Most 3(c)(1) private equity and hedge funds are impacted; exempt venture capital funds are not impacted.
Effective August 16, 2021, the dollar thresholds specified in the definition of “qualified client” under Rule 205-3 of the Investment Advisers Act of 1940, as amended (“Advisers Act”) will increase (i) from $2.1 million to $2.2 million (net worth test) and (ii) from $1 million to $1.1 million (assets under management (AUM) test). Clients that enter into investment advisory agreements (and existing fund investors that make additional fund investments) in reliance on the net worth test prior to the effective date will be “grandfathered” in under the prior net worth threshold. The increases are made pursuant to a five-year inflation adjustment required by section 205(e) of the Advisers Act (section 419 of the Dodd-Frank Act). (The most recent prior change was effective August 15, 2016.)
Section 205(a)(1) of the Advisers Act generally restricts 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 (“performance compensation prohibition”). Rule 205-3 of the Advisers Act provides a limited exemption from the performance compensation prohibition and permits investment advisers to receive performance-based compensation (incentive allocations, carry, carried interest, performance fee etc.) from “qualified clients.”
After August 16, a “qualified client” is a person that:
(i) has at least $1.1 million in assets under management with the investment adviser immediately after entering into the advisory contract (AUM test); or
(ii) has a net worth (in the case of a natural person client, together with assets held jointly with a spouse) that the investment adviser reasonably believes is in excess of $2.2 million immediately prior to entering into the advisory contract (net worth test).
As a reminder, the value of a natural person’s primary residence must not be included in net worth; indebtedness secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time the investment advisory contract is entered into, need not be counted as a liability toward net worth (except that debt acquired or a loan amount increased within 60 days before investment or contract execution date must be counted); and indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the residence also must be counted as a liability.
A qualified client also includes both a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), and an investment adviser’s “knowledgeable employees.” The newly revised definition will, therefore, affect certain private investment funds that rely on Section 3(c)(1) of the Investment Company Act (but not those funds relying on Section 3(c)(7)) and separately managed accounts that charge performance fees.
Advisory clients that established an advisory relationship (signed a contract) before the effective date of the new thresholds will be “grandfathered” in under the prior net worth threshold. Investors in a private fund are considered, for these purposes, a client of the adviser (fund manager). Therefore, future investments in a fund by the same investor who first invested in that fund before August 16 also will be grandfathered at the prior dollar thresholds. However, managers of section 3(c)(1) funds should update their subscription agreements and other offering documents to reflect the new qualified client threshold for new investors who first invest after August 16, 2021. In addition, notably, existing investors in a 3(c)(1) fund of funds (investor fund) that first invests in a 3(c)(1) fund (investee fund) after the effectiveness of a new threshold would nevertheless each have to be qualified client under the new thresholds because the investor fund’s investment in the investee fund would count as a new advisory relationship.
Private fund advisers (hedge fund, private equity and venture capital fund managers) that rely on the federal ‘private fund adviser” exemption from investment adviser registration will not be impacted, including with respect to their 3(c)(1) funds. The Adviser’s Act performance compensation prohibition applies only to registered investment advisers but does not apply to investment advisers relying on the federal private fund adviser exemption (so called “exempt reporting advisers”). Certain states (e.g., California, Texas), however, mandate under their state equivalent private fund adviser exemptions that even exempt reporting advisers, other than exempt venture capital fund advisers, only charge a performance fee to qualified clients with respect to their 3(c)(1) funds. Therefore, while private fund advisers that qualify as “venture capital fund advisers” will not be impacted by the new qualified client thresholds, exempt reporting advisers that are private equity or hedge fund managers will have to comply with the qualified client standard in their 3(c)(1) funds under certain state laws.
Please contact your attorney at Pillsbury’s Investment Funds Group for additional information.