By now, most managers of hedge funds, private equity funds, and venture capital funds know that they will be required to either register with the SEC or file Form ADV as a notice filing. But there is an additional change right around the corner for fund managers: those funds who will be required to register with the SEC will also need to increase their minimum investor qualification.
Many funds currently require only that their investors be accredited investors. Before the Dodd-Frank Act, this meant that each individual investor was required to have a net worth over $1 million or annual income exceeding $200,000 ($300,000 with his or her spouse). The Dodd-Frank Act removed the value of an investor’s primary residence from the calculation of an investor’s net worth. This is a subtle change, but could make the difference for some investors close to the $1 Million net worth threshold.
The far bigger change, however, is in the imposition of the “qualified client” standard on some private funds. Prior to the enactment of the Dodd-Frank Act, most private fund managers relied on the exemption from investment adviser registration contained in Section 203(b)(3) of the Investment Advisers Act, which exempted any adviser with under 15 clients from registration (the so-called “15 client exemption.”)[1] Now, after the enactment of the Dodd-Frank Act, many private funds will be required to register as investment advisers unless they either (a) exclusively manage venture capital funds (as defined in regulations) or (b) only advise private funds and manage assets under $150 million. Section 205 of the Investment Advisers Act prohibits investment advisers who are registered with the SEC from charging their clients a performance fee (i.e. a fee based on the gains made by the investors in the fund). Most private funds charge their investors a performance-based fee in the form of a performance allocation or carried interest (usually 20% of portfolio gains). However, since the Dodd-Frank Act eliminated the 15 client exemption, many private fund managers are no longer exempt from registration and are thus subject to the prohibition on charging a performance-based fee.
Luckily, there has always been a regulatory exception to the prohibition on performance-based fees: if each investor in a private fund is a “qualified client,”[2] then the prohibition does not apply. A “qualified client” is a client which has a net worth in excess of $1.5 Million or has more than $750,000 of investment assets managed by the adviser (this could be within the private fund or in a separate account). In recent rule-making, the SEC has proposed a number of changes to this standard:
- As in the case with the accredited investor standard, the value of an investor’s primary residence will no longer be counted towards his or her net worth; and
- A “qualified client” will now be defined as a client which has a net worth in excess of $2 Million or has more than $1 Million of assets managed by the investment adviser.
Prior to all of these changes, the minimum net worth required for an individual investor in a private fund managed by an unregistered adviser was $1 Million. Once the proposed rules have been adopted by the SEC, this minimum net worth requirement will have been effectively increased to $2 Million for private fund managers who are now required to register with the SEC because they will now be subject to the “qualified client” standard. This is certainly a significant and material increase. Fund managers who are engaging in on-going capital raising should consult their attorney to ensure that their practices are up to date and that their offering documents have been updated to include appropriate representations from investors.
Footnotes
[1] In determining the number of clients an investment adviser had, the adviser needed only to count the number of funds it advised, not the number of investors in each fund. Therefore an adviser who advised one fund with 60 investors would be considered to have only one client.
[2] This is not to be confused with a “qualified purchaser” which, for individuals, is defined as an individual person with $5 Million or more in investments.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
