FINRA Rule 2210: How to calculate IRR consistent with GIPS
Sean P. Gilligan, CFA, CPA, CIPM and Sara Celapino
April 26, 2021
In July 2020, the Financial Industry Regulation Authority (FINRA), a government-authorized not-for-profit organization that oversees US broker-dealers, published Regulatory Notice 20-21, which addresses retail communications concerning private placement offerings. Specifically, Regulatory Notice 20-21, which addresses FINRA Rule 2210 and the use of IRR in retail communications for completed investment programs, now requires IRR to be calculated according to the methodology outlined in the GIPS® Standards.
What is GIPS?
The Global Investment Performance Standards (GIPS®) are a set of voluntary standards utilized by investment managers and asset owners throughout the world to provide full disclosure and fair representation of their investment performance.
The fundamental aim of GIPS compliance is transparency and consistency. Firms that comply with the GIPS standards improve transparency in the industry and standardize reporting, allowing prospects evaluating managers with similar strategies to make the comparison easier and more meaningful.
What does FINRA Rule 2210 have to do with the GIPS standards?
Within the Regulatory Notice, FINRA states that, “FINRA interprets Rule 2210 to permit the inclusion of IRR if it is calculated in a manner consistent with the Global Investment Performance Standards (GIPS) adopted by the CFA Institute and includes additional GIPS-required metrics such as paid-in capital, committed capital and distributions paid to investors.” Ultimately, this means that firms that present IRRs in private placements must now calculate and present performance information in accordance with the methodology outlined in the GIPS standards.
This understandably has led to some confusion for non-GIPS compliant firms that include IRR performance in private placement offerings.
In the CFA Institute’s March 2021 GIPS Standards Newsletter, some common questions were addressed regarding FINRA Regulatory Notice 20-21 and its reference to the GIPS standards. Please keep in mind that CFA Institute’s interpretation of the Regulatory Notice has not been adopted or endorsed by FINRA. The key takeaways from the questions and answers listed in the newsletter are listed below.
Key Takeaways From CFA Institute about FINRA Regulatory Notice 20-21:
A firm is not required to claim compliance with the GIPS Standards in order to comply with FINRA Regulatory Notice 20-21.
An exception is being made to allow firms and their agents to make a specific statement regarding the GIPS Standards only in retail communications concerning private placements offerings that are prepared in accordance with FINRA Regulatory Notice 20-21.
For firms that do not claim compliance with the GIPS standards:
[Insert firm name] has calculated the since-inception internal rate of return (SI-IRR) and fund metrics using a methodology that is consistent with the calculation requirements of the Global Investment Performance Standards (GIPS®). [Insert firm name] does not claim compliance with the GIPS standards. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote [insert firm name], nor does it warrant the accuracy or quality of the content contained herein.
For firms that claim compliance with the GIPS standards:
[Insert firm name] has calculated the since-inception internal rate of return (SI-IRR) and fund metrics using a methodology that is consistent with the calculation requirements of the Global Investment Performance Standards (GIPS®). [Insert firm name] claims compliance with the GIPS standards. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote [insert firm name], nor does it warrant the accuracy or quality of the content contained herein.
Any IRR, as well as the additional metrics required under the GIPS standards, must meet the input data and calculation requirements of the GIPS standards.
Additional metrics must be included when presenting IRR performance in compliance with the GIPS standards. The following metrics are required under the GIPS Standards:
- Since-inception paid-in capital (PIC) – The amount of committed capital that has been drawn down
- Since-inception distributions
- Cumulative committed capital – The capital pledged to the investment vehicle
- Total value to since-inception paid-in capital (TVPI or investment multiple) – TVPI provides information about the value of the composite relative to its cost basis
- Since-inception distributions to since-inception paid-in capital (DPI or realization multiple)
- Since-inception paid-in capital to cumulative committed capital (PIC multiple)
- Residual value to since-inception paid-in capital (RVPI or unrealized multiple)
How to calculate IRR consistent with the GIPS Standards
To meet the requirements of the GIPS standards, money-weighted returns must be presented as an annualized since-inception figure that uses daily external cash flows (at least quarterly is acceptable for external cash flows prior to 1 January 2020). Additionally, stock distributions must be treated as external cash flows and must be valued at the time of distribution. For pooled funds, returns must be net of total pooled fund expenses.
While IRR is the most common money-weighted return, Modified Dietz is also an acceptable method. Not to be confused with linked Modified Dietz returns that many firms use as a time-weighted return (calculated monthly and then geometrically linked to calculate annual returns), this Modified Dietz return is calculated once covering the entire performance period.
Most firms use IRR, or more specifically, the XIRR function in Excel, which allows for daily cash flows.
One important consideration is ensuring that the return is properly annualized. If using XIRR and the period is greater than 1-year then the result of the calculation using this function in Excel is already properly annualized. If using Modified Dietz, the result is a cumulative return that will need to be annualized for periods greater than 1-year. This figure can be annualized as follows:
((1+Cumulative Modified Dietz Return)365/Total Days)-1
Conversely, if the XIRR is calculated for a period shorter than 1-year, it must be de-annualized. This can be done as follows:
For more information on additional considerations when presenting IRRs, i.e. money-weighted returns, in accordance with the GIPS standards, please reference the “2020 GIPS Report Utilizing Money-Weighted Returns” section of our article on presenting performance under the 2020 GIPS standards.
If your firm is interested in claiming compliance with the GIPS standards, or would like assistance in calculating and presenting performance in accordance with GIPS, we would be happy to help.