The SEC has updated the net worth threshold for “qualified clients” from $2.0 million to $2.1 million, effective August 15, 2016.
Section 205 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) generally prohibits a registered investment adviser from entering into an advisory contract that provides for compensation to the adviser on the basis of a share of capital gains upon or capital appreciation of funds of an advisory client. This prohibition on “performance-based fees” prohibits compensation arrangements commonly used in fund vehicles, such as “carry” or other incentive interests. However, Rule 205-3 provides is an exception to this prohibition if the client entering in to the advisory contract is a “qualified client.” Since July 2011, the definition of “qualified client” generally required the client to have either $1.0 million under management with the adviser or a net worth of $2.0 million. Every five years, however, Section 205(e) of the Advisers Act requires the SEC to adjust these dollar amount thresholds for the effects of inflation, rounding to the nearest $100,000. As a result of this process, the SEC determined to retain the $1.0 million under management threshold, but to increase the net worth threshold to $2.1 million.
Does this impact 3(c)(7) funds?
No. “Qualified purchasers” are automatically “qualified clients” pursuant to Rule 205-3(d)(1)(ii)(B).
Does this impact 3(c)(1) funds that are “exempt reporting advisors”?
Potentially, yes. While the prohibition on performance-based compensation only applies to investment advisers who are “registered or required to be registered” with the SEC, which does not include exempt reporting advisors, many 3(c)(1) funds attempt to future-proof their fund documents in case they become ineligible for private fund adviser (or other) exemptions and find themselves needing to register with the SEC. In addition, some states condition the availability of their state-level private fund advisor exemptions on the fund only charging performance-based fees to qualified clients, including several major investor hubs like California, Texas and Massachusetts.
Do we need to update documents for this?
Yes, but only on a going forward basis. The revised net worth threshold does not apply retroactively to contracts entered into prior to August 15, 2016. But investor representations reflecting the $2.1 million net worth threshold should be obtained for advisory contracts or fund subscription agreements providing for performance-based fees entered into on or after August 15, 2016. So, keep this in mind if after the deadline you are:
- Raising a new fund
- Letting a new investor join an open fund
- Facilitating a secondary transfer by an existing investor of a fund interest to a new investor