Understanding What Investor Standard Your Fund Will Require
We ask hedge fund managers five main questions to determine who can invest in their fund. Many prospective fund managers mistakenly believe that the “accredited investor” standard is the only required investor accreditation standard for their investors.
Understanding Your Fund's Investor Standard
The accredited investor standard is typically based on financial threshold, which, for individuals, must have a $1 million individual or joint net worth (excluding the primary residence), or $200k annual income ($300k with a spouse), for the previous two years, with the expectation to meet or exceed this standard for the current year. However, with the recently updated expansion to the accredited investor definition, an individual may qualify as this investor standard, regardless of net worth, dependent upon meeting other specific requirements. Read our article discussing these updates here.
The accredited investor standard applies to a minority of hedge funds, such as small New York-based funds, and certain real estate funds. Yet, for most startup hedge funds, a higher standard applies. Notably, these higher standards do not allow investors to qualify through yearly income, which can be problematic for emerging managers when raising capital. Read more about marketing an investment fund for emerging managers here.
Depending on the nature of the fund’s portfolio assets, the size of the assets under management (AUM), the fund managers’ home state, and other factors, the accreditation standard could be one of the following:
(i) $2.2 million net worth (“qualified clients”);
(ii) $5 million net investments (“qualified purchasers”); or
(iii) Qualified eligible persons (“QEPs”). The QEP standard is for those funds that are regulated by the Commodity Exchange Act (“CEA”), which includes funds that invest in commodities, futures, and foreign exchange assets. QEPs must meet a set of conditions described by the CEA. The QEP standard is divided into two groups; investors that do not need to meet the portfolio requirement and those that must meet the portfolio requirement.
Investors that do not need to meet the QEP portfolio requirement include, but are not limited to, those who would be deemed knowledgeable employees, qualified clients, qualified purchasers, and Non-United States persons.
Investors required to meet the portfolio requirement must own at least $2 million in securities and other investments with an aggregate market value of at least $2 million. Additionally, they must have at least $200,000 in initial margin and option premiums for commodity interest transactions on deposit with a futures commission merchant (“FCM”) in an account under the investor’s name at any time during the preceding six months or some combination of both.
Determining Your Fund's Investor Standard
To determine which minimum investor wealth standard applies to your fund, we would ask you the following five questions:
(i) What Instruments are You Trading
The investor standard will depend on the asset class, such as securities, real estate, commodities futures, trades, swaps, or currencies. This article looks only at the securities side. For funds investing in futures, currencies, real estate, cryptocurrencies, and other assets, the analysis would be different.
(ii) Is a 99-Investor Limit Acceptable?
Most startup funds rely on the 3(c)(1) exemption from the Investment Company Act. This exemption limits a fund to 99 investors but does not elevate the investor accreditation standard. More substantial, institutional level funds rely on the 3(c)(7) exemption. This exemption allows an unlimited number of investors per fund (technically unlimited, but typically kept at 2,000 or below to avoid having to disclose its financials to the public). 3(c)(7) funds can only have “qualified purchasers” or $5 million in net investments for individuals ($25 million for entities).
(iii) Will the Fund Charge Performance Compensation?
Most funds charge an incentive allocation (usually 20% of net asset value appreciation). Fund managers required to register as an investment adviser, or in some jurisdictions as an exempt reporting adviser, are typically allowed to only charge performance compensation from investors that are “qualified clients”, with some limited exceptions. The qualified client standard requires individuals to have a net worth (either individually or jointly with spouse) of $2.2 million, regardless of income. The most crucial factor here is whether a fund manager is required to register as an investment adviser or exempt reporting adviser, either at the federal or state level.
The next two questions will determine whether investment adviser or exempt reporting adviser registration is required, and therefore, whether the qualified client standard applies.
(iv) Is the Total AUM (including leverage) over $150 million?
For fund managers with AUM over $150 million, the fund manager will be subject to SEC registration as an investment advisor, requiring the $2.2 million net worth qualified client standard. Normally, the fund manager will register the management company (investment manager entity to the fund) with the SEC as the investment adviser. For fund managers with less than $150 million AUM, state law will govern.
(v) In what State Does the Fund Manager Live?
Commonly, the fund manager organizes the investment manager entity in the state where the majority of investment advisory activity occurs and place of business is located, usually where the primary fund manager resides.
Exempt Reporting Adviser Registration
Since the enactment of the JOBS Act, several states have enacted exemptions from investment adviser registration for fund managers that advise or manage solely private funds (the “Private Fund Exemption”). These states are commonly referred to as ERA States.
Generally, the fund manager must register the investment manager as an exempt reporting adviser with the state to take advantage of the Private Fund Exemption. Many ERA States require investors to be qualified clients, even if the fund is not immediately required to register as an investment adviser based on their initial AUM to take advantage of the Private Fund Exemption. Others limit the qualified client standard to those funds charging performance compensation.
States Not Yet Requiring Qualified Clients
In a shrinking minority of states, funds with less than $150 million in AUM may charge performance compensation to accredited investors, so long as the managers have no separately managed accounts or meet the state de minimis client standard.
Before deciding to start a fund, fully understand your investor base's requirements by speaking with our experienced legal counsel. Our attorneys will assist you in determining the structure, jurisdiction, and regulations required for your fund. Feel free to look at our State Regulations map here.
Capital Fund Law Group has authored numerous investment fund publications, including instructive eBooks, white papers, blog posts, and sample offering document excerpts with illustrative footnotes. These complimentary downloads are dedicated to helping fund managers understand the legal fundamentals of launching and operating an investment fund.