Investment Management

Investment Management

AUGUST 2002

Proposed AIMR Investment Performance Guidance Statement On the Treatment of Carve-Outs

By: Michael S. Caccese*

The Association for Investment Management and Research ("AIMR") recently proposed investment performance guidelines for the treatment of carve-outs (the "Guidelines"). The proposed Guidelines provide a clarification on the treatment of carve-outs in relation to the AIMR Global Investment Performance Standards ("GIPS") and the country versions of GIPS, including the AIMR Performance Presentation Standards ("AIMR-PPS"). AIMR defines a carve-out as a sub-set of a portfolio's assets used to create a track record for a narrower investment mandate from a portfolio managed to a broader mandate. Carve-outs are generally based on asset class, geographic region or industry sector. The GIPS Standards state that commencing January 1, 2005, carve-outs can only be used if they are managed separately within their own cash allocation. The Guidelines clarify the appropriate treatment of carveouts before and after January 1, 2005. Comments on the proposed Guidelines should be received by AIMR no later than September 15, 2002.

OVERVIEW AIMR believes that there are several inherent problems with the use of carve-outs. First, the use of carve-outs gives the impression that the investment management firm has experience managing portfolios dedicated to a particular strategy, where a carved-out strategy may

only be a small portion of a large composite and of the firm's expertise. Second, carve-outs may not account for cash separately and, thus, must be allocated to the carved-out segment causing the calculation of the performance return to potentially be less accurate. GIPS and AIMR-PPS standards require that returns from cash held in the portfolio must be included in the total return. By not treating a carve-out as a stand-alone portfolio, there will be no cash associated with the returns for that sub-set and, thus, may not accurately represent the actual management of a client's portfolio. The Guidelines intend to treat any carve-out used as a track record as representative of an actual segregated portfolio managed to that strategy. According to the Guidelines, a firm is required to structure the carve-out materially the same as the overall portfolio, with a substantially similar risk profile to determine if the carved-out segment is representative of a separately managed portfolio with the same strategy.

CARVE-OUT MANDATORY REQUIREMENTS The Guidelines set forth the following requirements that firms must meet in order to comply with GIPS Standards with respect to carve-outs both prior to and after January 1, 2005.

* Michael Caccese is a partner in the Boston Office of Kirkpatrick & Lockhart LLP. He works extensively with investment firms on compliance issues, including the AIMR-PPS and GIPS. He was previously the General Counsel to AIMR and was responsible for overseeing the development of AIMR-PPS, GIPS and other standards governing the investment management profession and investment firms. He can be reached at 617.261.3133 and mcaccese@.

Kirkpatrick & Lockhart LLP

 the carve-out should (must starting January 1, 2005) multiple cash accounts, where each segment's cash is

be managed separately;

accounted for separately.

the carve-out must be representative of a standalone portfolio managed to the same strategy;

for a carve-out of a particular strategy all similar portfolio segments managed to that strategy should (must starting January 1, 2005) also be carved-out and included in the composite;

fees representative of the fees charged for a separately managed portfolio for the assets carvedout must be allocated to the carve-out when presenting net-of-fees returns; and

the cash allocation method used must be disclosed.

CARVE-OUTS PRE-2005 Prior to January 1, 2005, the carve-out should have its cash accounted for separately applying a consistent, objective methodology using cash allocation methods on an ex-ante basis.

If the segment does not have its own cash, cash must be allocated to the segment according to one of the following allocation methods: (i) Beginning of Period Allocation, where a firm must identify the cash allocation percentage for each portfolio segment at the beginning of the period; or (ii) Strategic Asset Allocation, where a firm bases the allocation directly upon the target strategic asset allocation by using the difference between the target percentage and the actual percentage of investment (40% target with a 35% actual investment equals 5% cash). Firms must disclose which allocation strategy was used in creating the carve-out.

CARVE-OUTS POST-2004 Commencing January 1, 2005, the carve-out must have its own cash using three possible methods for properly accounting for the cash positions: (i) sub-portfolios, where each segment of a portfolio is accounted for as if it were a separate portfolio; (ii) separate portfolios, where cash and securities are actually segregated into a separate physical portfolio at the custodian; and (iii)

The Guidelines set forth acceptable uses for carve-outs which include:

carve-outs existing prior to January 1, 2005 need not be separately managed going forward ? the history of those existing carve-outs must not change;

firms are not permitted to combine different carveouts or composites to create a new, simulated strategy composite unless it is for purposes of compliance with GIPS Standards; any hypothetical composite created from existing accounts may be presented as supplemental information and not linked to actual composite returns; and

firms must disclose the underlying composites of which the carve-outs are members and the percentage for the current reporting period of each composite that is composed of carve-outs; prior periods must be made available upon client request.

EFFECTIVE DATE Guidelines are effective January 1, 2003 and earlier compliance is encouraged. The Guidelines set forth the requirements of how an investment firm must treat carve-outs for the purposes of complying with the GIPS and AIMR-PPS standards. Investment firms claiming GIPS or AIMR-PPS compliance should carefully review the proposed Guidelines, and keep apprised of the Guidelines as they are finalized.

If you would like to discuss the proposed Guidelines, or any other issues relating to your AIMR-PPS compliance, please contact Michael S. Caccese at 617.261-3133 or mcaccese@ or your primary K&L contact.

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Kirkpatrick & Lockhart LLP

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BOSTON DALLAS HARRISBURG LOS ANGELES MIAMI NEWARK NEW YORK PITTSBURGH SAN FRANCISCO WASHINGTON

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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting with a lawyer.

? 2002 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.

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