In recent years the US Securities and Exchange Commission has closely examined private equity fund performance and reporting during routine exams. The importance of this topic came to the forefront in December 2016 when the SEC subpoenaed Apollo Global Management for additional information on its internal rate of return calculation methodologies. This SEC enquiry has caused a number of private equity firms to review their IRR calculations and disclosures.
While IRRs have long been used by investors to measure a private equity firm’s performance and also to compare such performance to that of peer firms, to date, there has not been any industry-wide standard method for how they should be calculated and reported.
IRR calculation and reporting methodologies can considerably vary from firm-to-firm. The inclusion or exclusion from fund IRR calculations of the following items can have a material impact on such calculations:
1- Reinvestment of capital (i.e., recycling of distributable proceeds);
2- Capital sourced from subscription lines of credit or other lending facilities to make long-term investments (a relatively new practice that has recently started to attract SEC attention as described further below); and
3- The performance of capital accounts of the fund sponsor and/or its affiliates . Without sufficient disclosure in marketing materials and investor reports regarding the impact of such practices on IRR calculations, there is a significant risk that current or prospective investors may be unable to adequately comprehend the methodology used which, could also reduce investors’ ability to make meaningful fund performance comparisons between private equity firms.
Insufficient disclosure could implicate the broad anti-fraud provisions of the Investment Advisers Act, by which investment advisors have a fiduciary duty to avoid misleading their investors. Investment advisors that are found to have violated the anti-fraud rule could face enforcement action, as has been demonstrated by various SEC actions against private equity firms over the past several years.
SUBSCRIPTION CREDIT LINES
Historically, private equity firms have used subscription lines of credit as bridge loans in an effort to quickly close on time-sensitive deals without the delay of having to wait to receive capital called from investors. Such loans have historically been repaid by private equity firms within a few weeks (i.e., promptly upon receipt of capital called from investors). Several reports indicate a recent uptick in the use of such subscription lines for longer-term borrowing in the early years of a private equity fund to make acquisitions, and thereby obviate the need to call capital from investors.
Such longer-term borrowing creates the potential for a private equity firm to boost its reported IRR early on during a fund’s life and receive carried interest before the firm would otherwise have been entitled to do so. In addition, regulators and certain investors are concerned that this could impede the ability of investors to meaningfully compare the performance of fund managers who use subscription lines in this manner with those who do not. The impact of this practice on a private equity fund’s IRR calculations should be adequately disclosed to current and prospective investors.
The SEC has independently started to closely scrutinise such practices during its examination of private equity firms. The focus in such examinations has been on the adequacy of disclosure provided to investors regarding the impact of such practices on a fund’s reported IRR as well as other risks and/or conflicts of interest associated with such practices, and also the accompanying costs of such.
As with any other practice that impacts a fund’s reported IRR, private equity firms should carefully review and, where necessary, enhance the disclosures they provide to current and/or prospective investors relating to the use of subscription lines to ensure that the impact of such subscription lines on fund performance reporting and related risks and conflicts are adequately disclosed.