Compliance Solutions for Investment Advisers

FAQs — Performance Fees

 

What is a performance fee?

Performance fees (or performance-based compensation) is compensation based on a share of capital gains on, or capital appreciation of, the funds of a client.

Is an investment adviser permitted to charge a performance fee?

Section 205(a) of the Advisers Act and Rule 205-3 under the Advisers Act generally prohibit a registered investment adviser from charging a client a performance fee. However, Rule 205-3 exempts certain investment advisers from this prohibition and allows a performance fee to be charged to “qualified clients”.

What is a qualified client?

There are two tests under Rule 205-3 that determine whether a client is a qualified client. The first test is the “assets-under-management test”, which requires that the client have at least $1,000,000 of assets under management with the investment adviser. The second test is the “net worth test” and requires the client to have a net worth of more than $2,000,000.

Does a client have to satisfy both criteria in order to be considered a qualified client?

No.  A client would need to meet only one of these two criteria to be considered a qualified client.

How is net worth calculated for purposes of determining whether someone is a qualified client?

When calculating net worth, a client must exclude the value of their primary residence, including any debt secured by the property provided that the mortgage is not greater than the current market value of the property. Under certain circumstances, including those where the debt exceeds the current market value of the property and where the debt is incurred within 60 days of the date the performance fee arrangement is entered into, all or a portion of the debt may have to be included as a liability in calculating an individual’s net worth.

What are the disclosure requirements for an investment adviser that charges a performance fee?

Item 6 of Form ADV Part 2A requires investment advisers to disclose that they charge performance-based fees. If the adviser charges both performance-based fees and other non-performance-based fees (e.g., hourly, fixed, asset-based) the adviser must disclose this fact and explain the conflicts of interest that the adviser (or their supervised persons) face by managing these accounts at the same time, including that the adviser (or their supervised persons) have an incentive to favor accounts for which they receive a performance-based fee. The adviser must also describe generally how they address these conflicts.

 

Important Information

The information contained in this Frequently Asked Questions is only a summary and is not intended to be a comprehensive analysis of the rules and regulations applicable to registered investment advisers. It is not intended to constitute legal or compliance consulting advice or apply to any one investment adviser’s particular situation. For more information, please see our Terms of Use.

line