Hedge funds are organizations that manage pools of investments on behalf of clients using aggressive techniques and complex financial instruments. Individual hedge fund investors must be accredited, as defined by Rule 501 of the Securities and Exchange Commission’s Regulation D. The rule specifies a wealth test and an income test, either one of which must be satisfied to achieve accreditation. For institutions, Rule 501 specifies a minimum value of assets owned. The accreditation requirement exists to limit to the wealthy the risks associated with hedge fund investing.
The Rule 501 wealth test states that individuals or married couples must have at least $1 million in net worth to achieve accreditation status. Individuals can also be accredited if they pass the rule’s income test, which requires income exceeding $200,000 in each of the previous two years; married couples need to show at least $300,000 in income. Entities that are allowed to invest in hedge funds must generally have more than $5 million in total assets. This includes corporations, partnerships, benefits plans, trusts and charitable organizations. The Dodd–Frank Wall Street Reform and Consumer Protection Act has largely rendered individual accreditation moot by applying a higher standard to hedge funds.
Wall Street Reform and Consumer Protection
The Dodd-Frank law of 2011 requires most hedge funds to register with the SEC. Once registered, the funds becomes subject to Rule 205-3 of the Investment Advisers Act of 1940, which regulates how registered investment advisers charge performance fees to “qualified clients.” The effect of registration is that hedge funds can only charge performance fees, commonly 20 percent of profits, to qualified clients. The wealth test for qualification is higher than that for accreditation. There is no income test for qualification. Registered hedge funds routinely exclude new clients who are not qualified and thus not subject to performance fees.
Until 2012, the net worth requirement for qualified clients was $1.5 million. Clients could also be qualified if they had at least $750,000 invested in the hedge fund; this is called the assets-under-management test. On Feb. 15, 2012, the SEC amended Rule 205-3, raising the net worth threshold to $2 million for individuals and married couples, excluding the value of a primary residence. Any mortgage debt in excess of the property value or incurred within 60 days of investing in a hedge fund is subtracted from the investor's net worth. In addition, the SEC increased the assets-under-management test to $1 million.
The SEC rule changes provided two grandfathered exceptions to Rule 205-3. If you were a qualified client of a hedge fund before the 2012 rule change, your status won't change at that hedge fund even if you do not pass the new tests for net worth or assets under management. The second exception allows previously unregistered hedge funds to maintain investment contracts that existed before the funds were required to register with the SEC. Under this exception, hedge funds can continue to charge performance fees to preexisting clients who meet only the lower accredited investor standard.
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