Tag Archives: qualified client

Hedge Fund Comments/ Questions and Answers

Questions and discussions from Hedge Fund Law Blog readers

I get quite a few questions from readers and usually I am able to answer these questions via email within a couple of days. If you have any questions, comments or simply want more information on starting a hedge fund, please feel free to contact us. We also will take requests for blog posts on certain issues and we also will publish articles (with all appropriate recognition and links) by guest authors. [Note: any grammatical errors in the original messages have not been corrected.] Continue reading →

Non-Accredited Investors in Hedge Funds

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Many start-up hedge fund managers want to know if their friends and family can invest in the start-up hedge fund. Most of the time, such friends and family do not fall within the definition of accredited investor under the Regulation D rules. The regulation D rules allow a maximum of 35 non-accredited investors to invest in any single offering. Because a hedge fund offering is continuous, the limit of 35 non-accredited investors is cumulative. That means that over the life of the fund there can be no more than 35 non-accredited investors (as opposed to 35 non-accredited investors in the fund at any single point in time). Continue reading →

Hedge Fund Investors Overview

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The lifeblood of the hedge fund industry are hedge fund investors, those persons and institutions which put their money at risk with the hope of generating positive investment returns. While there have been recent predictions of large amounts of investor money leaving the hedge fund space due to poor performance, there are many potential hedge fund investors who are just beginning to warm to the idea of investing in a hedge fund.

Who can invest in a hedge fund?

In general there are two types of hedge funds which are open to different types of investors.

Section 3(c)(1) hedge funds are open to investors who are both accredited investors and qualified clients. An accredited investor is generally an individual with a $1 million dollar net worth (can include the equity in the investor’s primary residence) or an individual who has made $200,000 in each of the two most recent years (or joint income with that person’s spouse in excess of $300,000 in each of those years) and has a reasonable expectation of reaching the same income level in the current year. A qualified client is generally an individual with a $1.5 million dollar net worth. Because investors will need to be both an accredited investor and a qualified client, many hedge fund managers will just say that the investor needs to be a qualified client as it has the higher net worth threshold.

Section 3(c)(7) hedge funds are open to qualified purchasers, which is a higher net worth threshold than for the accredited investor or qualified client standard. A qualified purchaser is generally an individual investor with a $5 million dollar liquid net worth (cannot include the equity of the investor’s primary residence).

Occasionally you will see some Section 3(c)(1) hedge funds which allow non-accredited investors to invest in the fund. In such instances, the fund will typically charge the non-accredited investor a higher management fee because the non-accredited investor cannot be charged a performance fee. In general, hedge fund managers will not allow non-accredited investors into the hedge fund except for very close family and friends.

Why would someone invest in a hedge fund?

Hedge funds have historically been viewed as nimble investment vehicles run by savvy managers who are able to produce steady and absolute returns. Hedge funds come in a variety of different sizes (from the one-man shops to the multi-billion dollar operations) and strategies. The great diversity of funds and their investment objectives is what makes them exciting, but which also makes it difficult to describe them as a whole. Suffice it to say that whatever investment strategy an investor is looking for, there is a hedge fund which would be able to meet the needs of that investor.

Who can recommend hedge fund investments?

Hedge fund investments are made through private placements according to the Regulation D offering rules. This means that only the hedge fund manager and certain hedge fund brokers can offer an investor interests in a hedge fund, and that is only if the manager or the broker has a pre-existing relationship with the investor. There are some ways which investors can gain access to hedge funds, most notably through hedge fund databases.

What should an investor do before investing in a hedge fund?

At a minimum an investor should carefully read the hedge fund’s offering documents. An investor should also discuss any questions or concerns with the hedge fund manager. Additionally, I always recommend that investors conduct some sort of due diligence on the hedge fund and the manager.

HFLB note: we are not recommending that readers invest in hedge funds and we are not recommending any specific hedge funds. If an investor makes an investment into a hedge fund, any such investments should be made only after consultation with such investor’s legal and accounting advisors.

Other articles you may be interested in:

Hedge Fund Service Providers
Hedge Fund Due Diligence

Section 3(c)(1) Hedge Funds

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Almost all hedge funds which trade securities are deemed to be “investment companies” under the Investment Company Act of 1940. All “investment companies” are required to register under the Investment Company Act (like all mutual funds must do) unless the “investment company” falls within an exemption from the registration provisions.

There are two separate exemptions from the registration provisions of the Investment Company Act. This post deals with the more common Section 3(c)(1) exemption which generally requires that the hedge fund have 100 or fewer investors.

Not Owned by More Than 100 Investors

A 3(c)(1) hedge fund is exempt under the Investment Company Act provided that the fund is beneficially owned by not more than 100 investors and is not making a public offering of its securities. The actual text of Section 3(c)(1) provides:

None of the following persons is an investment company within the meaning of this title: Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer. For purposes of this paragraph:

(A) Beneficial ownership by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 per centum or more of the outstanding voting securities of the issuer, and is or, but for the exception provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of such company’s outstanding securities (other than short-term paper).

(B) Beneficial ownership by any person who acquires securities or interests in securities of an issuer described in the first sentence of this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or other involuntary event.

Certain Look Through Rules

Part A above provides “look through” provisions for certain entity investors. This rule provides that if another 3(c)(1) hedge fund (the “Investor Fund”) owns more than 10% of another 3(c)(1) hedge fund (the “Investee Fund”) then the Investee Fund would count all of the investors of the Investor Fund as investors as well. This rule is designed to prevent the pyramiding of 3(c)(1) funds to avoid the application of the mutual fund registration rules. Through various no-action letters the SEC has provided further guidance in this area which we will be writing about shortly.

Types of 3(c)(1) Investors

Generally speaking investors in Section 3(c)(1) hedge funds will be both accredited investors and qualified clients. A 3(c)(1) fund must limit its investors to qualified clients if it wants to charge a performance fee.

What is a qualified client? Qualified client definition

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UPDATE: the below article is based on the old “qualified client” definition. The new “qualified client” definition can be found in full here, and the SEC order increase the asset thresholds can be found here. As a gross summary, the new definition of a qualified client is:

entity or natural person with at least $1,000,000 under management of the advisor, OR
entity or natural person who has a net worth of more than $2,100,000

For the second test above, natural persons exclude the value of (and debt with respect to) their primary residence (assuming the primary residence is not under water).

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Certain hedge fund managers need to be registered as investment advisors with the SEC or with the state securities commission of the state which they reside in. For SEC-registered investment advisors, and most state registered advisors, the investors in their hedge fund will need to be “qualified clients” in addition to the requirement that such investors are also accredited investors. While many accredited investors will also be qualified clients, this might not always be the case because the qualified client defintion requires a higher net worth than the accredited investor definition. Hedge fund managers who are required to have investors who are both accredited investors and qualified clients cannot charge performance fees to those investors who do not meet the qualified client definition. Individual investors will generally need to have a $1.5 million net worth in order to be considered a “qualified client.”

The definition of “qualified client” comes from rules promulgated by the SEC under the Investment Advisors Act of 1940, specifically Rule 205-3. That rule provides:

The term qualified client means:

1. A natural person who or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser;

2. A natural person who or a company that the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:

a. Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1,500,000 at the time the contract is entered into; or

b. Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 at the time the contract is entered into; or

3. A natural person who immediately prior to entering into the contract is:

a. An executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser; or

b. An employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions with regard to the investment adviser) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company for at least 12 months.