Registered investment advisers generally can charge “performance fees” only
to qualified clients. If there is a performance fee, such as the typical carried
interest, then investors in a fund managed by a registered adviser need to be
This issue is not a problem in C7 (qualified purchaser) funds, because
qualified purchasers are qualified clients. However, a C1 (not more than 100
holders) fund may have investors that are not qualified clients.
Many fund managers have registered as investment advisers, or are in the
process of registering as investment advisers.
The SEC has amended the qualified client rule, effective May 22, 2012.
Definition of Qualified Client
A qualified client needs to either have:
- at least $1 million under management with the adviser; or
- more than $2 million in net worth (joint net worth with a spouse in the
case of a natural person).
These figures are currently effective as a result of an SEC order issued last
year, and the amendments do not change these figures. However, the amendments
change the way net worth is calculated.
Net Worth Does Not Include the Primary Residence
The amendments require that the value of the primary residence be excluded in
calculating net worth.
Debt secured by the primary residence does not count in calculating net
worth, up to the value of the primary residence.
Debt that is secured by the primary residence and is taken out within 60 days
before the status determination is included in calculating net worth (unless the
debt was incurred in purchasing the house).
The amendments make clear that investor relationships that were in compliance
at the time they were entered into do not need to be altered as a result of
changes in the rule, or registration as an investment adviser.
For example, a registered adviser who manages a fund that has investors that
were qualified clients under the rule as it existed when they became investors
may continue to manage that fund if these investors are not qualified under the
Also, an unregistered manager who becomes registered may continue to manage a
fund that contains investors who are not qualified, so long as all new investors
after registration are qualified.
There is also a provision that allows transfers of fund interests to
nonqualified investors in certain limited circumstances, such as gifts,
inheritance and divorces.
Fund managers who are exempt from federal adviser registration may still need
to comply with the qualified client rules as a result of state law.
Many states have amended, or are in the process of changing, their investment
adviser regulations in response to Dodd-Frank.
NASAA has adopted a model rule for possible use by the states in this regard.
This model rule requires a C1 fund that is not a venture capital fund to have
investors that are qualified clients, make certain disclosures and deliver
annual audited financials to fund investors. The model rule also contains a
grandfather clause that allows a pre-existing C1 fund to contain nonqualified
investors, so long as all investors coming in after the effective date are
qualified clients, and the other provisions applicable to C1 funds are
The NASAA model rule is important because some states have already adopted it
or proposed to adopt it, and it is likely that other states will also adopt it.
As a result, applicable state law may require the manager of a C1 fund to comply
with the qualified client rule, even if that manager is exempt from registration
as an adviser at the federal level.
Fund managers should monitor applicable state law on this point.