Investor qualification is an integral component of managing an investment fund. The type and character of each investor affect, among other things, (i) whether an investor qualifies to invest, (ii) whether the fund would be required to register with the Securities and Exchange Commission (SEC), and (iii) the fee that can be charged. The terms "accredited investor," "qualified purchaser," and "qualified client" are each defined in separate statutes or regulations and are important for different reasons. This article offers a brief explanation of each term and its relevance to a manager's fund-raising efforts and its ability to collect fees from its investors.
Accredited Investor
Securities Act of 1933
Under the Securities Act of 1933 Act (the 33 Act), a company that offers or sells its securities must register such securities with the SEC, unless an exemption from registration is available. A commonly used exemption is found in Rule 506 of Regulation D under the 33 Act. To get the greatest benefit from this exemption, a company must sell its securities only to "accredited investors." "Accredited Investor" is defined in Rule 501(a) promulgated under the 33 Act (the complete definition can be found here). An individual generally qualifies as an accredited investor if (1) such person's individual net worth, or joint net worth with such person's spouse, exceeds $1,000,000, or (2) for each of the two most recent years, such person's individual income exceeds $200,000 or joint income with such person's spouse exceeds $300,000.1 Accordingly, a fund offering or selling its securities only to "Accredited Investors" would not be required to register such securities with the SEC.
Investment Company Act of 1940
Under the Investment Company Act of 1940 (the 1940 Act), Section 3(c) exempts from the definition of investment company many types of entities that would otherwise be subject to the significant regulatory requirements of the 1940 Act. Section 3(c)(1) excludes privately held investment companies from regulation under the 1940 Act if it satisfies two requirements: (1) it must not make or propose to make a public offering of its securities, and (2) it must not have more than 100 beneficial owners of its securities. Accordingly, a straightforward manner of complying with the first requirement would be to have the fund comply with Rule 506 of Regulation D by, among other items, selling only to accredited investors. To comply with the second requirement, it must not have more than 100 beneficial owners.
Qualified Purchaser
Investment Company Act of 1940
Section 3(c)(7) of the 1940 Act excludes privately held investment companies from falling within the definition of an "investment company" under the 1940 Act if: (1) it is not making or proposing to make a public offering, and (2) the company's outstanding securities are owned exclusively by "qualified purchasers." "Qualified Purchaser" is defined in Section 2(a)(51)(A) of the 1940 Act (the complete definition can be found here). An individual generally qualifies as a "qualified purchaser" if it owns not less than $5 million in investments. Accordingly, by selling securities only to qualified purchasers, the fund itself would be excluded from regulation under the 1940 Act.
Qualified Client
Investment Advisers Act of 1940
As a general proposition, Section 205(a)(1) of the Investment Advisers Act of 1940 (the Advisers Act) prohibits an adviser registered with the SEC from charging clients a performance fee. However, the Advisers Act and the rules promulgated thereunder provide certain exemptions from this restriction. Rule 205-3(a) permits an investment adviser to collection a performance fee, such as carried interest, from "qualified clients," which is defined in such rule. In 2012, the SEC changed the definition of a "qualified client" to be, among other things, one of the following: (i) an individual or a company that, after contracting with the fund, has at least $1 million under the management of the investment adviser, (ii) an individual or company that the manager reasonably believes, immediately after contracting with the fund, has a net worth greater than $2 million (jointly with a spouse if an individual), excluding the value of the individual's primary residence and any indebtedness thereto, or (iii) an individual or company that the adviser reasonably believes is a qualified purchaser (see above). A complete definition of "qualified client" can be found here.
Generally excluded from the "qualified client" requirement are (i) family offices and venture capital fund advisers, (ii) advisers with less than $100 million in assets under management, and (iii) private fund advisers with less than $150 million in assets under management.
In general, every investor in a private fund should be an accredited investor – this allows such a fund to avoid the expensive and cumbersome registration of the fund's securities under the 33 Act. If a fund exceeds 100 investors – even if accredited – it will need to either (i) register as an "investment company" under the 1940 Act or (ii) seek another exemption. In the event that a fund exceeds 100 investors, it can rely on Section 3(c)(7) of the 1940 Act to avoid regulation as an investment company, which requires that the investors in the fund not only be accredited, but also be "qualified purchasers" – in most instances, a significantly higher threshold than that of an accredited investor. To charge clients a performance fee, fund managers generally must evaluate whether such investors are "qualified clients." Fund managers, compliance professionals, and investment professionals should understand the distinctions between these types of investors. Failure to do so could trigger a costly and unnecessary registration process or prohibit a fund manager from collecting performance fees.
[1] Certain covered entities with total assets in excess of $5,000,000 – such as select employee benefit plans and entities compliant with section 501(c)(3) of the Internal Revenue Code not formed for the specific purpose of acquiring the offered securities – generally may qualify as accredited investors as well.