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Different Investor Qualifications - Understanding Accredited Investors, Qualified Purchasers, and Qualified Clients

JL Law

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When it comes to investment funds, not all investors are alike. Accredited investors, qualified purchasers, and qualified clients are three different types of investors with varying legal and regulatory statuses. The three terms may sound similar but there are significant distinctions among them. Here is a breakdown of each term. 

Accredited Investors

Rule 501 of the Securities Act sets out the guidelines for who an accredited investor is. Under this rule, natural persons can qualify if they have an individual net worth or combined spousal net worth over $1 million, excluding the value of the primary residence; or individual income in excess of $200,000 or joint income over $300,000 in each of the previous two years, with a reasonable expectation of continuing that income level in the current calendar year.

Entities can be accredited investors too, if the entity is owned exclusively by accredited investors; or has assets over $5 million and is not formed specifically for the purpose of acquiring the securities being offered; or a trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a person who either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment; or A private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940.

Under the securities law exemption of Rule 506(c), issuers of securities are responsible for taking “reasonable steps” to verify their investors are accredited investors.

 

Qualified Clients

A qualified client is a category of investors that are exempt from the provision of the Investment Advisers Act of 1940 that prohibits private investment funds from charging performance-based fees. 

A qualified client can be one of the following:

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

  • 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: 

  1. has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,000,000, or;

  2.  is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the time the contract is entered into;

  • 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.

Qualified Purchasers

As defined in the Investment Company Act of 1940, qualified purchasers can be one of the following:

  • Any natural person (including any person who holds a joint, community property, or other similar shared ownership interest in an issuer that is excepted under 15 U.S.C.80a–3(c)(7) with that person’s qualified purchaser spouse) who owns not less than $5,000,000 in investments, as defined by the U.S. Securities and Exchange Commission, or;

  • Any company that owns not less than $5,000,000 in investments and that is owned directly or indirectly by or for 2 or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendants by birth or adoption, spouses of such persons, the estates of such persons, or foundations, charitable organizations, or trusts established by or for the benefit of such persons, or;

  • Any trust that is not covered by clause (ii) and that was not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a qualified purchaser under clause (i), (ii) or (iv), or;

  • An natural person or company, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.

 

Why does it matter?

These varying factors matter, as they determine whether the fund must register with the SEC in order to publicly solicit, whether a fund’s manager will be entitled to receive performance-based compensation, and whether the fund qualifies for the private placement exemption. 

The “Jumpstart Our Business Startups Act”, or “JOBS Act” allows companies to publicly solicit for funds and advertise while still conducting a private offering.  However, the only investors allowed to invest must be “accredited investors”, and the company raising money has to verify that their investors are truly accredited investors.  

SEC-registered private hedge fund managers and fund managers resided in certain states are allowed to receive performance-based compensation from “qualified clients”. Fund managers can charge a fee, typically 20 percent of the fund’s capital appreciation, to qualified clients.

Section 3(c)(7) of the 1940 Investment Company Act states that by selling securities only to qualified purchasers, the fund itself would be excluded from regulation under the 1940 Act.

Understanding these differences will help you better structure your fund, be legally compliant, and avoid unnecessary loss.