SEC homes in on IRR calculations

Firms should review whether capital from reinvestment or subscription credit lines should be included in IRR calculations.

Private equity firms should review their internal rate of return calculation methodology as the Securities and Exchange Commission turns its attention to disclosures, according to law sources.

The regulator is scrutinising IRR calculations after concerns about inconsistent methodology among firms, law firm Jones Day said in a client note.

“Inclusion or exclusion of capital from reinvestment, capital from subscription or other lending facilities, or capital from the fund sponsor or other entities that do not pay fees or carried interest can all affect the resulting IRR,” the note said.

Apollo Global Management was subpoenaed for information by the SEC in December over disclosure of IRR calculations for certain private equity funds, according to the firm’s 10-K filing. The nature of the regulator’s concerns is undisclosed and the investigation ongoing.

Fund sponsors, as investment advisors, owe fiduciary duties to their clients and as such must ensure reported IRRs provide “a fair and accurate reflection of investment performance,” the note said.

The SEC requires investment advisors to deduct fees, commissions and other expenses from their calculations, so investors are provided with net, rather than gross, performance results, it added.

“A common valuation issue [is that] investors disclose one valuation methodology, which can create a substantial change in the interim performance marketed to investors through measures such as IRRs,” according to the law firm.

Firms should keep valuation methodology and its effect on IRRs in mind when reporting their investment performance. Any advertising materials should contain clear and detailed disclosure about IRR calculations for the benefit of perspective investors, Jones Day advised.

“In light of the increasing prevalence of, and attention to, subscription line financing, firms that use these credit lines may wish to review the effect of subscription line financing on their IRR calculations and whether any specific disclosure is advisable,” a second law firm, Davis Polk, said in a client update.