On June 14, the Securities and Exchange Commission (“SEC”) issued an order increasing the net worth threshold for qualified clients from $2 million to $2.1 million. The SEC published notice of the proposed increase on May 18. Investment advisers, including private fund sponsors that charge their private fund investors an incentive fee or allocation, should make appropriate revisions to their advisory agreements and fund documentation in order to reflect the updated qualification criteria. The new standard is not retroactive, meaning any contracts entered into before it becomes effective would not be subject to the higher net worth threshold, but closings or transfers after the August 15, 2016, effective date must comply with the higher standard.
In addition to satisfying accredited investor status, investors are required to meet the qualified client criteria in order to invest in hedge funds and private equity funds that assess an incentive fee or allocation or carried interest where the fund is managed by an SEC-registered investment adviser.
The increase in the net worth threshold is part of an inflation indexing adjustment required every five years by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The change relates to Section 205(a)(1) of the Investment Advisers Act of 1940 (the “Act”), which generally prohibits SEC-registered investment advisers from entering into, extending or renewing an advisory contract which “provides for compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client,” including performance-based compensation such as a carried interest.
Rule 205-3 of the Act provides an exception to this prohibition in instances where clients meet the definition of a qualified client. For natural persons, this includes having at least $1 million under the management of the investment adviser; having a total net worth of $2 million or more (exclusive of a person's primary residence); meeting the definition of a qualified purchaser under the Act at the time immediately prior to entering into the contract; or being a senior employee of the investment adviser or an employee who has regularly participated in the investment activities of the adviser for at least 12 months.
By contrast, a natural person is an accredited investor if the investor has a net worth greater than $1 million (excluding the value of their primary residence) or annual income of at least $200,000 per year for each of the two most recent years (or $300,000 together with his/her spouse) and an expectation of reaching the same income level in the current year.
Under Rule 205-3(b), an equity owner of a private fund that is excepted from the definition of “investment company” by Section 3(c)(1) of the Investment Company Act of 1940 is also considered a client (A registered investment company or a business development company is also considered a client for purposes of Rule 205-3’s exception to the ban on performance-based fees). For 3(c)(1) funds that charge an incentive allocation or a performance fee, therefore, advisers must look through the fund to its investor base to ensure that the investors not only are accredited but, also meet the higher “qualified client” standard. Since the qualified client definition includes a higher net worth threshold than the current accredited investor definition, some individuals holding accredited investor status won’t meet the qualified client threshold, which could limit their investment options.
The SEC isn't proposing any change to the $1 million assets under management threshold at this time, as the required indexing adjustment is smaller than the amount specified under the Act.
On a separate but related topic, SEC staff have recently made various public comments regarding the definition of an accredited investor. In December 2015, the agency issued a staff report on the definition, as it is required to do every four years under Dodd-Frank, in order to determine whether the definition should be modified or adjusted.
The staff report recommended, among other options, that the definition be revised “to allow individuals to qualify as accredited investors based on other measures of sophistication” beyond the current measures of income and net worth. It suggested that individuals with a threshold level of investments or a professional certification could become eligible, as well as those with experience investing in exempt offerings, “knowledgeable employees of private funds” or anyone who passes a test. Both the “qualified client” and “qualified purchaser” standards permit knowledgeable employee investments, and Rule 3c-5 under the Investment Company Act excludes knowledgeable employees from being counted toward a 3(c)(1) fund’s 100-person limit.
Speaking at an industry event in January 2016, SEC Chairwoman Mary Jo White indicated that in her opinion the definition “needs changing,” arguing that the net worth and income criteria are not on their own “a very good or at least not optimal proxy” for determining who doesn't need protection from complex and potentially riskier investment strategies. She added that investment limits are “a very interesting concept in this space, obviously being used in [Regulation] A+ and crowdfunding, but I think ultimately it will result in a rulemaking.”
Potential changes to the definition also dominated discussions at a May 18 meeting of the SEC’s Advisory Committee on Small and Emerging Companies. SEC Commissioner Kara Stein commented on the “need to craft a definition of accredited investor that is flexible enough to differentiate between investors.” Similar to White’s previous comments, Stein also noted that crowdfunding and Regulation A+ already rely on investment limitations and asked if that could form part of a more “nuanced” definition. The committee itself has urged a relaxing of the definition in order to allow for greater investment in early-stage companies.
Qualifying as an accredited investor is significant, because under current SEC rules, accredited investors have access to private investment opportunities that are not available to retail investors such as investments in private companies and offerings by hedge funds, private equity funds and venture capital funds. As a result, changing the definition of “accredited investor” could alter the number of potential investors for privately offered vehicles, including alternative funds.
The SEC is continuing to accept comment on the staff report, and White has repeatedly urged interested parties to provide their feedback due to the wide range of options contained in the report and the significant ramifications each would have on market activity if adopted.