SECIn an order dated June 14, 2016, the Securities and Exchange Commission (SEC) adopted its prior proposal to increase the net worth threshold for “qualified clients” under Rule 205-3 of the Investment Advisers Act of 1940 (the Advisers Act) from $2 million to $2.1 million. This adjustment is being made pursuant to a five-year indexing adjustment required by §205(e) of the Advisers Act.

Registered investment advisers generally are prohibited by §205(a)(1) of the Advisers Act from charging performance-based compensation. An exemption from this prohibition is provided by Rule 205-3 under the Advisers Act for clients that meet the definition of a “qualified client.”

Currently, Rule 205-3 provides that in order to be a qualified client, a client must have either (i) at least $1 million of assets under the management of the investment adviser[1], or (ii) a net worth (together, in the case of a client which is a natural person, with assets held jointly with a spouse) which the investment adviser reasonably believes to be in excess of $2 million.[2]  These amounts were last adjusted on September 19, 2011, when the assets under management threshold was increased from $750,000, and the net worth threshold was increased from $1.5 million.  A qualified client also includes both a “qualified purchaser” as defined in §2(a)(51)(A) of the Investment Company Act of 1940 (the Investment Company Act) and an investment adviser’s knowledgeable employees.

A sponsor of a §3(c)(1) fund must be mindful of Rule 205-3(b) under the Advisers Act, which provides that each equity owner of a §3(c)(1) fund will be considered a client of the fund’s advisor for purposes of determining qualified client status. In contrast, this “look through” provision is not applicable to private funds relying on §3(c)(7) of the Investment Company Act.

The effective date of the increase of the net worth threshold is Monday, August 15, 2016.

The new net worth threshold will not be retroactively applied to advisory contracts entered into prior to the effective date. However, sponsors of §3(c)(1) funds should be aware of a couple of important implications.  First, prospective investor net worth representations in subscription agreements for any §3(c)(1) funds with closings on or after the effective date should reflect the updated threshold.  Second, documents used in effectuating secondary transfers of ownership interests in existing §3(c)(1) funds should also contain representations to reflect the revised net worth requirements.

[1] Because the indexing adjustment required to be made to the current $1 million assets under management threshold is smaller than the rounding amount specified under Rule 205-3(e) of the Advisers Act, the SEC is not adopting a change to the $1 million assets under management threshold at this time.

[2] While a natural person’s primary residence must not be included as an asset, 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, may be excluded as a liability (subject to limitations in the case of recently acquired debt).  Additionally, indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the residence must also be included as a liability.

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Photo of Christopher Wells Christopher Wells

Chris heads Proskauer’s Hedge Fund Group and has been a leading lawyer in the hedge fund industry for more than 30 years. During that time, he has assisted on hundreds of hedge fund launches, counselling and assisting hedge fund managers as they grew…

Chris heads Proskauer’s Hedge Fund Group and has been a leading lawyer in the hedge fund industry for more than 30 years. During that time, he has assisted on hundreds of hedge fund launches, counselling and assisting hedge fund managers as they grew from often very modest beginnings to become some of the world’s largest and best known hedge funds.

He advises fund managers and investors on all aspects of the hedge fund business, including fund structuring and formation, seed investments, asset manager M&A transactions, agreements among principals, employment and compensation issues, and regulatory and enforcement matters.

Chris’s long and deep experience in the hedge fund industry gives him a unique ability to counsel clients dealing with some of the most challenging situations that fund managers can encounter, including complex fund restructurings, evolving hedge fund investment terms, hybrid and alternative fund structures, liquidity challenges and constraints, internal disputes, and complex enforcement matters.

Photo of Howard J. Beber Howard J. Beber

Howard J. Beber is a partner in the Corporate Department and co-head of the Private Funds Group, which is recognized by Chambers GlobalChambers USA and US Legal 500. His practice focuses on representing private equity funds and institutional investors on…

Howard J. Beber is a partner in the Corporate Department and co-head of the Private Funds Group, which is recognized by Chambers GlobalChambers USA and US Legal 500. His practice focuses on representing private equity funds and institutional investors on a broad range of issues including fund formations, secondary transactions and portfolio investments.

Howard is actively involved in all stages of fund formation and fund sponsor representation, counseling on terms and marketing strategy, preparing offering documents, negotiating with placement agents, drafting partnership and general partner documents, negotiating with investors and providing advice on internal general partner and management company issues. His clients range from newly formed firms to a number of leading firms in the private equity industry. In addition, he routinely represents some of the most active institutional and fund-of-fund investors when investing in venture capital, buyout, real estate and other private investment funds, as well as co-investment transactions. Howard also represents institutional investors in connection with the acquisition and sale of partnership interests on the secondary market and has worked with several management teams on large spin-out transactions.

Photo of Michael Suppappola Michael Suppappola

Mike Suppappola is a partner in the Private Funds Group who specializes in representing asset managers across the globe in all aspects of their business and operations, with a particular focus on fund formation and the structuring and execution of secondary transactions. Mike…

Mike Suppappola is a partner in the Private Funds Group who specializes in representing asset managers across the globe in all aspects of their business and operations, with a particular focus on fund formation and the structuring and execution of secondary transactions. Mike also counsels clients on co-investments, portfolio investments and day-to-day operational and regulatory matters.

He advises a broad spectrum of fund sponsors who pursue a variety of strategies and sectors across North America, Europe and Asia, including buyout, private credit, secondaries, distressed and special situations, growth equity, venture capital, real estate and funds-of-funds. After the fundraising period, Mike continues to serve as a trusted adviser throughout the lifespan of a fund, with a focus on general partner and management company internal governance and day-to-day operational issues.

Mike is widely recognized in the private funds industry for his extensive experience in representing secondary fund managers in connection with all aspects of their business, including fund formation, secondary transactions (including GP-led liquidity processes, private tender offers, tail-end sales and preferred equity transactions), primary investments and co-investments. He also provides ongoing advice to private fund managers and other investment advisers on legal and regulatory compliance with federal and state securities laws, with particular expertise on the Investment Advisers Act of 1940.

An active member of the private funds community, Mike is frequently invited to lecture at industry events on business and regulatory topics. He is recognized as a top practitioner in ChambersLegal 500IFLR 1000 and Lawdragon Insights: Private Funds, where clients praise him as “extremely well respected,” “thorough and [with] a good sense for what’s important,” and commend his ability to “’get to the bottom line very quickly.” Mike has been published or quoted in numerous industry publications and treatises, including Private Equity International Modern Fundraiser, U.S. Private Equity Fund Compliance Companion, Private Equity International, Secondaries Investor, Private Funds Management, PE Manager, Compliance Intelligence and Regulatory Register.