The public comment periods will remain open for 60 days after the date of publication of the proposing releases and the notices in the Federal Register.

Expanding Investor Eligibility for Advisory Arrangements with Performance-Based Compensation

Today, SEC-registered investment advisers generally are not permitted to receive compensation based on a share of capital gains or appreciation from clients other than “qualified clients”, as that term is defined under Advisers Act Rule 205-3, subject to certain statutory exceptions and exemptions.

Currently, the Rule 205-3 net worth and AUM tests for natural persons or companies require at least $2.7 million in net worth or $1.4 million in assets under management with the adviser.¹

“Qualified Client” Status Expanded to Accredited Investors

The SEC’s proposal would amend Rule 205-3’s definition of “qualified client” to include investors that satisfy the “accredited investor” definition under Regulation D. The current “qualified client” net worth and AUM tests would be eliminated.

The SEC notes that the proposed change would harmonize the regulatory framework governing access to private funds by enabling advisers to funds that already limit their investors to accredited investors (e.g., Section 3(c)(1) private funds that rely on Regulation D) to enter into performance fee arrangements without needing to additionally limit investor eligibility by applying a separate qualified client screening standard.

The changes generally would not apply retroactively to existing contracts, but new investors joining existing funds would be tested under the rules in effect when they become parties to the contract. The SEC also asks whether the proposal could increase sponsors’ use of Rule 506(c) under Regulation D.

3(c)(1) fund look-through. Today, Rule 205-3’s “look-through” provision provides that, in the case of a Section 3(c)(1) private investment company or a regulated fund, each equity owner thereof (except for the investment adviser and any other equity owners not charged a fee on the basis of a share of capital gains or capital appreciation) is considered a “client” of the adviser for purposes of Rule 205-3. The SEC proposes to make technical changes to Rule 205-3’s look-through provisions for Section 3(c)(1) funds to clarify that the fund is the client, not the equity owners; however, the substance of the look-through for Rule 205-3 purposes would be the same. Under the new provisions, a Section 3(c)(1) private investment company or regulated fund would be a qualified client if each equity owner thereof, other than an equity owner with respect to which a performance fee is not provided for, meets the definition of a qualified client. The SEC notes that the revised language is intended to reflect that, in the case of a fund client, an adviser’s “client” under the Advisers Act and the rules thereunder is the fund itself rather than the equity owners of the fund.

Advisers may consider Section 3(c)(1) structures in additional contexts, although the SEC acknowledges that the 100-owner limit under Section 3(c)(1) may limit the proposal’s effect because sponsors may prefer larger capital commitments and may maintain investment minimums. The change may be most relevant for emerging managers and in the structuring of private wealth feeder vehicles.

Performance Fees for Certain Regulated Funds

Additionally, the SEC’s proposal would amend the qualified client definition to expand the ability of investment advisers to regulated funds to enter into investment advisory contracts with performance-based compensation arrangements, provided certain conditions are satisfied:

• the performance-based compensation does not exceed 20% of the fund’s net gains over a specified period;
• the fund satisfies the fund governance standards set forth in Rule 0-1(a)(7); and
• the fund’s board, including a majority of independent directors, determines that the arrangement is in the best interest of the fund and its shareholders and makes specific findings regarding its appropriateness, structure, and investor protection features.

“Regulated funds” would mean management investment companies registered under the Investment Company Act and business development companies under Section 202(a)(22) of the Advisers Act.

Expanding the Accredited Investor Definition to Include People with Certain Credentials

In addition to the proposed rules, the SEC also issued several requests for comment concerning expansion of accredited investor status. Since 2020, Rule 501(a)(10) of Regulation D under the Securities Act has permitted the SEC to designate professional credentials by order, and holders of the Series 7, 65, and 82 licenses in good standing currently qualify.

The SEC’s requests for comment consider designating holders in good standing of the CFA charter, the CFP certification, a U.S. CPA license, and the Series 79 or Series 86 and 87 licenses, as well as individuals who pass a new FINRA-developed accredited investor exam (valid for ten years), as additional persons who will qualify as accredited investors.

Interval Funds

The SEC also proposed amendments to Rule 23c-3 under the Investment Company Act to permit interval funds certain additional flexibility, such as to defer their first repurchase offer for up to two years after registration effectiveness or the shareholder vote first adopting its interval policy, whichever is later. Interval funds are registered closed-end investment companies and BDCs that make repurchase offers to shareholders at net asset value at periodic intervals pursuant to a fundamental policy. The SEC notes that the amendments would provide interval funds more time to build its portfolio. The proposed amendments would also allow more flexibility for repurchases and multiple share classes.

The SEC Chair stated that the proposed rulemaking is designed to facilitate use of the interval fund structure more broadly, which may allow for the broader adoption of the interval fund structure by fund managers seeking to offer retail investors exposure to private markets.

Key Takeaways for Advisers and Sponsors

If you have questions about these proposals and their potential impact on your fund structures, fee arrangements, investor eligibility, or compliance programs, please contact any of the authors listed below or your regular King & Spalding advisor.