Legal Insights
For fund managers, general partners, and sponsors operating private investment vehicles, understanding the regulatory framework governing performance-based compensation is essential. Performance-based fees, compensation structures that align your incentives with investor returns, are a cornerstone of the private fund business model. However, these fee arrangements are heavily regulated under federal securities laws, and failing to comply with the applicable rules can expose your fund to significant legal and regulatory risk.
What Is an Investment Adviser?
Before examining the rules governing performance fees, it is essential to understand what constitutes an investment adviser under federal law. Under the Investment Advisers Act of 1940, an investment adviser is any person or entity that, for compensation, engages in the business of advising others as to the value of securities or as to the advisability of investing in, purchasing, or selling securities. This broad definition encompasses most private fund managers who receive fees for managing client assets, including hedge fund managers, private equity sponsors, and venture capital fund general partners.
What Are Private Funds?
Private funds are pooled investment vehicles that are not registered with the Securities and Exchange Commission (SEC) as investment companies. These include hedge funds, private equity funds, venture capital funds, and similar structures. Because they operate outside the traditional mutual fund regulatory regime, private funds offer you greater flexibility in investment strategies, leverage, and fee structures. However, this flexibility comes with eligibility restrictions.
One of the most commonly used exemptions is Section 3(c)(1) of the Investment Company Act, which allows a fund to avoid registration as an investment company if it has 100 or fewer beneficial owners and does not make a public offering. Importantly, Section 3(c)(1) funds may accept “accredited investors,” a standard that requires, for individuals, annual income of $200,000 (or $300,000 jointly with a spouse) or a net worth exceeding $1 million (excluding the primary residence). While this threshold allows many high-net-worth individuals to invest in private funds, it is a lower bar than the qualified client standard discussed below, creating a critical compliance gap that fund managers must navigate carefully.
Alternatively, private funds may rely on Section 3(c)(7) of the Investment Company Act, which provides an alternative path for private funds to avoid registration as investment companies. Unlike Section 3(c)(1), which limits a fund to 100 beneficial owners, Section 3(c)(7) permits an unlimited number of investors so long as every investor (other than certain “knowledgeable employees”) is a qualified purchaser and the fund does not make a public offering. This structure is widely used by larger hedge, private equity, credit, real estate, and venture funds seeking to accommodate more than 100 investors and to raise capital from highly sophisticated institutions and individuals. Although Section 3(c)(7) eliminates the 100‑investor cap, it still requires a private offering. Most funds raise capital under Regulation D. If a fund uses Rule 506(c), it must take reasonable steps to verify accredited investor status under Regulation D; for a 3(c)(7) fund, the sponsor must also substantiate each investor’s qualified purchaser status to satisfy the Investment Company Act.
What Are Performance-Based Fees?
Performance-based fees, often referred to as incentive fees or carried interest, are compensation arrangements under which an investment adviser receives a fee based on the capital gains or overall appreciation of a client’s assets. The classic example is the “2 and 20” model common in hedge funds, where you charge a 2 percent management fee plus 20 percent of any profits. Unlike flat asset-based fees, performance-based fees reward you for generating positive returns, aligning your interests with those of your investors.
While this alignment can be beneficial, regulators have long been concerned that it also creates potential conflicts of interest. A manager compensated based on performance may be incentivized to take on excessive risk or favor accounts with performance-based arrangements over those without. These concerns led Congress to impose restrictions on when investment advisers may charge such fees, and understanding these restrictions is critical to structuring your fund appropriately.
The Investment Advisers Act and the General Prohibition
The Investment Advisers Act of 1940 is the primary federal statute governing the conduct of investment advisers in the United States. Section 205(a)(1) of the Act contains a general prohibition against performance-based compensation arrangements. Congress enacted this restriction out of concern that profit sharing arrangements could encourage speculative and imprudent investment decisions that might harm clients.
A critical point for fund managers to understand is that Section 205(a)(1) applies to investment advisers who are registered with the SEC or who are required to register with the SEC. If you operate under an exemption from registration, such as the private fund adviser exemption for managers with less than $150 million in assets under management, Section 205(a)(1) does not apply to advisory contracts entered into while you were exempt and not registered. However, if you later become required to register (for example, because your assets under management exceed the exemption threshold), the prohibition will apply to new investors who become parties to your fund after that point.
Recognizing that certain sophisticated investors do not require the same level of protection as retail clients, the SEC has carved out exceptions to this general prohibition for registered advisers. The most important of these exceptions is found in Rule 205-3 under the Investment Advisers Act.
Rule 205-3 and the Qualified Client Requirement
Rule 205-3 permits registered investment advisers to charge performance-based fees, but only to “qualified clients.” This requirement ensures that only investors with sufficient financial sophistication and resources are subject to these arrangements.
Under the current rule, an individual qualifies as a qualified client if they meet one of the following criteria. First, they have at least $1.1 million in assets under management with the adviser immediately after entering into the advisory contract. Second, the adviser reasonably believes, immediately prior to entering into the contract, that the client has a net worth of more than $2.2 million. For purposes of this net worth calculation, the value of the client’s primary residence is excluded. Certain individuals, such as executive officers, directors, or general partners of the investment adviser, may also qualify regardless of their financial status.
These thresholds are adjusted periodically by the SEC to account for inflation, so you must ensure you are applying the current figures when determining investor eligibility.
The Critical Gap: Accredited Investors vs. Qualified Clients
This is where careful attention to detail becomes essential for fund managers and sponsors. If you operate a Section 3(c)(1) fund, you may accept accredited investors who meet a relatively modest financial threshold. However, if you are a registered investment adviser (or are required to register), you cannot charge those same investors performance-based fees unless they also meet the higher qualified client standard.
In practice, this means that an accredited investor with a net worth of $1.5 million may lawfully invest in your Section 3(c)(1) fund, but you cannot charge that investor a performance-based fee because they fall below the $2.2 million net worth threshold for qualified client status. This regulatory mismatch requires you to implement careful screening procedures and, in some cases, to offer different fee structures to investors based on their qualification status, or to limit fund participation to only those investors who meet both standards.
Practical Implications and Compliance Considerations
Compliance with Rule 205-3 is not optional for registered advisers and those required to register. Charging performance-based fees to investors who do not meet the qualified client standard can result in SEC enforcement actions, rescission of fees collected, reputational harm, and potential civil liability. As a fund manager or sponsor, you must implement robust procedures to verify investor eligibility at the time of investment and maintain appropriate documentation demonstrating that each investor satisfied the applicable threshold.
From a practical standpoint, this means building qualified client verification into your subscription process. Investor questionnaires should be designed to capture the necessary financial information, and your compliance team should review this data before accepting capital commitments. You should also be aware that the qualified client standard applies at the time of contract execution, so subsequent changes in an investor’s financial status do not retroactively disqualify them.
As competition for capital continues to intensify, a thorough understanding of the performance fee regulatory landscape will help you structure compliant funds, avoid costly mistakes, and build lasting relationships with sophisticated investors who expect rigorous adherence to applicable rules.
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This DarrowEverett Insight should not be construed as legal advice or a legal opinion. This Insight is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. Please reach out to us if you need help addressing any of the issues discussed in this Insight, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.
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