Private Equity Compliance with the Modernized Marketing Rule

In November 2022, the SEC enacted the Modernized Marketing Rule for Investment Advisers, outlining refreshed marketing guidelines for private fund managers. Designed by combining the pre-existing Advertising and Cash Solicitation Rules and codifying decades’ worth of no-action letters, the Modernized Marketing Rule provides a consolidated framework of disparate, existing precedents, establishing a uniform definition of “advertisement,” seven general prohibitions, and parameters for performance marketing — among many other considerations.

The updated framework arrives when marketing is essential for firms looking to secure capital in a competitive fundraising environment. Public market volatility has left many institutional investors facing the denominator effect and imbalanced allocation models. In turn, some limited partners (LPs) have reduced their commitments to private funds or declined re-ups with existing managers.

This article explores some of the most notable implications of the Modernized Marketing Rule for private equity firms, including how the guidelines differ from prior regulations and how to navigate the new performance reporting requirements.

How Does the Modernized Marketing Rule Differ From the Cash and Advertising Solicitation Rules?

The Modernized Marketing Rule marks the first amendment to the SEC’s Advertising and Cash Solicitation Rules since 1961 and 1979, respectively. Before the new regulation, private equity firms pieced together marketing best practices from decades worth of no-action letters and one-off statements issued by the SEC.

The Modernized Marketing Rule intends to reflect the growth of technology and the evolution of how firms communicate with their clients while drawing on existing precedents. Designed using a “principles-based approach,” the framework deviates from the prior rule’s “broadly drawn limitations,” seeking to provide clearer guidance and flexibility without implementing rigid parameters. However, while updated guidelines under the Modernized Marketing Rule are broadly defined, they will be strictly enforced. When the SEC released its 2023 exam priorities in February, compliance with the Marketing Rule was at the top of the list.

Although the revised framework compiles existing rules, it also includes many new considerations, including establishing definitions for “advertisements,” “testimonials,” and “endorsements,” expanding the boundaries of paid advertisements to include non-cash compensation, and providing a prescriptive framework for the presentation of performance data. In line with the SEC’s principles-based approach, most of these additional amendments use generalized language, which has surfaced ambiguity for firms surrounding compliance.

How Does the Modernized Marketing Rule Impact Performance Reporting for Private Equity Firms?

One of the many areas the Marketing Rule addresses includes how private fund managers can leverage performance results in advertisements. From outlining guidelines for extracted and hypothetical performance to setting parameters on how private equity firms can advertise performance from a predecessor firm, the rules provide a comprehensive set of performance marketing guidelines.

Notably, the Marketing Rule explicitly prohibits presenting gross performance unless a net performance value is included in “equal prominence.” The SEC defines net performance as the “performance results of a portfolio after deducting all fees and expenses that a client would have paid in connection to the relevant portfolio.”

However, net performance values for portfolio companies or deals are not readily available, as fees and expenses constitute fund-level costs that cannot be easily attributed at the deal or portfolio company level. Further, the SEC has yet to offer its preferred methodology for calculating net performance values, leaving many firms scrambling to interpret the best mechanism they see fit.

Some private equity firms approach calculations at the fund level, calculating a ratio of net-to-gross IRR on a deal-by-deal basis and applying that to their portfolio using a weighted average. Others attempt to calculate net IRR and MOIC for each portfolio company by proportionally allocating expenses based on a deal’s percentage of costs in the total portfolio and then subtracting the portfolio companies’ actual realized carry to arrive at a net asset value.

Regardless of the methodology firms choose, documentation will be essential to substantiate the approach and data used in calculations. Firms should be able to point to every net and gross figure used in their marketing materials and confidently explain how they arrived at those values.

How Private Equity Firms Can Leverage Technology for SEC Compliance

The Marketing Rule has several implications for private equity sponsors. For one, firms must now review all their existing marketing materials and those used by placement agents to ensure compliance. Additionally, many private equity GPs must implement refreshed procedures for new marketing initiatives. From developing protocols for disclosures to adding footnotes to relevant marketing collateral and educating staff on new policies, firms will likely face added compliance burdens.

Further, the documentation, accuracy, and auditability of data used for performance calculations will be paramount. This holds particular significance for firms utilizing decentralized legacy systems for data management, which are susceptible to errors and lack essential transparency. Without a centralized, single source of truth, firms may struggle to trace specific values in their performance calculations to their source.

Ultimately, the Modernized Marketing Rule represents just one piece in the SEC’s considerable effort to regulate the private capital industry. The organization has implemented various other regulatory initiatives, including amendments to Form PF, enhanced electronic communications, and ESG monitoring. Thus, it is essential for firms to have the processes and technology in place to support compliance efforts smoothly.