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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