(Article from Registered Funds Alert, February 2018)
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When investment advisers pursue an M&A transaction, or an adviser seeks to hire new portfolio managers, the portability of advisory performance, or the “track record,” is a key topic for the adviser and/or portfolio managers to consider. “Portability” of performance refers to the ability of an investment adviser to reference its own historical performance record in its investment performance presentation once it has combined with another investment adviser or the ability of individual portfolio managers to use and access their performance record achieved while at another firm. In this portion of the Alert, we explore the regulatory considerations related to the portability of an investment adviser’s and portfolio manager’s track record as they relate to M&A transactions, particularly with respect to common diligence issues and negotiation of an individual’s ability to use their track record.
Legal background regarding use of performance track records
All investment advisers are subject to Section 206 of the Advisers Act, which is generally referred to as the “anti-fraud” provision of the statute, and provides that it is unlawful for an investment adviser “to engage in any act, practice or course of business which is fraudulent, deceptive, or manipulative.” In the context of advertising performance, what investment advisers include in their advertising is just as important as what they do not include, and they must ensure that all of the relevant facts concerning performance are included in an advertisement.
For decades after Congress enacted the Advisers Act, the SEC Staff treated advertisements of past performance as fraudulent by default. The SEC’s position evolved in the late 1970s to a facts and circumstances test. The general guidelines for when the SEC Staff would deem an advertisement to be misleading have been developed through multiple pieces of SEC guidance. In this guidance, the SEC Staff has stated that determining whether a communication is misleading is a facts and circumstances analysis, and includes evaluation of: (i) the form and content of the communication; (ii) the implications or inferences arising out of the content of a communication; and (iii) the sophistication of the prospective client.[1]
Specific due diligence issues involving the use of performance track records
Generally, a thorough review of an adviser’s advertisements is not high on the priority list for M&A diligence. A buyer can usually take significant comfort from representations that a seller makes on this point and, if the seller has been examined recently by the SEC, from the regulator not raising any issues regarding the advertisements it reviewed. There are, however, some issues that a buyer should keep in mind as it reviews a seller’s advertising materials.
- “Cherry picking” accounts to be used in advertisements in order to portray higher performance is prohibited—all accounts that have substantially the same investment strategy should be included in any prior performance presented.
- Advertising accounts where the individuals responsible for achieving the prior performance have changed could be construed to be materially misleading.
- While SEC guidance has permitted the use of hypothetical or “model” performance if a strategy had been utilized over a given time period in advertisements (as opposed to actual performance of client accounts), it is critical to evaluate the disclosure that accompanies such performance advertisements—extra diligence should be done regarding any advertisements that show model performance.[2]
- The portability of performance history in fund adoptions turns on the same factors as in investment advisory firm combinations, therefore managers should examine the similarity of the accounts and continuity of management.
- As discussed in more detail below, a buyer should make sure that a seller has all of the supporting information needed regarding the seller’s performance history to meet the requirements of the Advisers Act and related SEC guidance.
Specific negotiation considerations related to use of performance track records
To use a seller’s track record, the investment personnel managing accounts post-closing should also be those primarily responsible for achieving the prior performance results before the M&A deal. Advertising accounts where the managers responsible for achieving the prior performance have changed or did not join the lift out could be construed as materially misleading. Accordingly, negotiation of retention arrangements with key investment personnel is a critical point in structuring an M&A transaction, as a loss of key personnel could result in the inability to use a performance record in advertisements.
The Advisers Act also requires that advisers maintain “all accounts, books, internal working papers, and any other records or documents that are necessary to form the basis for or demonstrate the calculation of the performance or rate of return.” Accordingly, a buyer seeking to use a seller’s track record should ensure that it has negotiated to receive all necessary documentation to utilize the track record, such as advisory business financial and accounting records, including newsletters, articles, and computational worksheets demonstrating performance returns, records that document the adviser’s authority to conduct business in client accounts, client account statements, and other relevant records.
Some firms seek to comply with the Global Investment Performance Standards (GIPS), which is akin to a “gold star” certification for performance advertisements and indicates that an adviser adheres to a certain methodology for calculating its performance record. GIPS allows investors to compare more easily the performance of two GIPS-compliant advisers. GIPS has different requirements regarding calculation, presentation and recordkeeping, which should be separately evaluated in the event that a buyer/seller seek to claim GIPS compliance.
Performance track record of individuals
In some M&A deals, an individual portfolio manager employed by the seller (or a founder) may leave the firm in connection with the transaction. Similarly, sometimes individual portfolio managers or their teams are “lifted out” of an adviser by a rival adviser. When an individual (or team) leaves an investment adviser, the portability of their track record is a critical consideration.
All of the individuals who played a primary role in achieving the performance results shown in a track record should continue to be part of that team in order to use it in advertisements at their new advisory firm. To compare two scenarios, when a portfolio manager was the sole decision maker for a fund, the analysis of whether that individual’s track record is portable is fairly straightforward. When additional variables are added to the mix, such as co-portfolio managers, analyst teams or investment committees, it is a “facts and circumstances” analysis that likely requires input from experienced counsel.
The ability of an individual (or team) to continue to use a track record if they leave an adviser in connection with an M&A transaction can be a tricky point of negotiation in an M&A deal, as a buyer is usually interested in retaining the exclusive right to use a track record. If a departing individual or team is granted the ability to use their track record, it is advisable for the parties to carefully define access rights regarding the records and materials that from the basis of the track record.
In many M&A deals, diligence and negotiations around the use of an adviser’s track record are uneventful. However, it is useful to keep in mind some traps for the unwary so that parties and their counsel are able to spot potential advertising issues to avoid future limitations on use of prior performance or, in worst case scenarios, an SEC enforcement action.
[1] See, e.g., Anametrics Investment Management, SEC No-Action Letter (May 5, 1977).
[2] The SEC has been particularly focused on use of model performance in advertisements, especially in light of an enforcement action against a quantitative investment manager, F-Squared, in 2014. Buyers should beware of deficiencies related to advertisements that include model performance, as an SEC enforcement action in this area can pose heightened business and reputational risks (e.g., F-Squared has since filed for bankruptcy).