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The SEC Increases the Net Worth Requirement of the Definition of “Qualified Client” Impacting Both Registered and Some Unregistered Private Fund Managers

Private fund managers who are registered with the SEC are required to follow federal regulations on performance compensation.  Generally, if a registered fund manager desires to collect fees based on fund performance (such at the typical 20% carried interest), then each investor in the fund must be a “qualified client.”  Prior to the passage of the Dodd-Frank Act, a qualified client was defined as either (i) an individual or company that immediately after investing into the fund has at least $ 750,000 under the management of the fund manager or (ii) an individual or company that has a new worth of $1.5 Million or more or qualifies as a “qualified purchaser.”[1]  The Dodd-Frank Act required that the SEC update these two thresholds for inflation, which it did, effective September 19, 2011.  It updated the thresholds to $1 Million and $2 Million respectively.

Now, the SEC has issued an additional order further increasing the net worth threshold to $2 Million excluding the value of the investors primary residence, similar to the change that was made last year to the net worth threshold component of the definition of “accredited investor.”  Like the exclusion from net worth of a primary residence in the accredited investor definition, the exclusion from the net worth threshold of the qualified client definition has a number of wrinkles:

  • If the primary residence is encumbered by any mortgage indebtedness, then the investor can exclude that mortgage indebtedness as a liability up to the estimated fair market value of the home.  If the home is “underwater” and the indebtedness exceeds the value of the home, then the investor must count the excess as a liability.
  • If the mortgage indebtedness on an investor’s home increased within the 60 days prior to the investor’s execution of the subscription agreement, then the amount by which the indebtedness increased must be counted as debt.  Essentially, this prevents a potential investor from taking out a line of credit on their home right before investing and artificially increasing their net worth for the purposes of this regulation.

This change may have a significant effect on what investors a fund manager can accept if the fund manager is a registered investment adviser.  In addition, while on paper, this change does not affect fund managers that are not registered with the SEC, many states’ securities regulators are requiring, as a condition to being exempt with own their states’ registration requirements, that a fund manager only accept qualified clients.  So these regulations have the ability to affect unregistered fund managers as well.  They will come into effect 90 days after their publication in the Federal Register.

Footnote

[1] A “qualified purchaser” is defined roughly as a person with at least $5 Million in investment assets or a company with at least $25 Million in investment assets.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

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