Regulatory Compliance 101: What Fund Managers Should Know About Qualified Clients and Purchasers

Investing is a good idea for individuals of all ages and at all stages of life. Once someone decides to invest, there are countless factors to be aware of and any number of investment opportunities to be investigated and considered.  

For many people, investing in publicly traded assets makes sense. Publicly traded assets, like stocks and bonds, are highly regulated, providing significant investor protection. 

In contrast, private market investments, like private equity, venture capital, or real estate, can pose a greater risk to investors, in comparison to public markets, because they have less regulatory oversight and require greater investor sophistication and know-how.

While public markets garner more attention from the media, private markets are over five (5) times as big, and have, over time, produced better returns on investment on average.

It is important, of course, that investors understand the differences in risk, returns, and regulatory requirements between private and public markets.

But for fund managers, knowing these differences is critical, especially when it comes to the rules surrounding who may participate in an offering. 

Fund managers must know who can invest in an offering to properly structure it in a way that meets any exemption requirements and fully complies with the securities laws. 

Which brings us to a particularly vital aspect of regulatory compliance for fund managers: what they should know about qualified clients and purchasers.

Investor Status Matters

For investing, an individual or entity’s investor status — for example, as an accredited investor, qualified client, or qualified purchaser — matters.

These various legal designations are not superfluous. They directly determine who can or cannot participate in certain private market opportunities.

Because private equity (PE) investments generally have fewer disclosures than publicly traded offerings, they afford potential investors less protection. Thus, the securities laws require investors to meet certain criteria to be allowed to participate in many PE investment opportunities. The belief is that investors who meet the law’s specific criteria are more sophisticated and better able to “fend for themselves” when it comes to understanding the risks of investment.

Thus, an investor’s ability to participate in any particular PE offering depends on theirlegal investor status. Likewise, an issuer or fund’s compliance depends on the meticulous verification of investor status, whether that is verifying accredited investor status, qualified client verification, or qualified purchaser verification.

Don’t Be Fooled: A Qualified Client is not the Same as a Qualified Purchaser

The terms “qualified client” and “qualified purchaser” may seem alike, but they are not. Before we delve into the specific differences between the two, it is important to note that all qualified purchasers are automatically qualified clients, but all qualified clients are not automatically qualified purchasers.

Sound confusing?

Maybe. 

So let’s take a closer look at the differences between qualified clients and qualified purchasers.

Qualified Purchasers

The Investment Company Act of 1940 (“Investment Company Act” or “Company Act”) is the law that regulates investment companies. As to investment companies that issue securities, the Company Act requires them to register with the Securities and Exchange Commission (SEC) unless:

1. The company is not going to go public, and 

2. The company offers securities exclusively to qualified purchasers. 

Registering securities with the SEC is a time-consuming and expensive process. And it is one which many smaller companies dearly want to avoid. Understanding the burden that registration places on smaller companies, the law has carved out some exceptions. Thus, under the Company Act, if a firm has less than 100 investors and the investment is not going to be publicly offered, then the company does not have to register with the SEC. If, however, there are going to be more than 100 investors, then to avoid registering with the SEC, every single investor participating in the offer must be a qualified purchaser.

To assist in compliance, the Company Act defines “qualified purchaser.” 

Qualified purchasers can be individuals, trusts, family businesses, or institutional buyers so long as they meet the law’s requirements.

This concept of defining an investor’s status may be more readily familiar to readers when it comes to the term “accredited investors.” There, the law mandates that an individual have a specific net worth amount ($1 million USD, excluding a primary residence) or a specific income ($200,000 USD individually or $300,000 USD jointly with a spouse or spousal equivalent) for a recent two-year period to participate in certain securities offerings. 

Qualified purchasers, on the other hand, are not defined by their income or net worth, but by how much money they have in investments.

The amount required varies according to investor type (i.e., individual vs. institutional investor), but generally the amounts range from $5 million USD to $100 million USD or more as follows:

• individual investors (i.e., natural persons) — $5 million USD or more,

• family trusts or estate planning entities — $5 million USD or more,

• foundations or institutional investors (banks, insurance companies, pension funds, and corporations) —  $25 million USD or more

• qualified institutional buyers — $100 million USD or more.

The law assumes that investors who have such significant sums already invested in the market have the sophistication to know the risks of private investing and the financial wherewithal to withstand those risks. But this does not mean that qualified purchasers have no legal protections. The SEC still imposes regulations applicable to qualified purchasers that are designed to promote transparency and prevent investment fraud.

Qualified Client 

In accordance with the Investment Advisers Act, unless an exemption exists, investment advisers that have more than $100 million USD in assets under management must register with the SEC. In addition, under the Investment Advisers Act, only “qualified clients” may be charged a performance fee. 

For investment advisers structuring fee arrangements or using performance-based compensation models, this means that a client’s status as a “qualified client” is of special importance. 

To be a qualified client, the investor must meet certain financial thresholds, net worth amounts, or assets-under-management (with the adviser) amounts. Briefly, to be considered a “qualified client” a person or entity must:

• have a net worth of $2.2 million USD (excluding primary residence), or

• have $1.1 million USD in assets under management with the adviser, or

• be an officer, director, or employee of the fund manager involved in investment activities for at least 12 months, or

• be a qualified purchaser.

If an investor meets these criteria, then the investment adviser may charge the client performance-based fees.

Understanding this is important both for clients and fund managers because this requirement can limit the potential investor pool if the fund intends to charge performance fees. 

Finally, fund managers (as will be discussed more fully below) must carefully document and verify the investor’s qualified client status before charging performance fees. 

The Benefits of Having Qualified Purchaser and Qualified Client Investors 

Although the financial requirements are much higher for qualified purchasers and qualified clients than those applicable to accredited investors, for issuers and fund managers, there are some very tangible benefits that come from working with qualified clients or qualified purchasers.

One major benefit is that having this level of investor gives funds greater investment opportunities. This is because qualified purchasers and/or qualified clients can invest in funds that are more complex and carry a higher risk, which other investors (for example, accredited investors) are prevented from participating in. This allows funds to structure their investment products and strategies with more flexibility than would otherwise be the case. 

Another benefit is that qualified purchasers can access larger funds, such as 3(c)(7) funds, which can accommodate up to 2,000 qualified purchasers, providing a much larger investor base.

Among several other benefits, one is that working with qualified purchasers and qualified clients can reduce the intensity of regulatory scrutiny. This is not because the SEC does not regulate this area (it does), but because the SEC recognizes that these types of investors are highly experienced and sophisticated and thus need less legal protection. 

The Regulatory Framework Fund Managers Must Be Aware Of.

As briefly noted above, unless an exemption exists, investment companies must register with the SEC. 

Also, as touched on above, unless an exemption exists, investment advisers that have more than $100 million USD in assets under management must register with the SEC and may only charge “qualified clients” a performance fee. 

While investor status of “qualified purchaser” or “qualified client” may mean that a fund does not have to register with the SEC, it does not mean that funds and/or advisers are not regulated or are less regulated. Issuers still have to comply with a myriad of required disclosures and reporting requirements. They are still subject to audits and regulatory reviews. While registration may not be required, the SEC nevertheless has an active regulatory presence that aims to protect investors while allowing those with higher financial thresholds to participate in more investment opportunities.

Fund managers must know how the laws apply to them so that they can properly and compliantly structure their funds.  

Qualified Purchaser and Qualified Client Verification

Finally, fund managers need to understand that they are responsible for verifying the qualified purchaser or qualified client status of investors. 

Issuers or fund managers are required to perform their own due diligence to verify the status of their investors to ensure that the fund qualifies for an exemption. Importantly, there is no formal process for becoming a “qualified purchaser” or a “qualified client.” There are no exams or tests to take. Instead, most qualified purchasers simply “self-certify” their status.

So, how does a fund manager ensure the status of each and every investor? 

Generally, it requires obtaining documentation from each investor proving that the investor has met the qualifying criteria. This usually takes the form of financial statements, proof of assets, and other records of ownership. Depending on the exclusion being used, fund managers must carefully review, verify, and document that every investor qualifies either as a “qualified purchaser” or as a “qualified client.”

Not surprisingly, the SEC requires proof of qualified client verification or qualified purchaser verification. This can be done by verifying the documents provided by potential investors. A crucial part of onboarding typically includes varying levels of document verification. Basically, this means checking documents for:

• authenticity,

• validity, and 

• integrity. 

The goal is to ensure that only those who truly meet the law’s criteria (whether financial thresholds or net worth, etc.) are taken on as investors. All documentation must be up-to-date and accurate. Misrepresentations in this area can be fatal to the offering and costly to the fund.

The verification process is a detailed but critical aspect of any offering and must be meticulously carried out. This process can be handled by the fund itself or by a third-party service that specializes in investor verification. Either way, verification is an essential step that protects both the fund and the potential investors.

Because investments that involve qualified purchasers or qualified clients are high-risk opportunities, it is essential to ensure that those participating are indeed of sufficient financial means to withstand any risks of loss. Regulators are intent on limiting the risk that inexperienced or unsophisticated individuals will participate in high-risk investments to protect both the investors themselves, and the integrity of the financial markets.

Whether it is the need for qualified client verification or qualified purchaser verification, complying with the securities laws is always of paramount importance. The securities laws touch on a vast number of financial and investment issues of importance to investors and issuers alike. VerifyInvestor.com makes verifying accredited investors easy, cost-effective, secure, and reliable. Our services (which also include qualified purchaser and qualified client verification) are always code-compliant and confidential. We help companies fully and easily comply with their legal obligations to verify accredited investors.