Corporate Finance & Securities

Hedge Fund Accredited Investors

Accredited InvestorWe are continuing our series on understanding hedge funds; we will be discussing the definition of “accredited investors” and why it is important to your hedge fund.

As a brief primer, you should know that all hedge funds considering a securities offering must comply with federal and state securities laws. The Securities Act of 1933 and 1934 (“Acts”) were put in place to protect investors after the market crashed in 1929, and prior to this point in time, securities were chiefly governed by state law (which still applies in may situations). The two main objectives of the Acts were: 1) to require that investors receive significant (or “material”) information concerning securities being offered for public sale; and 2) to prohibit deceit, misrepresentations, and other fraud in the sale of securities to the public.

So based on the Acts, in order to raise capital for your hedge fund via a securities offering, you must either register the securities or find an exemption. If you only remember one thing in this article, remember this: securities MUST be registered UNLESS you find an exemption. Nearly all hedge funds that are raising capital via a securities offering do so under an exemption, because the process and reporting requirements of registering securities is extremely burdensome and expensive.

So what kind of exemptions exist?

The most common types offering exemptions relied upon by hedge fund issuers are commonly referred to as “Regulation D”, or “Reg D” offerings. Regulation D is a set of rules enacted by the SEC pursuant to the Securities Act of 1933, and it provides exemptions from registration for offerings meeting certain criteria. Many states have enacted rules to facilitate Regulation D exemptions, including the State of Washington.

There are three exemptions contained in federal Regulation D: Rule 504, Rule 505, and Rule 506. Nearly all hedge funds use the Rule 506 exemption because: 1) There is no maximum offering amount; and 2) You can sell to an unlimited number of accredited investors. This is why the definition of an “accredited investor” is important to hedge funds.

Currently individuals can qualify as accredited investors by satisfying one of two financial status tests:

  • The investor either has to have a net worth (exclusive of value of primary residence) exceeding one million dollars; or
  • The investor has to have an annual income of $200,000 (or a joint annual income of at least $300,000 with his or her spouse).

Accredited Investors and Performance Fees

In order to raise capital for your hedge fund under Rule 506, it is important that your investors be accredited but that still doesn’t allow the hedge fund to charge performance fees. If a hedge fund manager wants to charge performance fees, the investors in their hedge fund will need to be “qualified clients,” which is in addition to the requirement that such investors also be accredited investors. An accredited investor must only have a $1,000,000 net worth or an annual salary of $200K ($300K for a married couple) in the last two years with a reasonable expectation of the same or higher salary in the current year. A qualified client must have a net worth of $2,000,000. This means that a hedge fund manager may have investors that meet the accredited investor income or net worth test but not the qualified client test. A hedge fund manager who has taken money from a non-qualified client is not able to charge performance fees to that client. An alternative arrangement many hedge fund managers use is charging a performance fee to qualified clients and an assets-under-management fee to accredited investors.

If you’d like to learn more about hedge fund law, hedge fund management, or securities offerings generally, please contact us today.

Photo: Ibrahim I Flickr

        


Collin Roberts

When he's not in the office, Collin enjoys IPAs and burgers at Latona Pub.


146 N Canal Street, Suite 350   |   team@invigorlaw.com