The SEC proposed a new rulemaking on May 10, mandated under Dodd-Frank Section 418, that would increase the dollar amount thresholds for investment advisors to charge performance fees to $1 million in AUM and $2 million in net worth. Comments are due to the Commission by June 20. Those thresholds are what makes a prospective investor a qualified investor for many private investment vehicles.
A separate rulemaking by the SEC under Dodd-Frank would similarly change the threshold for 'accredited' investors.
Section 418 of Dodd-Frank Act requires the SEC to amend Rule 205-3 of the Investment Advisers Act to adjust for inflation the dollar amount thresholds by July 21, 2011, and every five years thereafter, that need to be met before advisors can charge clients performance fees. Such fees are usually set for private investment vehicles such as hedge funds, private equity funds and other non-public investments. Under Rule 205-3 of the ’40 Act, those thresholds were set at $750,000 in assets under management with the advisor, and that the advisor “reasonably believes” that its advisory client has net worth of more than $1.5 million.
Other amendments proposed by the SEC to Rule 205-3 would exclude the value of a client’s primary residence from the net worth threshold; would provide the method for calculating future inflation adjustments of the dollar amount tests; and would modify the transition provisions of the rule to take into account performance fee arrangements that were permissible at the time the advisor and the client entered into their advisory contract. Comments on the proposed rule amendments are due by July 11, 2011.
David Tittsworth, executive director of the Investment Adviser Association (IAA), said in a Friday interview with AdvisorOne that the notion of a "qualified" investor had long been a proxy in U.S. securities laws that a higher-net-worth investor “equals a certain level of financial sophistication equals the ability to take higher risk” when investing.
As for which advisors these new levels would affect, Tittsworth (left) says that IAA’s research on RIAs is that while the number of advisors who charge clients a percentage of their AUM is over 11,000, or about 90% of all advisors, only slightly more than 3,000 charge performance fees, according to their Form ADVs. That number has doubled over the past 10 years that IAA has been tracking the numbers, which he suspects reflects the growth of hedge fund advisors.
Originally, said Tittsworth, Congress had prohibited, under the ’40 Act, the use of performance fees, fearing advisors would “take undue risks to gain that higher fee, but over the years it’s been chipped away.” That took place in particular in 1996 and in 1998 when the AUM and net worth thresholds “found their way into the regulations.”
The biggest impact of the proposed new rule will be on hedge funds and private equity advisors, though he points out that the proposed rule includes a “ broad grandfathering” provision so if clients of those advisors “met the test before, they will be grandfathered.”
Tittsworth is not sure whether excluding the value of a primary residence will be controversial, and he says the SEC was not required under Dodd-Frank to do so. He does believe that Dodd-Frank’s requirement that the SEC consider adjusting the thresholds every five years “makes sense,” and that the sense of Congress was that the earlier, lower limits were perhaps outdated.