Many wealthy and sophisticated investors include hedge fund investments in their portfolios. These funds are entities that manage investment pools using techniques, strategies and financial instruments not normally employed by open-end mutual funds or by ETFs. Rule 501 of the Securities and Exchange Commission’s Regulation D defines the minimum requirements for investing in a private securities, a mainstay of hedge funds. For these so-called accredited investors, the rules set tests for income or wealth that must be satisfied.

Net Worth Requirements for Investing in Hedge Funds

Rule 501 also lays out the minimum asset value, $5 million, for institutions — corporations, partnerships, benefits plans, trusts and charities — to be considered accredited. The purported reason for having accreditation rules is to identify investors wealthy enough to absorb the risks associated with unregistered investments, such as private equity and, formerly, hedge funds.

Accredited Investors

Here in a nutshell are the two Rule 501 accreditation tests for individuals:

  • Wealth Test: Individuals or married couples with a net worth of at least $1 million, excluding their primary residence
  • Income Test: Individuals with income of at least $200,000 in each of the past two years and with the reasonable prospect of maintaining that level of income in the current year. For married couples, the threshold is $300,000.

The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2011

Dodd-Frank had a profound effect on hedge fund investing by de facto raising the bar above the accredited threshold. The Act forced virtually all hedge funds to register with the SEC. As a result, the newly registered hedge funds found themselves subject to the 1940 Investment Advisor Act, Rule 205-3. The rule sets out how registered investment advisors can assess qualified clients for performance fees, which for hedge funds are usually 2 percent of assets under management (AUM) and 20 percent of profits. Because Rule 205-3 sets the requirements for qualified clients higher than those set for accredited investors under Rule 501, hedge funds that want to collect performance fees must routinely exclude accredited investors who are not also qualified clients.

Qualified Clients for investing in hedge funds

There is no income test for qualified clients. Instead, the tests involve net worth or AUM. Until February 15, 2012, $1.5 million was the minimum net worth requirement for qualified clients, and the minimum AUM in the hedge fund was $750,000. On that date, the SEC changed the rule such that the present definition of a qualified client is:

  • The net worth threshold is $2 million for individuals and couples, excluding primary homes.
  • You must subtract from your net worth any mortgage debt either exceeding the home’s value or incurred within two months of the hedge fund investment.
  • The AUM-test threshold is $1 million.

Loopholes

Two loopholes granted by the SEC apply to pre-existing investors in hedge funds:

  1. Grandfathering Provision: If you were considered a qualified client at a particular hedge fund before the rule change, you still are qualified at that fund even if you don’t meet the new requirements.
  2. Pre-Existing Clients: A hedge fund that was forced to register with the SEC can continue to assess performance fees from pre-registration investors as long as those clients continue to meet the less stringent accredited-investor criteria.