If you charge performance-based compensation (carried interest, incentive fees, or performance allocations), your investors may need to meet the qualified client standard. Under SEC rules, advisers generally can only charge performance-based fees to qualified clients, and the threshold is higher than accredited investor status. Understanding this requirement is critical for structuring your fund economics correctly.
Why This Matters
Section 205 of the Investment Advisers Act generally prohibits investment advisers from charging performance-based compensation. Rule 205-3 provides an exception: advisers may charge performance fees to "qualified clients." For private fund managers, this means that fund LPs must meet the qualified client standard if the adviser charges carried interest or any other form of performance-based compensation.
This rule applies to registered investment advisers. Exempt Reporting Advisers are exempt from Section 205 and Rule 205-3, so ERAs can charge performance fees to any investor regardless of qualified client status. However, state-registered advisers may face similar or even stricter restrictions under state law.
The practical consequence is significant: if you are an RIA (or become one after crossing $150 million in AUM), every investor in a carry-bearing fund must be a qualified client. Admitting a non-qualified client to such a fund creates a compliance violation.
Qualified Client Thresholds
An investor qualifies as a qualified client by meeting either of two financial tests. These thresholds are adjusted for inflation by the SEC every five years.
- Assets under management test. The investor has at least $1.1 million in assets under management with the adviser immediately after entering into the advisory contract.
- Net worth test. The investor has a net worth of at least $2.2 million at the time of entering into the advisory contract. The primary residence is excluded from the net worth calculation, consistent with the approach used for accredited investor determinations.
Qualified purchasers (investors with $5 million or more in investments) automatically qualify as qualified clients. Most institutional investors, including pension funds, endowments, and fund-of-funds, also meet the qualified client standard. The requirement is most relevant for individual investors who may be accredited but fall below the qualified client thresholds.
Interaction with Other Investor Standards
The qualified client standard is distinct from both the accredited investor standard and the qualified purchaser standard. These three classifications serve different regulatory purposes and have different thresholds:
- Accredited investor. Required for Regulation D offerings. Income test ($200,000 individual or $300,000 joint) or net worth test ($1 million excluding primary residence).
- Qualified client. Required for performance fee arrangements with RIAs. $1.1 million AUM or $2.2 million net worth.
- Qualified purchaser. Required for Section 3(c)(7) fund investments. $5 million in investments.
An investor who is accredited may not be a qualified client. This creates a potential gap for 3(c)(1) funds advised by an RIA: the fund can accept accredited investors under Regulation D, but the adviser cannot charge those investors performance-based compensation unless they also meet the qualified client standard. This gap is a common source of compliance issues when managers transition from ERA to RIA status.
State Variations
States impose their own requirements on performance-based compensation. Some states adopt the federal qualified client thresholds, while others have different or additional requirements. State-registered advisers (those with less than $100 million in AUM who register at the state level rather than with the SEC) should check the performance fee rules in each state where they are registered.
State requirements can be more restrictive than federal rules. Some states prohibit performance fees entirely for state-registered advisers, while others impose their own financial thresholds. If you operate in multiple states, you must comply with the most restrictive applicable rule.
This article is for informational purposes only and does not constitute legal advice. Consult qualified professionals for guidance specific to your situation.