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Private Fund Regulatory Update: Recent Developments Regarding the Marketing Rule FAQ, SEC’s Rulemaking Agenda and 2023 Exam Priorities

Time to Listen: 24:13 Practices: Asset Management, Regulatory Compliance for Private Funds, Private Funds, Hedge Funds, Investment Management, Investment Advisers

In this Ropes & Gray podcast, asset management partners Nicole Krea and Joel Wattenbarger discuss three recent headline items in regulatory compliance for private funds: first, the new marketing rule FAQ, with respect to extracted performance; second, the recently released Regulatory Flex Agenda; and, third, the SEC's 2023 exam priorities. The Private Fund Regulatory Update is a series of podcasts discussing key issues of interest and updates in the regulatory and compliance space, focusing in particular on private fund managers.


Joel WattenbargerJoel Wattenbarger: Hello, and thank you for joining us today for this Ropes & Gray podcast. This is one of a series of podcasts discussing key issues of interest in the regulatory and compliance space, focusing, in particular, on private fund managers. My name is Joel Wattenbarger, and I'm a partner in the asset management practice and co-head of our private fund regulatory group. I'm joined today by fellow private fund regulatory group partner, Nicole Krea. We will be discussing three recent headline items in regulatory compliance for private funds: first, the new marketing rule FAQ, with respect to extracted performance; second, the recently released Regulatory Flex Agenda; and, third, the SEC's 2023 exam priorities.

To start us off, I thought it would be helpful to give a quick overview of the marketing rule FAQ. And after that, Nicole and I will spend a little time just discussing some of the most commonly asked questions that we've been fielding from clients in recent weeks on this FAQ. On January 11, the SEC's Division of Investment Management updated its FAQs on the new marketing rule to state that extracted performance, either multiple investments or, critically, a single investment such as a case study, needs to be shown on a net basis. We were, I was, and, I think, we were as a firm, extremely frustrated with the timing of that guidance because the question that the SEC was addressing in its FAQ is one that folks have been asking across the industry really for two years since the rule was adopted by the SEC in late December of 2020, but nevertheless, perhaps we could say, “better late than never.” We do now have clear guidance from the SEC that they believe the definition of extracted performance in the marketing rule does cover not just a subset of investments (plural) within a private fund, but also in the performance of a single investment in a private fund. In light of that guidance, we have seen our clients and the market, in general, really moving in the direction of reexamining marketing materials to address the guidance on a go-forward basis. And with that, I'll put the first question to you, Nicole: How have you seen the market reacting to this guidance from the SEC?

Nicole KreaNicole Krea: Thanks, Joel. As you noted, this is not necessarily welcome news to most of the market. Generally speaking, we're seeing advisers, to the extent their materials don't already address the points raised in the FAQ, look to update their materials to address this. Joel, as you noted, up until this latest guidance was issued, we know that there was a lot of ambiguity in terms of whether the individual investment return constituted extracted performance—and some (but not all) managers took the position it didn't, and therefore, didn't necessarily include single-deal net returns. Now, with the new rule, our sense is on a pretty widespread basis that most managers see that the SEC is now clearly opining on this point and that single-deal performance can in fact be extracted performance, and so, those managers are generally looking to include net returns for single deals in their materials. So, of course, the next question then is: How are those net returns going to be calculated? As we know, in the private fund context, fees, expenses, carried interests are calculated at and applied at the fund level. And so, Joel, to that point, what would you say is the right methodology for calculating extracted performance on a net basis? I know that this is a question that a lot of advisers are grappling with in the light of this marketing rule FAQ.

Joel Wattenbarger: It's a great question, Nicole. And I think the only honest answer is there is no single rate methodology for calculating extracted performance on a net basis. If you go back to the marketing rule and the marketing rule adopting release, the SEC was actually quite clear at that time that they were not mandating a particular methodology, just in general, under the rule for calculating net performance and certainly with respect to extracted performance, which can raise some more complicated methodological issues and is a case when you're calculating net performance for an entire fund or account as a whole. The new guidance, which made clear that in the SEC's view, a single investment does constitute extracted performance, did not shed any further light on what the SEC believes is an appropriate methodology for calculating net performance regarding extracted performance. And so, the good news and the bad news is managers have, in my mind, a fair degree of latitude in determining what is an appropriate methodology, given the particular circumstances in which they are calculating performance. We have seen our clients pursue a range of approaches—I will spare listeners to this podcast all of the details of the different methodologies we've seen. I will say that, broadly speaking, many of the methodologies that we see our clients seeking to apply involve looking at the overall fees and expenses borne at a fund or account level and allocating those proportionally across individual investments or subsets of investments without necessarily seeking to allocate specific expenses, let's say those associated with a specific investment, at the level of returns with respect to that specific investment. Other managers are doing other things, including processes that may seek to allocate expenses more directly, as well as fees and carried interest more directly to individual investments.

From my perspective, the key here is disclosure, as it often is under the Advisers Act and other federal securities laws. You want to be sure that however you're calculating net performance for extracted performance, you're doing so and you're disclosing how you're doing so in a way that makes it clear to investors or prospective investors what is behind the numbers that they're seeing in your marketing materials. And I think the other key is just taking a consistent approach, so that you're not calculating net performance in one context in one way, and then you're preparing a new marketing document a month later, and now you're preparing net performance in a different way, even though the overall context seems quite similar. So, disclosure, consistent approach, and then making sure that you're thinking through with your legal and compliance team, your finance and operations team, and taking advice from external advisors, as necessary—so, that's methodology.

Nicole, I would say that is the question I've been fielding most often, but perhaps right behind that is a question about: How broadly should we really be reading this new guidance? And that comes up in a couple of different contexts, but maybe most notably, it is common for certain categories of private fund managers to include schedules of investments in their marketing materials that typically would list out all of the investments within one or more predecessor funds and would include various information, including often performance information with respect to those individual portfolio investments within the schedule of investments. How do you think about the requirement to show or not show net performance in that context in light of this new guidance?

Nicole Krea: Thanks, Joel. My experience has been very similar in that this is probably one of the first or second issues that I am seeing come up when folks are attempting to apply the newly released FAQ. And I think it's generally perceived as one of the biggest areas of potential ambiguity, even under an FAQ that I think was intended to provide some clarity on this point. What I think we can all agree is clear here is that net performance, when in the context of a case study or when otherwise set out and apart from the performance of the rest of the portfolio's investments, is going to be treated as extracted performance, and therefore, needs a corresponding net return. The FAQ actually says the words "case study"—it's very clear on that point. What the FAQ doesn't hit quite as directly, as you noted, however, is how that applies to a single-deal gross return that's included in, for example, a schedule of investments where all of the investments made by the portfolio are listed, and therefore, nothing is actually set apart from the whole—in a sense, one could say nothing is in fact extracted from the whole. There's certain language in the FAQ that actually speaks in terms of SEC concerns regarding presentation of a misleadingly selective profitable performance, which is admittedly a concern that's less present when showing a full schedule of investments. At the same time, there are statements in the FAQ that state very unequivocally the need for net returns for single investments and the need for net returns wherever gross performance is shown. Ultimately, I think where this lands is that advisers do need to consider this FAQ when looking at any presentation of gross performance in advertising materials, and I expect advisers are going to make certain risk-based determinations regarding how this is going to apply in very specific presentation formats, like schedule of investments. And this is going to continue to be a point of evolution in the market.

I would say as a very related, but slightly different topic that I've seen come out maybe as the next question right after that one, Joel, is how this guidance then applies in the context of, say, attribution analysis, which perhaps comes up a little bit more in the hedge fund context. But similarly, would we necessarily take the view that this FAQ and the requirement for net performance applies every time we see attribution analysis in marketing materials? I'm curious how you are seeing that play out.

Joel Wattenbarger: Yes, another oft-asked question, Nicole. And to be fair, this is a question that I think we were fielding pretty regularly, particularly from our hedge fund clients, dating back to before the compliance date for the new rule last November, and there were a number of fund managers. As you note, attribution analysis is something that's very common in the hedge fund area. It may be less common, but not unheard of, for other types of funds where you're basically seeking to communicate to investors or prospective investors, "Here is our overall return. How would we attribute that performance to different strategies within the fund or otherwise divvy up performance, whether it's by geography, whether it's type of asset, or whether sometimes it's attribution at the level of individual holdings?"

Attribution analysis appears in different contexts and in different ways. In terms of different contexts, it's always worth asking the question—and this is a question really across the board when you're thinking about a new marketing rule: Is this attribution analysis actually appearing in something that is an advertisement under the marketing rule, or is this something that is only appearing in reporting to investors in one form or another that you feel comfortable taking the view it does not constitute an advertisement under the rule? But assuming, for now, that you're talking about an attribution analysis that you are presenting in the context of an advertisement, I think, my sense is in light of this new guidance, there is an increasing acceptance amongst many fund managers that when they're presenting attribution analysis that provides performance of individual investments or subsets of investments, it should be calculated and presented on a net basis.

I will say that attribution analysis can be presented in lots of different ways. Sometimes, I see attribution expressed just as a percentage of the whole—so, in other words, "Here's a pie chart showing 100% of our total performance and what percentage out of 100% is attributable to this type of investment versus that type of investment." There, I think it's sufficiently removed from actual performance of particular investments as just proportional performance that I think many managers will conclude that net performance requirements don't apply in that context. But when you're indicating that this type of investment contributed X basis points over the reporting period and that type of investment contributed Y basis points of performance over the reporting period, I'm at least concerned that the SEC's view is going to be that that sort of attribution analysis in an advertisement does need to be presented on a net basis—and that means, of course, that you have to address all the questions about methodology and disclosure that we've described earlier in this podcast.

Last question, Nicole. We have talked about many of the substantive and interpretive questions you have been fielding—let's turn to just implementation and timing. Is there any particular timeline that clients need to be bearing in mind with respect to this new guidance, or how soon should clients be coming into compliance?

Nicole Krea: Perhaps for better or worse, the FAQ is silent on the issue of timing. Of course, this guidance is coming out as an interpretation of language in an existing rule, with a compliance date of November 4, 2022. Therefore, I think our view, generally, is that to the extent that we have an adviser with marketing materials still being used at the date of this FAQ that aren't already compliant with the FAQ, that advisers really should be updating their materials as soon as practicable. Of course, I think it's generally understood that this does sometimes take time, and some of these determinations really can't be rushed. It might mean the development and disclosure of new calculation methodologies, as Joel was touching on earlier, updating materials, potentially supplementing PPMs and other offering documents, and, perhaps in certain cases, coordinating with placement agents and other distributors to ensure that they are sending out the latest updated materials. I think that there is an acknowledgment within the industry that just logically and practically that does take time, but ultimately, we think advisers are well served to move forward with this process really as expeditiously as possible given the circumstances of the materials they need to update. I think where we would be concerned is if the SEC had a perception that an adviser saw the FAQ, but then didn't really take action to comply as quickly as it could. It's a bit of a facts-and-circumstances analysis, but ultimately, I think that the view and how we've seen it applied in the market to date has been moving forward as doing what's reasonably practicable.

Now, to move on to our next topic—wrapping up the marketing rule discussion—Joel is going to address the SEC's recently announced regulatory agenda. Joel, over to you.

Joel Wattenbarger: Great—thanks, Nicole. So, the SEC releases its rulemaking agenda, otherwise known at the Reg Flex Agenda, twice a year. In theory, that Reg Flex Agenda is due to be released each spring and fall. The fall 2022 agenda was released on January 4, 2023—and I will leave it to the listener to determine what the timing of that Reg Flex Agenda release says about the potential timing of future rulemaking actions reflected in the agenda. But the rulemaking agenda that was released was very ambitious. I'm sure it will not be a surprise to any of the listeners to this podcast that the current SEC under Chair Gensler has been very proactive on the rulemaking front, and the agenda that was released last month is a continuation of that theme. There were a total of 52 rules identified on the agenda. Twenty-three of those were in the so-called “proposed rule” stage, meaning the SEC has not yet proposed these rules, but is internally contemplating proposing them—actually, a handful of those have now already been proposed or we know they're about to be proposed. And then, there were another 29 rules that were listed as being in the “final rule” stage, so those are rules that have already been proposed and the SEC is preparing to finalize and adopt the rules. So, a very large number of rules.

The rules that appear on the Reg Flex Agenda are rules that the SEC expects to take action on, either proposing or adopting within the next 12 months. Many of these rules will be relevant to private fund managers. Obviously, first and foremost, that includes the private fund adviser rules that were proposed early last year. The Reg Flex Agenda indicates that the SEC is projecting final action on the private fund adviser rules by April of this year (April 2023). You should take all timing in the Reg Flex Agenda with a grain of salt. It is necessarily imprecise, and history shows that very often, rules may be adopted either before or well after the time indicated in the agenda, and sometimes not at all. But in addition to the private fund adviser rules, the cybersecurity rules proposed last year are also identified as potentially by April 2023, similarly with the two sets of outstanding foreign PF amendment rules that have been proposed. And then, the ESG disclosure rules for investment advisers and registered investment companies are identified as final action projected by October 2023. There's also a couple of interesting rules that are listed on the proposed rule stage part of the agenda. One relates to custody rule amendments—we now know that the SEC intends to move forward with that proposal next week. There's also listed as a proposed rule stage updated rules regarding Reg D and Form D. So, as I said previously, you shouldn't assume that all of the rules will be acted on, and certainly not necessarily on the time indicated on the agenda. But it is notable that the SEC continues to have a very active rulemaking agenda and that many of these rules will absolutely have a significant impact on the private fund industry if and when the SEC moves forward, so more to come on all that.

I will now turn it over to Nicole for the last item on our agenda, which is to discuss the SEC's recently released exam priorities for 2023. Nicole?

Nicole Krea: Thanks, Joel. So, last but not least, we wanted to provide an update on the SEC's 2023 exam priorities, which just came out on Tuesday, February 7. Overall, we really don't find anything terribly novel here when looking through the lens of advisers to private funds and institutional clients, but I'm going to hit on some highlights that I think may be of interest. As some overall commentary, the Division of Examinations, which I'll refer to here as "Exams," disclosed that during a typical exam, it reviews compliance programs in one or more of the following core areas: valuation, accuracy of regulatory filings, custody portfolio management, brokerage and execution, conflicts of interest, and related disclosure—that is not really in any way distinct from what we see in practice on examinations at this point. Fees and expenses are going to continue to be a focus area, including, in particular, with respect to the calculation of fees, which is something we routinely see on exams these days. Consistent with historical practice, Exams indicated that it's going to prioritize advisers that have never been examined or have not been examined for several years—that has been the case for the last several years, as well. In addition, Exams plans to focus on policies and procedures for selecting and using third-party service providers, and I think that's notable, particularly given the recently proposed rule relating to service provider oversight. And Exams is also going to focus on procedures for retaining and monitoring electronic communications, which has been an ongoing area of interest for both exams and enforcement.

In the exam priorities, Exams also indicated an intent to spend time focusing on whether advisers have adopted marketing rule policies and procedures, and whether they've complied with the substantive requirements of the marketing rule. This is really a surprise to none of us—the SEC has long signaled that it plans to focus on marketing rule compliance once the new rule hits its compliance date. It's worth noting that, as of yet, we really haven't seen a full-sweep exam focused exclusively on marketing rule compliance, but we've definitely seen increased focused on marketing rule compliance during routine examinations.

The exam priorities report indicated some priorities with respect to private fund managers specifically, in particular, a focus by Exams on continuing to focus on conflicts of interest, calculation and allocation of fees and expenses—including, in particular, the calculation of post-commitment period management fees and the impact of valuation practices at private equity funds—also policies and procedures regarding the use of alternative data and compliance with code of ethics requirements, compliance with the Custody Rule, and as we saw in some recent enforcement actions, including timely delivery of audited financials. Exams also named additional areas of particular focus for private funds and an indication that they'll be looking at private fund managers with specific risk characteristics. It included in those highly leveraged private funds, private funds managed side by side with BDCs, private equity funds that use affiliated companies and advisory personnel to provide services to their fund clients and underlying portfolio companies (which has long been an area of interest), private funds holding certain hard-to-value investments such as crypto assets or real estate assets, private funds that invest in or sponsor SPACs (which we've seen the SEC dig into in exams for a few years), and private funds involved in adviser-led restructurings, including stapled secondary transactions and continuation funds. As you can probably sense, these priorities that the SEC flagged for private funds are really actually quite consistent with what we've seen in practice in examination.

As an additional area of focus, but really not a surprise at all, Exams plans to continue their focus on ESG, in particular, whether advisers are accurately disclosing their ESG investing practices and assess whether ESG products are appropriately labeled.

Finally, in the SEC exam priorities, they indicated a number of other areas that will continue to be a focus, such as fiduciary duty and, for example, hedge clauses that might purport to inappropriately weight or limit an adviser’s standard of conduct, focus upon information security and operational resiliency, focus on crypto assets and application of an adviser’s duty of care when investing in crypto assets, and issues relating to LIBOR transition and related preparedness, among a number of other specific matters listed in the priorities.

With that, I want to thank you all for joining us today. And also, thanks to my co-host, Joel. Please watch this space for more podcasts like this one, where we will continue to keep you up to date with key regulatory developments. For more information on the topics that we’ve discussed or other topics of interest to the asset management community, please visit our website, www.ropesgray.com. And, of course, if we can help you navigate any of the topics we've discussed, please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you listen to podcasts, including Apple, Google and Spotify. Thanks again for listening.

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