The hedge fund industry generally supports the SEC’s proposal raising the assets under management and net worth tests to become a qualified client under the performance compensation provisions of the Investment Advisers Act. As directed by Section 418 of the Dodd-Frank Act, the SEC would raise the assets under management amount to $1 million from the current $750,000 and the investor net worth test to $2 million from the current $1.5 million. Although not required by Dodd-Frank, the SEC proposes to exclude the value of a natural person’s primary residence from the net worth test.
These proposed changes would be to Advisers Act Rule 205-3, which currently exempts an investment adviser from the prohibition against charging a client performance fees, thereby allowing the adviser to charge performance fees if the client has at least $750,000 under management with the adviser immediately after entering into the advisory contract or if the adviser reasonably believed the client had a net worth of more than $1.5 million at the time the contract was entered into. These standards are designed to limit the availability of the exemption to clients who are financially experienced and able to bear the risks of performance fee arrangements.
In a letter to the SEC, the Managed Funds Association said that Section 418 of Dodd-Frank is a proper mechanism to ensure that the qualified client standard does not become diluted over time as a result of inflation by requiring the SEC to adjust the dollar amount tests under Section 205 of the Advisers Act for the effects of inflation within one year of the enactment of Dodd-Frank, and every five years thereafter.
Thus, the MFA supports the SEC’s proposal to implement Section 418 by increasing the assets under management threshold in Rule 205-3 to $1 million and the net worth threshold to $2 million, and by issuing an order every five years to adjust the thresholds to account for inflation. The hedge fund association also supports the proposal to exclude the value of a natural person’s primary residence from the determination of a person’s net worth since this would more closely align the calculation with the definition of accredited investor in Rule 501 under the Securities Act and qualified purchaser in Section 2(a)(51) of the Investment Company Act, and ensure that only sophisticated investors are able to purchase interests in private funds.
The SEC proposes to replace the current transition rules with two new subsections of Rule 205-3 maintaining existing performance fee arrangements that were permissible when the advisory contract was entered into, even if performance fees would not be permissible under the contract if it were entered into at a later date. These transition provisions are designed so that restrictions on the charging of performance fees apply to new contractual arrangements and do not apply retroactively to existing arrangements, including investments in companies that are excluded from the definition of an investment company by reason of section 3(c)(1) the Investment Company Act, which exempts a fund whose securities are owned by 100 or fewer persons and is not making a public offering.
The MFA generally supports the proposed transitional relief and appreciates that it would provide relief to advisers that are currently exempt from SEC registration and will be required to register as a result of Title IV of the Dodd-Frank Act. This transitional relief, which is similar to the relief that the SEC provided in connection with the hedge fund manager registration rule in 2004, is necessary to allow advisers to continue to operate their businesses without significant disruption.
However, the MFA cautioned that the proposed transitional relief could affect the operations of a 3(c)(1) fund that invests in another 3(c)(1) fund. In complying with the qualified client rule, a 3(c)(1) fund must look through another 3(c)(1) fund that is an equity owner of the fund to its individual investors. Under this look through analysis, the SEC proposal could be interpreted to lead to the anomalous result that a 3(c)(1) fund in compliance with Rule 205-3 and relying on the transitional relief for one or more of its investors would be effectively precluded from purchasing interests in another 3(c)(1) fund.
Such a result would be significantly disruptive to the investment strategies and operations of many 3(c)(1) funds, noted the MFA, and inconsistent with the goal of the transitional relief to apply the new thresholds prospectively. The MFA urged the SEC to clarify in the final rule that a 3(c)(1) fund will be deemed to have satisfied Rule 205-3 if an equity owner of the fund that itself is a 3(c)(1) fund is in compliance with Rule 205-3.