Performance results are the ribbons of the hedge fund industry. In order to raise institutional money for your hedge fund, you will need good performance results. Even hedge fund managers who will not be focusing on raising money from institutional investors will need to have performance results in order to market the hedge fund. Performance results are usually displayed in a hedge fund pitchbook format, a tearsheet format and/or with monthly or quarterly performance reports to investors. Whenever performance results are included, the manager must make sure that the proper performance disclosures accompany the results. As a routine matter, all hedge fund performance results and advertisements should be reviewed by a hedge fund attorney.
SEC Guidance – Clover Capital No-Action Letter
The SEC has authority under the anti-fraud provisions of the investment adviser’s act (which apply to both registered and unregistered hedge fund managers) to police the performance results of hedge fund managers. [HFLB note: please see "Basis of SEC authority" below for explanation.] Under this authority, the SEC has provided some guidance on this subject through the Clover Capital no-action letter. Clover Capital is not famous because of the position of the staff with regard to a certain party, but because the staff went further and provided guidelines for all managers in how performance results should be disclaimed.
The Clover Capital letter is notable for a few reasons including that (i) it provides guidance on both model results (sometimes referred to as “backtested”) and actual results and (ii) it requires that performance results be present “net of fees.” While some aspects of the Clover Capital requirements have been softened in certain specific fact circumstances, through subsequent no-action letters, Clover Capital remains the central source of guidance for performance reporting requirements. These requirements (with footnotes omitted) are broken down below.
Model and Actual Results
With regard to model and actual results, the staff believes that a hedge fund manager is prohibited from publishing an advertisement that:
- Fails to disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in the value 25% without disclosing that the market generally appreciated 40% during the same period);
- Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid;
- Fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
- Suggests or makes claims about the potential for profit without also disclosing the possibility of loss;
- Compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g. an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio);
- Fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation);
- Fails to disclose prominently the limitations inherent in model results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if the adviser were actually managing clients’ money;
- Fails to disclose, if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and, if so, the effect of any such change on the results portrayed;
- Fails to disclose, if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate, or only partially relate, to the type of advisory services currently offered by the adviser (e.g., the model includes some types of securities that the adviser no longer recommends for its clients);
- Fails to disclose, if applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model;
Additionally, with regard to actual results, the staff believes that a hedge fund manager is prohibited from publishing an advertisement that fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material.
The SEC staff closed the Clover Capital letter with the following statement that should be given great weight by all hedge fund managers:
We wish to emphasize that: (1) it is the responsibility of every adviser using model or actual results to ensure that the advertisement is not false or misleading; (2) the list set forth above of advertising practices the staff believes are prohibited by Rule 206(4)-1(a)(5) is not intended to be all-inclusive or to provide a safe harbor; and (3) the staff, as a matter of policy, will not review specific advertisements.
Clover Capital – Basis for SEC authority
The following comes from the Clover Capital no-action letter and states the SEC staff’s basis for their authority to produce guidance on performance advertising requirements.
Section 206 of the Act prohibits certain transactions by any investment adviser, whether registered or exempt from registration pursuant to Section 203(b) of the Act. Under paragraph (4) of Section 206, the Commission has authority to adopt rules defining acts, practices, and courses of business that are fraudulent, deceptive, or manipulative. Pursuant to this authority, the Commission adopted Rule 206(4)-1, which defines the use of certain specific types of advertisements by advisers as fraudulent, deceptive, or manipulative.* Although the rule does not specifically prohibit an adviser from using model or actual results, or prescribe the manner of advertising these results, paragraph (5) of the rule makes it a fraudulent, deceptive, or manipulative act for any investment adviser to distribute, directly or indirectly, any advertisement that contains any untrue statement of a material fact or that is otherwise false or misleading.** Accordingly, the applicable legal standard governing the advertising of model or actual results is that contained in paragraph (5) of the rule, i.e., whether the particular advertisement is false or misleading.***
* For example, Rule 206(4)-1 prohibits an adviser from using advertisements that include testimonials (paragraph (a)) or that refer to past specific recommendations unless certain information is provided (paragraph (b)). The staff is currently reviewing Rule 206(4)-1 to determine whether it needs to be revised or updated. See Investment Advisers Act Rel. No. 1033 (Aug. 6, 1986).
** As a general matter, whether any advertisement is false or misleading will depend on the particular facts and circumstances surrounding its use, including (1) the form as well as the content of the advertisement, (2) the implications or inferences arising out of the advertisement in its total context, and (3) the sophistication of the prospective client. See, e.g., Covato/ Lipsitz, Inc. (pub. avail. Oct. 23, 1981)(“Covato”); Edward F. O’Keefe (pub. avail. Apr. 13, 1978)(“O’Keefe”); Anametrics Investment Management (pub. avail. May 5, 1977)(“Anametrics”).
*** Of course, if an advertisement containing model or actual results also includes any of the specific advertising practices addressed by paragraphs (a)(1)-(a)(4) of the Rule 206(4)-1, the advertisement would have to comply with the requirements of these paragraphs.
If you have any questions on this article or would like to discuss your hedge fund performance results, please contact us.