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.
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