Compliance with the Global Investment Performance Standards (GIPS®) can provide a powerful advantage to private equity firms as investors increasingly demand more transparency on investment performance results. Given the special nature of their business, private equity fund managers that intend to claim compliance with GIPS face some unique reporting requirements. The methodology private equity firms use for calculating returns and maintaining records under the U.S. generally accepted accounting principles (GAAP) or International Financial Reporting Standards will provide a good starting point for GIPS compliance, but extra steps most likely will be needed to understand GIPS, to incorporate GIPS compliance into their policies and procedures and to maintain good governance over their continued compliance.
GIPS is a set of standardized, industry-wide principles that provide investment management firms with broadly accepted guidance on how to calculate and report investment performance to their investors and prospective clients. While GIPS compliance is voluntary, more than 1,500 firms now claim compliance with GIPS. GIPS compliance can, among others:
- Provide a competitive edge for winning the new U.S. and global investor business
- Provide a sound practice framework for performance measurement and reporting suitable for a variety of strategies and operating scenarios
- Fulfill a key screening criterion for evaluating investment advisers
- Satisfy performance reporting requirements to gain and maintain institutional investor business
- Permit investors to assess and compare performance among investment advisers
- Deliver distinct competitive advantage over noncompliant investment advisers
Most of the growth in GIPS compliance in recent years has come from the alternative investment industry, with an increasing number of hedge fund firms, private equity firms, and real estate investment firms claiming compliance.
Private equity and GIPS
In addition to its general provisions for all firms, GIPS includes special provisions for private equity firms. For purposes of compliance with GIPS, private equity encompasses investments in nonpublic companies at various stages of development and includes venture capital, buyout, mezzanine capital, and some distressed securities investing. Private equity also includes investments in public companies with the intent of taking them private or investments directly in public companies through private investments in public equity (PIPEs). Investments in private equity may include investments in individual funds, fund of funds, as well as direct investments in operating companies. The GIPS private equity provisions typically apply to funds that are independent, private, fixed-life closed-end funds that have a fixed amount of committed capital. They do not apply to evergreen funds that have unlimited life and no fixed commitments. They also do not apply to exchange-traded funds and other types of open-end vehicles where the investment manager has no control over the timing of cash flows, even if they invest in private-equity type assets. These investments would fall under the regular GIPS provisions and are outside the scope of this article.
One of the main challenges for a firm that intends to become GIPS compliant is to establish an appropriate firm definition. For a firm that manages a variety of strategies and structures, defining the scope of its GIPS compliance requirement may involve a thorough analysis of its business and marketing strategy. A firm that manages a combination of private equity funds and hedge funds, for example, may find it appropriate to define the private equity arm of the firm and the hedge fund arm as two separate GIPS firms, because the two businesses:
- Are marketed separately
- Are organizationally and functionally segregated
- Retain discretion over the assets they manage
- Have separate operations
Under GIPS, the firm is not necessarily the investment adviser firm as a legal entity. The firm definition should be based on the substance of a firm’s business and on how the firm holds itself out to potential investors.
Under GIPS, performance reports are created for each composite, which is an aggregation of portfolios with a similar investment style or strategy. In the case of private equity firms, composites typically consist of funds that have a similar investment strategy and vintage year (the year of the first capital call or drawdown). A fund manager with a series of funds with a similar investment strategy but that started in different years will typically create separate composites (and performance reports) for each fund or group of funds, based on the year in which the first capital call took place.
In a private equity firm, cash flows typically are controlled by the investment manager, who has the authority to call capital from the fund’s investors and make distributions when deemed appropriate. Accordingly, GIPS requires firms to calculate returns using the annualized since-inception internal rate of return (SI-IRR) rather than the time-weighted method, to reflect the impact of the timing of cash flows on investment performance results. Firms typically will cover in their policies how to address situations in which the effective date of a contribution or distribution is different from the date in which the related cash flow actually occurs, which may happen particularly in the initial “build-up” period. Returns must be presented on an annual basis at a minimum, and quarterly returns are recommended. Gross returns must be calculated net of transaction expenses, which are the fees associated with making, managing, and selling an investment, and before deducting carried interest and investment management fees. In addition to the gross IRR, firms also are required to present a measure of net returns after deducting carried interest and investment management fees from the gross return. To comply with GIPS, management fees should factor into the cash flow calculation as of the date on which they are accrued (typically quarterly) rather than at the end of the year when the return is computed, and carried interest should be estimated including the accrued, but not yet realized portion that pertains to the unrealized gain (loss) component in the fund’s return. The type of expenses included in the IRR calculation and the timing of cash flows related to expenses may have a significant effect on returns and is an area to monitor for GIPS compliance.
The concept of fair value used in GIPS for private equity funds mirrors the fair value principles under U.S. GAAP. Accordingly, investments are required to be reported at fair value consistent with the fair value reported in U.S. GAAP financial statements.
GIPS generally requires the presentation of benchmark returns (SI-IRR returns for private equity composites). The benchmark chosen to compare the performance of the composite must reflect the same vintage year used for the composite. Firms may elect not to present a benchmark if the investment managers believe that a benchmark is not available or appropriate for a specific composite. In this case, GIPS requires the reason for not including a benchmark to be disclosed in the composite presentation.
Compliant presentations and disclosures
GIPS requires private equity funds to provide additional information on their equity structure, capital activity, and the character of their gains and losses. For each reporting period, firms are required to report cumulative committed capital, cumulative-since-inception contributions, and distributions (for annual periods, these can be drawn from the fund’s financial statements).
They also have to report a number of additional metrics that include the total-value-to-since-inception-paid-in-capital ratio, the residual-value-to-paid-in-capital ratio, the distributions-to-paid-in-capital ratio, and the paid-in-capital multiple, a ratio of the total paid-in capital to the cumulative committed capital. Typically, the presentation of these additional disclosures would not represent a significant challenge for funds that already prepare U.S. GAAP financial statements.
To be in compliance, firms that have been in existence for fewer than five years are required to report GIPS-compliant performance since inception. Firms that have been in operation for five years or more are required to show a minimum of five years of GIPS-compliant performance records in their initial GIPS-compliant reports. Firms are then required to add the GIPS compliant record of each subsequent annual performance until they reach a 10-year record, which can then be maintained on a rolling basis. Firms may report more than the minimum GIPS-compliant track record if desired.
GIPS compliance offers real advantages in a market where investors are seeking increased transparency and want more confidence in the reported performance of the funds they are considering. By understanding the steps above, private equity funds can better manage their GIPS compliance efforts.