Higher Threshold for Performance Fee Proposed
Under current SEC Rule 205-3, an SEC registered investment adviser can charge a performance fee (also called a performance allocation, incentive fee or incentive allocation) only to those investors who either has:
- a $1.5M net worth or
- at least $750,000 in assets with the manager
Many states have the same rules for state registered advisers or they explicitly make reference to the SEC regulation.
As a result of the Dodd-Frank act, the SEC is now proposing to increase the threshold for managers to be able to charge these performance fees. The proposal declares that clients or investors of an SEC registered investment adviser can be charged a performance fee only if the client has:
- a $2M net worth (excluding a primary residence) or
- at least $1M in assets with the manager
What this means for SEC Registered Managers
While there will likely be a grandfathering provision for current fund managers with current investors who are “qualified clients”, when the new regulations go into effect, SEC registered managers (and potentially state registered managers) will likely need to make sure new investors meet the new threshold in order to charge these investors a performance fee. Additionally, managers will need to update their offering documents to reflect the new definition (reprinted in full as proposed below).
The new regulation is likely to affect smaller funds disproportionally. Many times smaller funds have investors who may just meet the qualified client threshold. [Note: for some managers, they may allow non-qualified clients into the fund, but then just charge them a higher management fee in lieu of a performance allocation.]
Managers are urged to send comments to the SEC. The comment period is open until July 11, 2011.
The SEC notice can be found here.
The full proposed rule can be found here: Performance Fee Rule Proposal.
Current comments on the proposal can be found here.
Proposed Changes to Rule 205-3
Section 275.205-3 is amended by:
a. Revising paragraph (c);
b. Revising paragraphs (d)(1)(i) and (ii); and
c. Adding paragraph (e).
The revisions and addition read as follows.
§ 275.205-3 Exemption from the compensation prohibition of section 205(a)(1) for investment advisers.
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(c) Transition rules.
(1) Registered investment advisers. If a registered investment adviser entered into a contract and satisfied the conditions of this section that were in effect when the contract was entered into, the adviser will be considered to satisfy the conditions of this section; Provided, however, that if a natural person or company who was not a party to the contract becomes a party (including an equity owner of a private investment company advised by the adviser), the conditions of this section in effect at that time will apply with regar
d to that person or company.
(2) Registered investment advisers that were previously exempt from registration. If an investment adviser was exempt from registration with the Commission pursuant to section 203 of the Act (15 U.S.C. 80b-3), section 205(a)(1) of the Act will not apply to an advisory contract entered into when the adviser was exempt, or to an account of an equity owner of a private investment company advised by the adviser if the account was established when the adviser was exempt; Provided, however, that section 205(a)(1) of the Act will apply with regard to a natural person or company who was not a party to the contract and becomes a party (including an equity owner of a private investment company advised by the adviser) when the adviser is no longer exempt.
(d) Definitions. For the purposes of this section:
(1) The term qualified client means:
(i) A natural person who, or a company that, immediately after entering into the contract has at least $1,000,000 under the management of the investment adviser;
(ii) A natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:
(A) Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property; or
(B) 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)) at the time the contract is entered into; or
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(e) Inflation adjustments. Pursuant to section 205(e) of the Act, the dollar amounts specified in paragraphs (d)(1)(i) and (d)(1)(ii)(A) of this section shall be adjusted by order of the Commission, effective on or about May 1, 2016 and issued approximately every five years thereafter. The adjusted dollar amounts established in such orders shall be computed by:
(1) Dividing the year-end value of the Personal Consumption Expenditures Chain-Type Price Index (or any successor index thereto), as published by the United States Department of Commerce, for the calendar year preceding the calendar year in which the order is being issued, by the year-end value of such index (or successor) for the calendar year 1997;
(2) For the dollar amount in paragraph (d)(1)(i) of this section, multiplying $750,000 times the quotient obtained in paragraph (e)(1) of this section and rounding the product to the nearest multiple of $100,000; and
(3) For the dollar amount in paragraph (d)(1)(ii)(A) of this section, multiplying $1,500,000 times the quotient obtained in paragraph (e)(1) of this section and rounding the product to the nearest multiple of $100,000.
Cole-Frieman & Mallon LLP is a hedge fund law firm focused on the investment management industry. Bart Mallon can be reached directly at 415-868-5345.