An SEC rule proposal that would raise the net-worth thresholds at which advisers would be allowed to charge performance-based fees would likely cut into the bottom lines of smaller hedge funds, private-equity firms and some registered investment advisers
An SEC rule proposal that would raise the net-worth thresholds at which advisers would be allowed to charge performance-based fees would likely cut into the bottom lines of smaller hedge funds, private-equity firms and some registered investment advisers.
The Securities and Exchange Commission last week proposed a rule change that would require “qualified clients” to have $1 million invested with the adviser or a total net worth of at least $2 million before the adviser could charge a performance-based fee. Currently, advisers can charge a performance fee if they manage at least $750,000 of a client's assets or if the client's net worth exceeds $1.5 million.
In the wake of the financial crisis, however, the SEC is proposing that the value of an investor's primary home be excluded from the net-worth calculation. If passed, the home value exclusion would likely keep many wealthy — but not fabulously wealthy — investors out of hedge funds or other private-investment vehicles.
Existing selling arrangements would be honored under the SEC proposal.
Even so, “these changes will have a significant impact on advisers who charge performance fees,” said Todd Cipperman, a compliance attorney. “Raising the net-worth requirement to $2 million and excluding the value of a client's personal residence will likely exclude many potential investors.”
The SEC estimates that 1.3 million households would be ineligible for performance fee arrangements if the $2 million net-worth threshold excluded the value of their primary residence.
NEW RESTRICTIONS
Hedge funds and private-equity firms would feel the greatest hit, as they live and die by performance fees.
“The proposal would make access to investments more restrictive at a time when investors are looking for more products to diversify and prosper,” said David Friedland, president of the Hedge Fund Association.
Small hedge funds — that is, those with between $100 million and $250 million in assets — probably would have the toughest time qualifying investors under the new rules. That's because they typically court the mass affluent, as opposed to “super-high-net-worth individuals,” who are more apt to have in excess of $1 million invested with an adviser, he said.
“The mass affluent are investors who need capital growth and capital preservation for their asset base. They need hedge funds the most,” said Mr. Friedland, who is also president of Magnum US Investments Inc., a fund of hedge funds.
About 3,000 hedge funds fall into the $100 million to $250 million range, he said.
Funds with less than $100 million in assets are not required to register with the SEC. Still, investors in those funds must meet “accredited investor” standards, which require that clients have a net worth of at least $1 million, not including the value of one's primary residence, or have made $200,000 each year for the previous two years.
The Managed Funds Association, which represents large hedge funds, will review the proposal and “may file a comment letter,” said spokesman Steve Hinkson.
The agency is accepting comments on the proposal through July 11.
RIAs TAKE HIT
Hedge fund operators and private-equity firms are not the only ones that would take a hit. About 3,233 of the nation's 11,000 SEC-registered advisers charge some performance fees, according to the Investment Adviser Association.
“By taking out the value of the residence, a big pool of potential future clients will be out of the category of folks you can charge a performance fee to,” said Patrick J. Burns Jr., a compliance consultant. “The client doesn't usually mind paying a little more if they are making money.”
Mr. Burns estimates that up to 15% of his RIA clients charge performance fees.
The rule proposal, some of which was mandated by the Dodd-Frank financial reform law, is the latest twist in the SEC's efforts to extend more protections to investors. The net-worth thresholds have not been adjusted for inflation since 1998. In fact, they have been adjusted only two other times since advisers were first allowed to charge performance-based fees in 1970.
The proposal says that under Dodd-Frank, the SEC is not required to adjust the net-worth calculation used in this rule, even though it was required to take out residence values for those considered “accredited investors” in other rules.
However, the change to this rule was proposed because a person's residence value probably has little to do with his or her “ability to bear the risks of performance fee arrangements” and thus has “little relevance” to his or her need to be protected from such arrangements, the proposal said.
E-mail Liz Skinner at lskinner@investmentnews.com.
