Publications

Performance Fee Proposal

Increased Flexibility for Advisers of Regulated Funds

Under the SEC’s Performance Fee Proposal, investment advisers to retail regulated funds (i.e., open- and closed-end management investment companies and business development companies, or BDCs)[3] would be permitted to charge performance-based fees on realized and unrealized capital gains or capital appreciation, provided that the regulated fund meets certain 1940 Act governance standards[4] and that the performance-based compensation does not exceed 20% of the regulated fund’s net gains over a specified period.[5] It is worth noting that the SEC considered whether performance fees should be limited to realized capital gains, but highlighted the potential drawbacks to that approach and called out pros and cons to including unrealized capital appreciation/capital gains in the calculation.[6]

Under current regulation, registered investment advisers are permitted to charge regulated funds performance fees on income (as many private credit managers of retail funds already do) and are otherwise permitted to charge performance fees based on capital appreciation or capital gains to clients who are "qualified clients" under Rule 205-3 of the Investment Advisers Act of 1940, as amended (Advisers Act) (more on that below).[7] An adviser to a BDC is also currently permitted to receive compensation — regardless of whether investors in the BDC are “qualified clients” — based on a share of capital gains, provided that such compensation currently may not exceed 20% of realized capital gains over a specified period or as of definite dates (computed net of all realized capital losses and unrealized capital deprecation).[8]

Given the foregoing, the retail fund managers that stand to be most impacted by the Performance Fee Proposal are those pursuing strategies that produce capital gains (e.g., private equity strategies), and such fees are likely to be most popular in closed-end funds pursuing private markets strategies. However, the SEC has so far left the door open for open-end funds and exchange-traded funds (ETFs) to charge performance-based compensation.[9]

The Role of the Regulated Fund Board

As proposed, a regulated fund’s board, including a majority of independent directors, would be required to determine, as part of its initial approval and annually thereafter, that the performance-based compensation arrangement is in the best interest of the regulated fund and its shareholders and to make specific findings regarding the arrangement's appropriateness, structure and consideration of investor protection features like a preferred return or high-water mark. In the SEC’s words, while consideration of a performance-based compensation arrangement would “necessarily [be] within the board’s existing obligations under both sections 15(c) and 36(b) … the proposed rule 205-3 conditions are designed to operate independently of, and in addition to, the board’s existing statutory duties.”[11]

Specifically, the board of a regulated fund would need to consider the appropriateness of the compensation arrangement in light of the fund’s investment strategy and valuation practices, with the SEC expecting heightened scrutiny over the valuation process in portfolios where fair values depend on subjective inputs and assumptions, as is often the case with private markets investments.[12]

In connection with the required best-interest finding, boards would be expected to consider whether the adviser is managing the fund’s assets in a manner consistent with its strategies and whether the compensation structure may be incentivizing the adviser to take on excessive risk or increase volatility beyond what would be consistent with the fund’s objectives and strategies, and whether the structure exposes investors to risks that may not be reflected in the fund’s disclosures.

The Performance Fee Proposal also includes certain proposed disclosure requirements, including specific fee table disclosures and a management discussion that includes a “graphical representation illustrating the calculation of the performance fee across a range of hypothetical performance scenarios.”[13]

Lowering the Bar for ‘Qualified Client’ Definition and Adding New Categories of Accredited Investors

Outside of the retail regulated fund context, registered investment advisers would still be limited to charging performance-based fees on capital appreciation or capital gains to those clients who meet the definition of a “qualified client” under Rule 205-3 under the Advisers Act. But importantly, the SEC is proposing to include in that definition investors who the adviser reasonably believes meet, at the time the advisory contract is entered into, the definition of an “accredited investor” for purposes of Regulation D under the Securities Act of 1933, as amended.

On a related but separate note, the SEC also issued a series of notices related to potential ways the SEC might expand accredited investor status under the federal securities laws, including various designations that would be based on professional licenses. Most notably, the notices include a proposal that the Financial Industry Regulatory Authority (FINRA) would develop a test that any individual over the age of 18 could take in order to qualify as an accredited investor.[14]

In combination, the Performance Fee Proposal and additional designations could significantly expand the ability of advisers to charge performance fees to a much broader group of clients.[15]

Modernization Proposal

Updates to the Interval Fund Rule

Under the SEC’s Modernization Proposal, proposed amendments to Rule 23c-3 under the 1940 Act (Interval Fund Rule) would provide additional flexibility to interval funds in the following ways:

• Two Years to Conduct First Repurchase Offer: Under the current rule, interval funds must conduct their first repurchase offer such that the first repurchase request deadline falls within the end of two periodic intervals (e.g., within six months, for a fund with quarterly repurchases) from the date of the effectiveness of the fund’s registration statement or adoption of a fundamental policy to operate as an interval fund. Under the Modernization Proposal, interval funds would be permitted to defer their first repurchase offer for up to two years from the date of the effectiveness of the fund’s registration statement or adoption of a fundamental policy to operate as an interval fund.
• Monthly Repurchases: Under the current rule, interval funds may conduct repurchases in intervals of three, six or 12 months for an amount between 5% and 25% of a fund’s outstanding common stock, provided that a number of funds have obtained exemptive relief to conduct monthly repurchases. Most recently, certain funds have obtained relief to conduct monthly repurchases for at least 2% of the fund’s outstanding common stock, provided that the amount repurchased in any quarter must be between the rule’s parameters of 5% to 25%.[16] Under the Modernization Proposal, interval funds would have the flexibility to offer monthly repurchases, but would be required to offer to repurchase a minimum of 5% at each interval (including monthly intervals). Existing monthly repurchase exemptive orders would be rescinded after one year, even for funds whose orders are currently more permissive (e.g., certain funds would lose the flexibility to offer 2% monthly repurchases).[17]

• Annual Discretionary Repurchase Offers: Under the current rule, interval funds are permitted to engage in discretionary repurchase offers outside of (and in addition to) the normal repurchase offer schedule once every two years. Under the Modernization Proposal, interval funds would have the flexibility to conduct a discretionary repurchase offer annually.
• Principles-Based Liquidity Framework: Under the current rule, from the time an interval fund notifies investors of a repurchase offer until the repurchase offer is priced, the interval fund must hold, in an amount equal to the full amount of the repurchase offer, assets that can be sold or disposed of in the ordinary course of business at approximately the price at which the interval fund has valued the investment. The Modernization Proposal would replace this rigid liquidity requirement with a more principles-based approach that would instead require interval funds to manage their portfolio’s liquidity so that the interval fund can satisfy repurchase requests without requiring a sale or disposition of investments at a price that deviates significantly from the value of those investments.
• Sales Loads/Redemption Fees: Currently, interval funds may only charge deferred sales loads pursuant to multi-class exemptive relief, and repurchase fees are limited to no more than 2%. Under the Modernization Proposal, fees will be permitted to be deducted from repurchase proceeds so long as they are compliant as if the interval fund were an open-end fund with Rules 6c-10, 11a-3, and, if varied, waived or eliminated, 22d-1 under the 1940 Act, meaning that interval funds will be on par with open-end funds and ETFs on this point.
• Timing of Repurchase Offer Notices: Under the current rule, an interval fund must provide shareholders with notice of a repurchase offer no less than 21 and no more than 42 days before the repurchase request deadline. Certain funds with exemptive relief allowing for monthly repurchases are required to provide such notice no less than seven and no more than 14 days prior to the repurchase request deadline. Under the Modernization Proposal, this timeframe would be changed — for all interval lengths — to require notice to shareholders no less than 14 and no more than 42 days before the repurchase request deadline.
• Repurchase Pricing Date Timing: Under the current rule, the repurchase payment deadline must occur seven days after the repurchase pricing date (which has been interpreted by the SEC as requiring payment within seven days). The Modernization Proposal would update the language to clarify this point and would add a requirement that the repurchase payment date must occur at least one business day prior to notification of the next repurchase offer (which would be a relevant change for funds that conduct monthly repurchases).
• Other Clarifications and Updates Regarding the Repurchase Process: The Modernization Proposal would update the rule to no longer require that interval funds include the maximum number of days between the repurchase pricing date and repurchase payment date in their fundamental policies. The Modernization Proposal also amends the rule language to clarify that in the event that a repurchase offer is oversubscribed by an amount less than 2%, the interval fund may still use the 2% flex provision set forth in the rule to purchase the additional tendered shares. 

Multi-Class Relief for Unlisted Funds

In addition to these amendments to the Interval Fund Rule, the Modernization Proposal would codify multi-class exemptive relief that has routinely been granted to unlisted closed-end funds over the years. The relief to be codified as part of the Modernization Proposal would track older, more established versions of multi-class exemptive relief for closed-end funds, which effectively allow unlisted closed-end funds to rely on various provisions of the 1940 Act available to open-end funds with multiple share classes (e.g., Rules 18f-3 and 12b-1, among other provisions).[18] The SEC has not yet proposed to codify the more recently granted form of exemptive relief, which not only allows closed-end funds to operate with multiple share classes but also allows such funds to have a class of shares that is listed and/or tokenized.[19]