On August 16, 2021, the financial thresholds specified in the definition of “qualified client” under Rule 205‑3 of the Investment Advisers Act of 1940 (“Advisers Act”) will increase (i) from $1 million to $1.1 million (assets under management test), and (ii) from $2.1 million to $2.2 million (net worth test). Contracts entered into prior to August 16, 2021 will be “grandfathered” in and will not be subject to the adjusted dollar amounts, unless a client who was not a party to such contract becomes a party following this effective date. Investment advisers and fund managers should consider whether their agreements must be updated to reflect the new thresholds.
Section 205(a)(1) of the Advisers Act generally prohibits investment advisory contracts that provide for compensation to an investment adviser that is based on a share of capital gains on, or capital appreciation of, the funds of a client. However, Rule 205-3 of the Advisers Act provides a limited exemption from this prohibition and permits investment advisers to receive performance-based compensation (e.g., performance allocations and carried interest) from “qualified clients.” Under Texas law, any private hedge fund that (i) is managed by an exempt reporting adviser filed with the Texas State Securities Board and (ii) is relying on Section 3(c)(1) of the Investment Company Act of 1940, as amended, may only have investors that are “qualified clients.”
The Dodd‐Frank Wall Street Reform and Consumer Protection Act amended Section 205 of the Advisers Act and requires that the Securities and Exchange Commission to adjust these financial threshold amounts every five years beginning July 21, 2011 for inflation based on the Personal Consumption Expenditures Chain‐Type Price Index published by the United States Department of Commerce. After the August 16, 2021 increase in the financial threshold, an investment adviser will only be able to received performance‐based fees when: (i) the client has at least $1,100,000 in assets under management with the adviser immediately after entering into the advisory contract; or (ii) immediately prior to entering into the contract, the adviser reasonably believes that the client has a net worth of $2,200,000 or more.