Tag: Rule 205-3

Increasing the Threshold for Qualified Clients and Performance Fees

The U.S. Securities and Exchange Commission proposed to increase the net worth threshold for “Qualified Clients” from $2 million to $2.1 million.

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Rule 205-3 currently requires “qualified clients” to have at least $1 million of assets under management with the adviser or a net worth of at least $2 million.

Under the Investment Advisers Act, an adviser can only charge a performance fee if the client is a “qualified client”. The SEC equates net worth with sophistication, so a “qualified client” had to have a level assets to prove their financial sophistication.

The Dodd-Frank Wall Street Reform and Consumer Protection Act required a change for Section 205(e) of the Advisers Act by adjusting the levels for inflation and to re-adjust the levels every five years. The SEC also tossed out the value of a person’s primary residence, just as they did with the accredited investor standards.

The last inflation adjusted increase was in 2011, so it’s time to adjust again.

Inflation has been low, so the increase is small. So small that the inflation increase for the $1 million assets under management prong is below the rounding amount specified in Rule 205-3.

So it’s time to revise you client intake / investor subscription documents.

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Tighter Rules on Advisory Performance Fee Charges

Under the Investment Advisers Act, an adviser can only charge a performance fee if the client was a “qualified client”. The SEC equates net worth with sophistication, so a “qualified client” had to have a level assets to prove their financial sophistication. Those levels are now officially increased.

The original standard was that the client had to have at least $500,000 under management with the adviser immediately after entering into the advisory contract (“assets-under-management test”) or if the adviser reasonably believed the client had a net worth of more than $1 million at the time the contract was entered into (“net worth test”). Those levels were increased to $750,000 and $1.5 million in 1985 to adjust for inflation.

The Dodd-Frank Wall Street Reform and Consumer Protection Act called for Section 205(e) of the Advisers Act to adjust those levels for inflation and re-adjust the levels every five years. The SEC also decided to toss out the value of a person’s primary residence, just as they did with the new accredited investor standards.

The rule now requires “qualified clients” to have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million.

The SEC is using the same primary residence calculation they used in the new accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. As the SEC did with the accredited investor standard, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce. One of the questions from the SEC in the proposed rule was whether the PCE index was the appropriate measure of inflation. They’ve decided to use this index and continue to benchmark it against the original test amounts. In five years, you will be able to predict what the new levels will be.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  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.

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SEC Made It Harder to Earn Performance Fees

As a general rule, investment adviser cannot charge performance fees. Section 205(a)(1) of the Investment Advisers Act of 1940 generally prohibits an investment adviser from entering into, extending, renewing, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client. That means no performance fees.

Unless the SEC makes an exception, which it has done so for people that don’t need the protections of that prohibition. Historically, that has meant the person has a “big pile of cash”. The big pile of cash standard had been if the client has at least $750,000 under the management of an investment adviser or the adviser reasonably believes the client has a net worth of more than $1,500,000.

Back in May the SEC has proposed raising those limits to $1 million under management or a minimum net worth of $2 million. The SEC was required to adjust the standard under Section 418 of Dodd-Frank. The adjustment was keyed to inflation. The SEC decided to exclude the value of person’s home, just as they did with the accredited investor standard, in calculating net worth.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund if it is relying on the 3(c)(1) exemption under the Investment Company Act. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  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.

The new standard will go into effect on September 19, 2011.

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The SEC Is Making it Harder for Investment Advisers to Earn Performance Fees

The Securities and Exchange Commission is proposing to raise the dollar thresholds for someone to be considered a “qualified client.”

The definition of a qualified client is set out in Rule 205-3. This is an exemption to the Section 205(a)(1) general prohibition on performance fees.  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.”

Section 418 of the requires the SEC to adjust the standard for a Qualified Client for the effects of inflation within one year and then every five years.

Back in August I predicted the standard would be raised to a minimum investment of $1 million and the minimum net worth would rise to $2 million. I was proven wrong about my prediction of a rise in the accredited investor standard.

The SEC is proposing that the standard increase to a minimum investment of $1 million and the minimum net worth would rise to $2 million. As to net worth, they are excluding the value of a person’s primary residence.

The SEC is using the same primary residence calculation they used in the “new” accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce

One of the comments the SEC is seeking in the proposed rule is whether the PCE index is the appropriate measure of inflation.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  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.

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Changes to the Qualified Client Standard

In addition to the changing standard for an accredited investor, the standard for a “qualified client” under the Investment Advisers Act is also changing. Section 418 of the requires the SEC to increase the standard.

SEC. 418. QUALIFIED CLIENT STANDARD.
Section 205(e) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–5(e)) is amended by adding at the end the following: ‘‘With respect to any factor used in any rule or regulation by the Commission in making a determination under this subsection, if the Commission uses a dollar amount test in connection with such factor, such as a net asset threshold, the Commission shall, by order, not later than 1 year after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010, and every 5 years thereafter, adjust for the effects of inflation on such test. Any such adjustment that is not a multiple of $100,000 shall be rounded to the nearest multiple of $100,000.’’.

Unlike some of the arguments over whether the accredited investor standard should be adjusted based on inflation, this standard is explicitly tied to inflation.

The definition of a qualified client is set out in Rule 205-3.

Currently, the investor has to have at least $750,000 under management with the adviser/fund.  That standard was adopted in July 1998. Using the CPI-U of 163.2 in  July 1998 and 217.965 in June 2010, the minimum investment amount should increase to $1,000,000.

The net worth amount of $1.5 million was also adopted in July 1998. Using the same ratio, I would expect the minimum net worth to rise to $2 million.

As for private  funds, Rule 205-3 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.

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That fancy SEC logo appeared briefly on the SEC’s website on Monday. (Thanks for pointing this out Bruce.) It was odd enough that I thought it should be re-used.

Performance Fees for Private Investments Funds under the Investment Adviser Act

regulatory umbrella

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.

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The image is a black Tour de France umbrella available at the official store of Le Tour de France. (Yes, I’m a huge fan of the Tour de France.)