As more private investment funds will be pulled under the regulatory umbrella of the Investment Advisers Act,they will need to focus on the limitation on performance fees.
Section 205(a)(1) of the Advisers Act generally prohibits any investment adviser, unless exempt from registration pursuant to Section 203(b) of the Advisers Act, from entering into, extending, renewing, or performing under any investment advisory contract if the contract includes a performance fee. With the financial reform bill likely to pass any day, the 203(b) exemption will evaporate for many private investment funds.
Section 205(e) grants the SEC the power to create an exemption from the limitation “on the basis of such factors as financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management, relationship with a registered investment adviser,” and other factors. The SEC created an exemption in Rule 205-3 for “qualified clients.”
A “qualified client”
1. has at least $750,000 under the management with the investment adviser
2. has a net worth of more than $1.5 million at the of the investment
3. is a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 [15 U.S.C. 80a-2(a)(51)(A)]
4. is an executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser
or
5. is an employee of the investment adviser who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser.
The rule requires a look -through from the fund to the investors in the fund. If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should all be qualified purchasers or knowledgeable employees and you won’t need to look much further.
If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.
Sources:
- Section 205 of the Investment Advisers Act – Investment Advisory Contracts
- Rule 205-3 – Exemption From the Compensation Prohibition of Section 205(a)(1) for Investment Advisers
- SEC Release No. IA-1731 Final Rule for 205-3
- SEC Modifies Rule 205-3 Requirements for Performance Fees
by Simpson Thacher & Bartlett - SEC Amends Rule Allowing Investment Adviser to Charge Performance Fees by Saterlee Stephens Burke & Burke LLP
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