser must ensure that any track record or other performance presented in an advertisement includes net performance in a manner that complies with the Rule. While this requirement is simple on its face, calculating net performance can be challenging for private fund advisers, especially because of the breadth of the application of this requirement. The Rule defines “gross performance” as the performance results of a portfolio before the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser’s investment advisory services to the relevant portfolio.[5] The Rule also defines “net performance” as the performance results of a portfolio after the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser’s investment advisory services to the relevant portfolio, including any advisory fees and performance-based fees.[6]

The SEC staff has stated that this requirement applies to the performance of any single investment or group of investments within a private fund (e.g., a case study).[7] This requirement also applies to any portion of a portfolio that is included in extracted performance (e.g., a subset of the larger portfolio).[8] If a private fund adviser seeks to present the performance of a subset of specific types of investments from a private fund’s portfolio—for example, a subset of fund investments focused on emerging markets or a specific industry—the performance of the subset of investments must be presented on a net basis. In practice, this presents a challenge for private fund advisers, as fees and expenses are charged to the entire fund (and not with respect to any specific investment or group of investments). Neither the SEC nor its staff has provided any guidance on how to calculate net performance for a specific fund investment. Generally, however, private fund advisers implement a process for allocating a portion of the private fund’s fees and expenses to each investment and disclosing the material facts of this allocation process in the relevant materials. In these situations, a private fund adviser must be careful to comply with the Rule’s general prohibitions, which apply to all aspects of an advertisement and are highly fact dependent.

The Rule permits an adviser, in calculating net performance, to use a model fee, which can be useful for an investment adviser that is launching a new fund and advertising the performance of prior funds or a fund with different fee structures. The Rule specifies that net performance can reflect the deduction of a model fee if:

• The model fee would result in performance figures that are no higher than if the actual fee had been deducted; or
• The deduction of a model fee is equal to the highest fee charged to the intended audience to whom the advertisement is disseminated.[9]

If it opts for this second approach to calculate net performance, an investment adviser must ensure that it maintains records of the “intended audience” of the relevant advertisement, which will typically be a short document that identifies the types of prospective investors the fund intends to target.[10] In practice, the private fund adviser should also track the distribution of the advertisement to ensure that the actual recipients of the advertisement reflect the investor types identified in the record noted above.

2. Predecessor Performance

The Rule also addresses “predecessor performance,” which, for private fund advisers, commonly arises when investment personnel attempt to port their performance track record to a new investment adviser. Similarly, new private fund advisers that launch their first fund may seek to use a track record achieved at a prior firm, which will generally implicate the Rule’s conditions for predecessor performance. The SEC views predecessor performance as potentially misleading because it may imply that an investment adviser achieved performance for which other investment personnel were actually responsible.

Under the Rule, an investment adviser may not include predecessor performance (i.e., such investment adviser’s track record while working at another fund) in an advertisement unless:

• The persons who were primarily responsible for achieving the prior performance results manage accounts at the advertising adviser;
• The accounts managed at the predecessor investment adviser are sufficiently similar to the accounts managed at the advertising investment adviser such that the performance results would provide relevant information to clients or investors;
• All accounts that were managed in a substantially similar manner are advertised (subject to certain permitted exclusions); and
• The advertisement clearly and prominently includes all relevant disclosures, including that the performance results were from accounts managed at another entity.[11]

A person is “primarily responsible” for achieving prior performance results if the person made the applicable investment decisions.[12] The Rule does not define the term “primarily responsible,” but the SEC stated that it generally refers to the person or persons who have the authority or influence in making the decisions that produced the investment results. When more than one person is involved in making investment decisions, advisers should consider the varying levels of authority and influence that each person has in making those decisions.[13] This is highly fact dependent and will require a private fund adviser that seeks to present such predecessor performance to ensure that its investment personnel have sufficient evidence supporting their relevant authority to make investment decisions supporting that track record.

In addition to the conditions imposed by the Rule regarding predecessor performance, the Advisers Act Recordkeeping Rule requires an investment adviser that presents predecessor performance to retain records to support such performance.[14] Thus, if an investment adviser wishes to include in its track record the performance achieved by advisory personnel while working for a prior firm, the investment adviser must obtain records from that prior firm to support the calculation of the predecessor performance to comply with the Recordkeeping Rule. In practice, this can present challenges for new investment advisers, since advisory personnel are commonly prohibited (e.g., in employment agreements or otherwise) by their prior firm from taking the firm’s performance records when they depart to work for another investment adviser. Investment professionals should keep this negotiating point in mind when entering into a relationship with a new firm, as securing rights to these records can preserve the investment professional’s ability to use a track record later in his or her career.

Finally, the Rule’s restrictions on predecessor performance may arise in the context of internal restructurings. In most cases, if an advisory firm changes its branding or its form of legal organization, the Rule’s conditions for predecessor performance likely will not apply. However, if an advisory firm is subject to a reorganization, sale, or restructuring and there is no substantial business nexus between the predecessor and successor firms, the restrictions on predecessor performance will likely apply. This will require an analysis of the facts and circumstances.

3. Related Performance

A private fund adviser may seek to present the performance of a “flagship fund” or a representative account when advertising a particular fund or strategy. In most cases, this type of performance will constitute “related performance” under the Rule. The Rule imposes conditions on an advertisement’s presentation of related performance, which are intended to prevent investment advisers from cherry‑picking only the best related performance to present in an advertisement, which the SEC views as potentially misleading.

Consequently, the Rule requires that any advertisement that includes related performance must include the performance of all “related portfolios”—i.e., all other private funds and portfolios managed with substantially similar investment policies, objectives, and strategies as the one presented—either as a composite or on a standalone basis.[15] Determining whether any private fund or other portfolio of an advertised fund is “substantially similar” and thus a related portfolio depends on the facts and circumstances. The SEC has stated that a fund or portfolio with material client constraints, for example, may serve as a basis to conclude that it is not substantially similar to the advertised portfolio. However, different fees and expenses alone would not allow an adviser to exclude a fund that has substantially similar investment policies, objectives, and strategies as the fund being offered.[16]

4. Extracted Performance

Similar to the restrictions on related performance, the Rule imposes conditions on an advertisement’s presentation of extracted performance to prevent advisers from cherry-picking subsets of funds to promote in its advertisements. Under the Rule, an investment adviser may not include in an advertisement any extracted performance, unless the advertisement provides, or offers to provide promptly, the performance results of the total portfolio from which the performance was extracted.[17] The Rule defines “extracted performance” as the performance results of a subset of investments extracted from a portfolio.[18] This typically applies to any situation in which a private fund adviser presents a case study, performance attribution metrics, or the performance of certain portfolio companies or sub-strategies extracted from a private fund it manages to highlight that performance. In all cases, such performance likely constitutes extracted performance subject to the conditions of the Rule. Generally, private fund advisers will opt to include disclosures in an advertisement that offers to provide the full performance promptly, rather than including that performance in the advertisement. However, in practice, a private fund adviser that relies on this approach to comply with the Rule’s conditions for extracted performance must ensure that it maintains organized records of that full performance and can document that it is able to provide such information to investors promptly upon request.

5. Hypothetical Performance

The SEC has historically viewed hypothetical performance with skepticism, given that it does not reflect performance actually achieved by an investor and thus has the potential to mislead investors. Under the Rule, an advertisement may not include hypothetical performance unless:

• The adviser has adopted and implemented policies and procedures reasonably designed to ensure that the hypothetical performance information is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement;
• The adviser provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and
• The adviser provides (or, if the intended audience is a private fund investor, provides or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using hypothetical performance in making investment decisions.[19]

The Rule generally defines “hypothetical performance” as performance results that were not actually achieved by any portfolio of the investment adviser, including model performance, back-tested performance, and targeted or projected performance.[20]

Back-tested performance generally refers to performance that results from the application of a strategy to market data from prior periods when the strategy was not actually used during those periods. Model performance generally includes the performance of investments that the investment adviser implements but does not reflect the management of actual client assets (e.g., a paper portfolio). Typically, these types of hypothetical performance arise more commonly in hedge fund strategies. Conversely, performance targets and projections reflect forward-looking performance aspirations, and are more commonly used in connection with venture capital or private equity funds. Note that while Rule 206(4)-1(d)(6) does not necessarily prohibit performance targets, FINRA rules effectively do prohibit this type of performance.[21] While investment advisers are not subject to FINRA rules, FINRA’s prohibition of performance targets effectively prevents a registered broker-dealer (e.g., the fund’s placement agent) from disseminating materials on behalf of a fund to prospective fund investors that contain such performance.

In developing policies and procedures to comply with Rule 206(4)-1(d)(6), a private fund adviser should consider the SEC’s position that hypothetical performance is not appropriate for advertisements directed to a mass audience or intended for general circulation because unsophisticated investors generally do not understand the risks and limitation of hypothetical performance.[22] Instead, the SEC has suggested that an investor that meets the definition of a “qualified client,” as defined in Rule 205-3(d)(1) under the Advisers Act, or a “qualified purchaser,” as defined in Section 2(a)(51) of the Investment Company Act of 1940 (“1940 Act”), could be deemed to possess the requisite level of financial sophistication to understand the risks and limitations of hypothetical performance for purposes of Rule 206(4)-1(d)(6).[23]

Accordingly, private fund advisers should ensure that their marketing policies and procedures reflect these standards and limitations. Most private fund advisers will be able to restrict the presentation of hypothetical performance to investors that meet one or both of the above standards, especially if the investment adviser is able to charge a performance fee to the fund (which requires that each investor in the fund is a “qualified client”)[24] and/or if the fund relies on the exclusion from the definition of “investment company” under Section 3(c)(7) of the 1940 Act (which generally requires that all beneficial owners of the fund are “qualified purchasers”). However, if an adviser manages a private fund that may admit investors that do not meet either of those standards, the adviser should ensure that its policies and procedures are appropriately designed to restrict hypothetical performance from being presented to such investors.

Conclusion

In addition to the specific performance-related conditions of the Rule, a private fund adviser should consider the Rule’s general prohibitions and the antifraud provisions under the Advisers Act when presenting track record and performance information in any advertisement. In all cases, an investment adviser should consider whether it has provided investors with the necessary context for evaluating its track record so the track record is not misleading, is presented in a fair and balanced manner, and includes disclosure of any relevant assumptions, factors, and limitations. If you have any questions about presenting track records or other performance of private fund advisers, please contact a member of MoFo’s Private Funds or Investment Management Group.

[1] See Rule 206(4)-1 under the Advisers Act; see also Investment Adviser Marketing, SEC Rel. No. IA-5653 (Dec. 22, 2020) (the “Adopting Release”).

[2] Many private fund advisers rely on the registration exemptions under Rule 203(l)-1 or Rule 203(m)-1 under the Advisers Act and file reports as ERAs with the SEC.

[3] See Section 206 of the Advisers Act.

[4] See Rule 206(4)-1(d)(1) under the Advisers Act.

[5] See Rule 206(4)-1(e)(7) under the Advisers Act.

[6] See Rule 206(4)-1(e)(10) under the Advisers Act.

[7] See Marketing Compliance Frequently Asked Questions, SEC Staff (last updated Jan. 11, 2023).

[8] See Rule 206(4)-1(e)(7) under the Advisers Act.

[9] See Rule 206(4)-1(e)(10) under the Advisers Act.

[10] See Rule 204-2(a)(19) under the Advisers Act.

[11] See Rule 206(4)-1(d)(7) under the Advisers Act.

[12] See Adopting Release, supra n.1, at 232.

[13] Id.

[14] See Rule 204-2(a)(16) under the Advisers Act.

[15] See Rule 206(4)-1(e)(14)–(15) under the Advisers Act. However, related performance may exclude any related portfolios if (i) the advertised performance results are not materially higher than if all related portfolios had been included; and (ii) the exclusion does not violate the time-period requirement under paragraph (d)(2) of the Rule. See Rule 206(4)-1(d)(4) under the Advisers Act. Note that the time-period requirement under Rule 206(4)-1(d)(2) is not applicable to the performance of private funds.

[16] See Adopting Release, supra n.1 at 193.

[17] See Rule 206(4)-1(d)(5) under the Advisers Act.

[18] See Rule 206(4)-1(e)(6) under the Advisers Act.

[19] See Rule 206(4)-1(d)(6) under the Advisers Act.

[20] See Rule 206(4)-1(e)(8) under the Advisers Act. In recent enforcement actions against registered investment advisers, the SEC alleged that the investment advisers presented hypothetical performance to the general public on their websites without adopting and implementing policies and procedures reasonably designed to ensure that the performance was relevant to the likely financial situation and investment objectives of the intended audience, as required by the Rule. See SEC Sweep into Marketing Rule Violations Results in Charges Against Nine Investment Advisers (Sept. 11, 2023).

[21] See FINRA Rule 2210(d)(1)(F).

[22] See Adopting Release, supra n.1 at 220.

[23] Id. at 221. A “qualified client” generally includes: (i) a natural person who has at least $1.1 million in assets under management with the investment adviser, (ii) a natural person with a net worth of $2.2 million (including assets held jointly with a spouse), or (iii) a qualified purchaser. See Rule 205-3(d)(1) under the Advisers Act. A “qualified purchaser” generally includes an individual with more than $5 million in investments or certain entities with more than $25 million in investments. See Section 2(a)(51) of the 1940 Act.

[24] Rule 205-3 under the Advisers Act provides an exception to the Advisers Act’s general prohibition against performance fees and generally permits an advisory contract to provide for such fees if the client (or each investor in a private fund client) is a “qualified client.”

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