Kreischer Miller recently held its annual investment industry update, which covered a host of topics including the latest updates on GIPS, the SEC Marketing Rule, fair value guidance, taxes, and compliance, as well as a discussion on valuation drivers in an investment firm.

During the event, Thomas Peters, Director of Kreischer Miller’s Investment Industry Group, moderated an SEC Marketing Rule panel discussion with Joshua Kramer, Manager in Kreischer Miller’s Investment Industry Group, John Canning, Director at Chenery Compliance Group, and Michael Beck, Performance Measurement Vice President at Glenmede Trust. The goal of the panel was to address various questions from the audience surrounding the new SEC Marketing Rule and to provide an update on any recent changes since Kreischer Miller’s previous panel on the Rule held last July. Below is a summary of the questions covered during the session and the panelists’ responses.

Question: Is it really a common practice to charge a model fee with the highest fee from the composite’s inception fee regarding the SEC Marketing Rule’s net of fee return requirement?

Response: Advisors have three general options when reporting net performance under the SEC Marketing Rule. They can use actual fees charged to the portfolios. Advisors can also use a model fee that results in performance results that are less than or equal to performance that would have been calculated had actual fees had actual fees been used.  The final option is using a model fee where the fee applied must be equal to the highest fee that would be charged to the intended investors. Panelists noted that the decision is highly dependent on the facts and circumstances of the advisor. However, the model fee approach will typically be easier to implement for larger firms due to the varied actual fees that may be charged to a large pool of investors.  When advisors are contemplating which option to employ, panelists stressed the importance of always keeping in mind the general prohibitions, which require that all advertisements are presented in a manner that is fair and balanced and not otherwise misleading.

Question: How does the SEC Marketing Rule relate to sub-portfolios, carveouts, and extracted performance included in composites?

Response: The main issue discussed by the panelists dealt with how advisors define what a portfolio is and how that definition is then applied to the definition of extracted performance provided in the SEC Marketing Rule.  In general, panelists explained that multi-strategy portfolios can either be identified as a single portfolio, inclusive of all the strategies, or as multiple portfolios segmented for each strategy.  The definition given to these portfolios by the advisor will then allow them to determine whether the or not they should be treated as extracted performance under the SEC Marketing Rule. In making these decisions, panelists offered various factors to consider including whether the strategies are managed with separate cash accounts, whether each strategy is managed under a separate investment management agreement, and whether the strategies are managed by investment teams at the advisor. The panel also referenced a recent SEC Marketing Compliance FAQ, which was updated January 11, 2023.

Question: Does net attribution and risk returns on data that is presented outside of the performance returns need to be shown?

Response: Panelists acknowledged that it has been standard industry practice to present attribution based on gross returns due to most internal systems applying fees at the total return level and not allocating the fee to individual sectors or asset classes. However, it should also be disclosed that the availability exists to calculate net returns.  While this has historically been the case, panelists raised concerns surrounding the recent FAQ published the SEC staff, which reiterated the need for advisors to show the net performance of a single investment or a group of investments when presenting the gross performance.  Panelists cautioned that additional information and clarity surrounding this FAQ may indicate a need for advisors to start presenting attribution on a net basis.

Question: What is considered a material fact that would need to be substantiated?

Response: Materiality consideration should be given to any advertising material, third party source, or performance claim that can be selected for substantiation by an auditor. The importance of backing up recordkeeping was also emphasized.

Question: What are considerations of material risks and material risk disclosures?

Response: The panelists advised leaning on investment professionals to identify and ensure that risks and potential benefits are being disclosed to potential investors.

Question: Should performance submitted to an online consultant database be considered an indirect advertisement subject to the SEC Marketing Rule?

Response: Performance submitted to an online database is subject to the SEC Marketing Rule if that performance will then be presented to a broader audience. Panelists discussed a rift among advisors and databases related to the information that some databases are accepting and the information that advisors are required to provide in order to comply with the SEC Marketing Rule.  This disconnect is causing advisors to make the difficult decision of whether to continue to provide databases with incomplete information under the SEC Marketing Rule, thereby incurring risk, or discontinue providing information to databases until the issue is resolved.

Question: Do advertisements that pre-date the SEC Marketing Rule need to be updated in order to be in compliance?

Response: It would depend on whether the advertisements are still being used and able to be viewed by potential investors. Advertisements that are still being used would need to be updated, while those that are no longer in use and are not viewed by potential investors would not need to be updated.

Question: Can a firm provide a link to a disclosure, testimonial, or endorsement?

Response: External links cannot be used for testimonials or endorsements; the source needs to be clear within the testimonial or endorsement. Other types of advertising disclosures can provide a link.

Question: What is considered hypothetical performance now for the SEC Marketing Rule?

Response: Hypothetical performance is considered to be any instance where performance is back/forward tested, projected, or calculated on hypothetical assets; availability restrictions on hypothetical performance were also emphasized by the panelists.

If you’d like to view the video of this panel discussion or any of the other presentations from our annual investment industry update, click here.

If you have any questions about the SEC Marketing Rule or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group. 

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• What Drives Value in an Investment Firm?
• Update on Accounting for Equity Securities with Contractual Sale Restrictions
• The Top 3 Custody Rule Pitfalls We’ve Observed

We recently held our annual investment industry update which covered a host of topics including the latest updates on GIPS, the SEC Marketing Rule, fair value guidance, taxes, and compliance. The event also included a discussion on valuation drivers in an investment firm. Jennifer Kreischer, M&A Advisory Consultant for Kreischer Miller’s Investment Industry Group, provided insights into the key levers that investment firms can use to drive value in their businesses.

Value determination is a critical aspect of any business, as it plays an essential role in making strategic decisions, be it in the context of a business transaction, succession planning, or growth financing. Understanding the value of a business is imperative for any owner or investor to make well-informed decisions and ensure that they are getting a fair deal.

In the context of business transactions, it is essential to be prepared for unsolicited offers, even if an owner is not actively planning to sell or buy the business. Having a well-established business value can help an owner be better prepared for negotiations. Value determination is also crucial in succession planning. Without proper planning, the options available for transitioning ownership of the business may be limited, and the value of those options may be lower. Understanding the value of the business can help the owner make more informed decisions about the best course of action for their business. Additionally, value determination is critical for growth financing, as banks and other financial institutions use it to assess the risk of lending to a business and to determine the loan amount they are willing to provide.

The main objective of value determination is to protect the interests of the business owners and help new investors to assess the opportunity to invest in the business. It also helps business owners evaluate whether they are ready to bring in new partners or promote team members to ownership positions. One way to think about it is that it helps potential partners determine whether they would be in a position to borrow money to buy into the firm and how long it would take them to pay back that loan based on the company’s cash flow.

The concept of the multiplier effect, which refers to the impact of certain value drivers on the value of a business, is also crucial. These value drivers can include factors such as revenue growth, profitability, and risk management. By understanding and focusing on these key value drivers, business owners can improve their options for succession and increase the value of their business. Earnings multiples are a better proxy for a discounted cash flow valuation. By increasing earnings and positioning the business to command multiples at the higher end of the range, the value of the business increases.

Value determination is a critical aspect of any business and plays a vital role in making strategic decisions. By understanding your business value, owners and investors can make more informed decisions and ensure that they are getting the best possible price for the business.

We invite you to watch the rebroadcast of Jennifer Kreischer’s full presentation here. If you have any questions about investment firm value drivers or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group.

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• Update on Accounting for Equity Securities with Contractual Sale Restrictions
• The Top 3 Custody Rule Pitfalls We’ve Observed
• SEC’s New Transparency Rules Target Private Fund Advisors

The Financial Accounting Standards Board (FASB) recently issued Accounting Standards Update (ASU) 2022-03, which amends Topic 820 (Fair Value Measurement) and helps clarify how entities should value and disclose investments in equity securities measured at fair value that are subject to a contractual sale restriction. This update did not change the principles of fair value measurement in ASC 820.

Prior to this ASU, there was conflicting guidance that resulted in a diversity in practice as to whether the effects of a contractual restriction that prohibits the sale of an equity security should be considered in measuring that equity security’s fair value.

The ASU helps clarify when a discount should be applied to the fair value of an equity security by understanding whether there is an entity specific restriction or an equity security with an asset specific restriction. If there is an entity specific restriction, this is a characteristic of the holder of the equity security rather than a characteristic of the equity security itself, and therefore, should not be considered in measuring the equity security’s fair value. If there is an equity security with an asset specific restriction, that restriction is included in the equity security’s unit of account and should be considered in the measurement of the fair market value.

The ASU also provided guidance on the following disclosures for equity securities subject to contractual sale restrictions that should be made:

• The fair value of equity securities subject to contractual sale restrictions reflected in the balance sheet
• The nature and remaining duration of the restriction(s)
• The circumstances that could cause a lapse in the restriction(s)

Equity securities restricted from sale because they are pledged as collateral and included in disclosures required by other topics should not be included in guidance for the ASU note above.

These clarifications resulting from the ASU should help entities understand when they are required to apply a discount on the fair values of equity securities and when it would not be needed.

The amendments in this update will be effective for public business entities for fiscal years beginning after December 15, 2023 and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2024 and interim periods within those fiscal years. Early adoption will be permitted for both interim and annual financial statements that have not yet been issued or made available for issuance.

We would be pleased to provide further information related to this subject matter. For more information, contact Frank Varanavage, Manager, Investment Industry Group at fvaranavage@kmco.com.

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• The Top 3 Custody Rule Pitfalls We’ve Observed
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• Recent SEC Rule Proposal Changes and Additions

Rule 206(4)-2 of the Investment Advisers Act of 1940, known as the Custody Rule, can be extremely complex to apply. The Custody Rule was first adopted in 1962, and the current version follows amendments made by the SEC in 2009 as a response to Bernie Madoff’s Ponzi scheme. The Custody Rule requires four primary controls of investment advisers that have custody of client funds:

1. Client assets must generally be maintained with a qualified custodian. If the qualified custodian is a related person, an internal control report is also required.
2. Clients must be notified who the qualified custodian is, as well as when any changes are made to the custodial relationship.
3. Qualified custodians should send account statements directly to clients at least quarterly and advisers must have a reasonable belief that the qualified custodians are doing so.
4. Advisers must generally have an annual surprise examination by an independent public accountant.

For further background on the Custody Rule, the adopting release containing the latest amendments can be found here. The SEC has also posted several frequently asked questions, known as the Staff Responses, here.

Common Custody Rule Pitfalls

At times, an in-depth evaluation of individual circumstances may be required to determine whether an adviser has custody and should be subject to the requirements of the Custody Rule and an annual surprise examination. Based on years of performing such surprise examinations, our team has identified three common Custody Rule pitfalls. The SEC also identified some of these pitfalls as significant deficiencies in this 2013 risk alert as well as in this 2017 risk alert. We continue to see them today.

Pitfall #1: Client Checks

Rule 206(4)-2(d)(2)(i) specifically indicates that custody includes, “possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them.”

Based on that language, an adviser that has a client check or other assets in its possession, even momentarily, has custody. While Question II.1 of the Staff Responses indicate limited circumstances – such as receipt and forwarding of tax refunds from taxing authorities – do not constitute custody, as noted, the only way an adviser can normally alleviate itself of the requirements of having custody would be to return the client check to the sender within three business days of receipt. Thus, an adviser should have policies and procedures in place to address such situations.

We’ve often heard the argument from advisers that the purpose of the Custody Rule is to safeguard client assets and, therefore, routing a check back to the sender likely puts it in more danger of being lost than just forwarding it to the custodian on the client’s behalf. Such an argument may make a great point, but unfortunately the Custody Rule does not permit an adviser to forward client checks to the custodian. An adviser’s only option is to log the receipt of the check and promptly return the client check to the sender.

This type of situation could be a double whammy for an adviser. If it fails to return the client check, not only would that adviser have custody and be subject to all the other requirements of the Custody Rule, but it would likely also fail the requirement that client assets be maintained with a qualified custodian. That is unless the adviser is a qualified custodian.

Pitfall #2: Pooled Investment Vehicle Financial Statements

As noted above, the Custody Rule requires four primary controls of investment advisers that have custody of client funds. Advisers to pooled investment vehicles (e.g., hedge funds, private equity funds, etc.) generally have custody of the pooled investment vehicles they offer due to their role, or an affiliate’s role, as general partner. With that said, an adviser may be permitted to self-custody such assets rather than maintain them with a qualified custodian and would be exempt from the notice, account statement, and surprise examination requirements if the adviser relies on and complies with the audit exemption contained in Rules 206(4)-2(b)(2)(ii) and 206(4)-2(b)(4).

The most common pitfall we have come across when an adviser attempts to comply with the audit exemption is that it has not prepared the financial statements of the pooled investment vehicle in accordance with accounting principles generally accepted in the United States (U.S. GAAP). More specifically, advisers cannot comply with these provisions of the Custody Rule by providing financial statements prepared on the tax basis of accounting.

Additionally, advisers cannot apply U.S. GAAP on a selective basis. For instance, if U.S. GAAP requires all investments to be maintained at fair value, an adviser cannot value only those that are easy to value while leaving those that are more difficult, at cost.

Pitfall #3: Employees or Related Persons

Rule 206(4)-2(d)(7) defines a related person as “any person, directly or indirectly, controlling or controlled by you, and any person that is under common control with you.” Based on that description, an adviser is responsible for the actions of its employees and/or affiliated entities (e.g., any wholly owned subsidiary, etc.).

Taking that one step further, an adviser is responsible for the actions – at least as it relates to the Custody Rule – of employees of affiliated entities. Ultimately, an adviser is deemed to have custody and thus subject to the requirements of the Custody Rule if its employees or affiliated entities are deemed to have custody.

The most common pitfall we have come across is an adviser’s failure to identify that one of its employees serves as trustee to a firm client. This is the exact subject of Question II.2 of the Staff Responses. The SEC’s response is that, “The role of the supervised person as trustee is imputed to the advisory firm, thus causing the firm to have custody.” Consequently, an adviser should have policies and procedures in place that require all employees to identify any current or potential new situations where it is asked to serve as trustee. These policies should be in place prior to an employee officially agreeing to take on such a role.

Honorable Mentions

The following topics have also tripped up advisers when it comes to the Custody Rule:

• Bill-paying services: Due to this added service, an adviser can withdraw funds or securities and would thus be deemed to have custody.
• Online access: If an adviser has access to a client’s online account, including knowing the client’s username and password, and such access is not read-only, the adviser is deemed to have custody because of its ability to withdraw funds or securities.
• Inadvertent custody through custodial agreement language: An adviser’s investment management agreement does not overwrite language in a custodial agreement that provides the adviser access to client funds, even if the investment management agreement indicates the adviser will not take custody.
• SLOAs (Standing Letters of Authorization): While the SEC has issued a no-action letter for an adviser to avoid a surprise examination as long as it complies with certain criteria, advisers nevertheless have custody and must comply with all other aspects of the Custody Rule.
• Books and records to be maintained by investment advisers: Although not specifically under the Custody Rule, advisers that have custody or possession of funds and securities must also maintain certain documentation in accordance with Rule 204-2(b) (the Recordkeeping Rule). A qualified custodian’s maintenance of books and records for an adviser’s custody accounts, including trade confirmations, does not relieve the adviser from its requirement to maintain these records under the Recordkeeping Rule. Advisers should understand the retention policies of these records at custodians, especially if the adviser is not maintaining physical copies. This understanding should include the adviser’s ability to access the records in the event it is no longer the adviser or the custodian relationship has terminated.

If any of the above pitfalls impact your firm or you have another topic that might be subject to the intricacies of the Custody Rule, we’d be happy to have a conversation.

For more information, contact Craig Evans, Director, Audit & Accounting at cevans@kmco.com or Eric Sakelaridos, Director, Audit & Accounting at esakelaridos@kmco.com.