Qualified client

A qualified client is an investor who meets specific wealth requirements under Investment Advisers Act Investment Advisers Act of 1940 The Investment Advisers Act of 1940 is the primary U.S. legislation regulating investment advisers, including hedge fund managers, establishing registration requirements, fiduciary duties, disclosure obligations, and compliance standards for advisers meeting certain thresholds. Rule 205-3SEC rule that allows registered investment advisers to charge performance-based fees to qualified clients. that allow investment advisers to charge them performance-based fees. These clients must have either $1.1 million in assets under management with the adviser or $2.2 million in net worth. The qualified client framework sets higher wealth requirements than standard accredited investor Accredited investor An accredited investor refers to an individual or entity that meets specific financial thresholds set by securities regulations, qualifying them to invest in unregistered securities offerings such as hedge funds, with standards including minimum income or net worth requirements. thresholds because performance-based compensation creates potential conflicts of interest that require additional investor protection.

Investment advisers registered with the SEC generally cannot charge performance-based fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. under Section 205(a)Section of the Investment Advisers Act that generally prohibits performance-based compensation arrangements. of the Investment Advisers Act. Congress created this restriction because it worried that performance fee Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. structures might encourage advisers to take excessive risks with client money. The qualified client exemption in Rule 205-3 provides a carefully designed exception that allows sophisticated investors to access performance fee arrangements while still maintaining important investor protections.

This regulatory approach assumes that investors who meet the qualified client wealth thresholds have enough financial resources and sophistication to understand and handle the risks that come with performance-based compensation. The tiered system reflects a graduated approach to protecting investors based on their wealth and assumed financial knowledge.

Rule 205-3 provides several ways to achieve qualified client status. The two main tests are having at least $1.1 million under management with the investment adviser or having a net worth that exceeds $2.2 million. Additional categories include qualified purchasers Qualified purchaser Qualified purchasers are investors who meet specific wealth thresholds under the Investment Company Act of 1940. These investors are required for participation in Section 3(c)(7) funds. Generally, individuals must own at least $5 million in investments, while institutions must own at least $25 million in investments. under Investment Company Act definitions and certain employees or executives of the investment adviser who participate in investment activities.

When calculating net worth, the value of the investor's primary residence and any debt secured by that residence are excluded. This approach matches how accredited investor status is determined under Securities Act regulations. This consistent approach ensures harmony across federal securities law investor qualification standards, while keeping the qualified client threshold higher than basic accredited investor status.

The Dodd-Frank Act Dodd-Frank Act The Dodd-Frank Act (Dodd-Frank Wall Street Reform and Consumer Protection Act) is comprehensive U.S. financial regulatory legislation enacted in 2010 that significantly impacted hedge funds through registration requirements, reporting obligations, trading restrictions, and enhanced compliance standards. required that qualified client thresholds be adjusted periodically based on the Personal Consumption Expenditures Chain-Type Price IndexAn inflation measure used by the Federal Reserve and federal agencies to adjust regulatory thresholds and economic data for price changes.. The SEC must review and adjust these thresholds approximately every five years, rounding to the nearest $100,000. The most recent adjustment took effect on August 16, 2021, raising thresholds from the previous levels of $1.0 million and $2.1 million respectively.

This systematic adjustment process ensures that qualified client standards maintain their intended restrictiveness over time. Without these adjustments, inflation would gradually expand access to performance fee arrangements beyond the investor population that regulators originally intended to include. The next scheduled review is expected around 2026.

The qualified client standard serves as a middle-tier sophistication requirementAn investor qualification standard that falls between basic accredited investor status and the highest qualified purchaser thresholds. within the broader regulatory framework. While accredited investors can participate in most private fund offerings, only qualified clients can participate in performance fee arrangements with registered investment advisers Registered investment adviser (RIA) A registered investment adviser (RIA) is a hedge fund manager or other investment adviser that has registered with the SEC or state securities regulators. These advisers must follow comprehensive rules including fiduciary duties, compliance requirements, and regular examinations. . Qualified purchasers represent an even higher threshold that is required for certain Investment Company Act Investment Company Act of 1940 The Investment Company Act of 1940 is a U.S. law that regulates companies whose main business involves investing in securities. Hedge funds typically use special exemptions under Sections 3(c)(1) or 3(c)(7) to avoid having to register under this law, which allows them to maintain the flexibility they need for their investment strategies and fee structures. exemptions.

This tiered structure reflects regulatory recognition that different investment arrangements carry varying levels of risk. Performance fee structures create unique risk profiles that warrant higher investor qualification standardsFinancial and sophistication requirements that determine which investments and fee arrangements investors may access under securities laws. than those required for basic private placementA securities offering that is exempt from public registration requirements and typically limited to accredited or sophisticated investors. participation.

Investment advisers must establish strong procedures for verifying and documenting qualified client status when contracts are signed. This ongoing compliance obligation requires advisers to maintain proper records and implement systems for tracking investor qualification status across their entire client base.

For domestic funds that rely on Investment Company Act Section 3(c)(1) exemptions, advisers must evaluate each underlying investor's qualified client status when charging performance fees. This look-through requirementA regulatory approach that evaluates the characteristics of underlying investors rather than treating the fund entity itself as the relevant party for compliance purposes. creates additional compliance complexity for multi-investor fund structures compared to Section 3(c)(7) funds, which are treated as single clients for qualified client analysis.

Transition rulesRegulatory provisions that specify how existing arrangements are treated when new rules take effect, often providing grandfathering protections. protect existing contractual relationships that were entered into under previous threshold levels. However, new investors or additional commitments from existing investors must meet current standards. This grandfathering approachA regulatory or contractual mechanism that allows existing arrangements to continue under previous rules when new requirements are implemented. balances the need for current regulatory standards with contractual stability for established adviser-client relationships.