Beyond Qualified Clients: Are Performance Fees Coming to a Registered Fund Near You?

SEC Previews New Rule Proposal

As part of its regular “regulatory flexibility” agenda under the Regulatory Flexibility Act, the U.S. Securities and Exchange Commission (SEC) is required to release its latest list¹ of rules that it may consider in upcoming months. The current list includes an agenda item² stating that the SEC’s Division of Investment Management is

considering recommending that the Commission propose amendments to existing rules and/or propose new rules under the Investment Advisers Act of 1940 and the Investment Company Act of 1940 to better facilitate retail investor exposure to private markets through registered investment companies and to allow investment advisers to charge performance fees to an expanded set of clients.

The title of the item is “Enhancing Retail Exposure to Private Markets,” and its “Statement of Need” elaborates on the abstract: 

Facilitating retail investor exposure to private markets through registered funds and modernizing the performance fee framework would provide needed investment opportunities for retail investors seeking to diversify their investment allocation in line with their investment time horizon and risk tolerance and open more opportunities for retail investors.

Currently, under Advisers Act Rule 205-3, investment advisers are generally prohibited from charging registered investment funds performance-based fees on capital gains unless all investors in the fund are “qualified clients” as defined in the same rule.³ While the content of any rule amendments the SEC may propose is uncertain, it appears the SEC may alter this requirement in some way with respect to advisers charging performance fees to registered funds. 

Priority of Rulemaking

In his statement accompanying the SEC’s release of its regulatory flexibility agenda,⁴ SEC Chair Paul Atkins included the following: “Exposure to the full dynamism of our markets – both public and private – should not be reserved for wealthy insiders. Our agenda includes a proposal to better facilitate retail investor participation in private markets while preserving their protection with appropriate safeguards.” While the statement did not specify details as to the content of any proposed rule amendments, the fact that Chair Atkins included that item in his public statement indicates that the item likely is a high priority for the SEC and that proposals are likely to be issued sooner rather than later.

The Registered Fund Market Impact Could Be Substantial

While there has been substantial growth in the number of registered funds offering access to private markets in recent years, the limit on charging performance fees to such funds whose investors are not all “qualified clients” has been a disincentive for many private fund managers who have considered offering registered funds. If the SEC does propose and adopt rules allowing greater flexibility in charging performance fees to registered funds, we expect many private fund managers would be more willing to offer registered funds with private market exposure. This could be the factor that changes the minds of many managers as to whether offering registered funds is commercially worthwhile.

Additionally, there could be other secondary effects in the registered fund market depending on the details of the proposed and eventually enacted rules. The SEC will also need to consider the impact on existing registered funds that are not charging performance fees because their investors are not limited to “qualified clients” but might be eligible to do so if such rule proposals are enacted. For example:

• Under Section 15(a) of the ICA, as amended, registered funds generally are not permitted to amend their investment advisory agreements to change the fees described in the contract without shareholder approval. Will the proposed rules offer any relief from this shareholder approval requirement to allow existing funds that meet the rules’ eventual criteria to begin charging performance fees without a shareholder vote?
• If not, and if such funds choose to forego the time and expense of obtaining shareholder approval that would be necessary to begin charging a performance fee, will the eventual rules put such existing funds at a competitive advantage in the marketplace if they offer similar exposures to private markets without charging a performance fee?

We are watching these developments closely and would be glad to discuss these issues with you at your convenience.