A qualified client is a category of investors that are exempt from the provision of the Investment Advisers Act of 1940 that prohibits private investment funds from charging performance-based fees. The requirement for a qualified client is a $2.1 million net worth, more than is required for accredited investors, or at least $1 million in assets with the advisor immediately after participating in the investment.
For example, hedge funds often have a "2 and 20" fee structure, which means a fee equal to 2% of assets under management and 20% of the fund's capital appreciation. However, investors must meet the definition of "qualified clients" in order for the latter portion of the fee to legally be assessed.
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Criteria to be a "qualified client"
A "qualified client" must meet one of the following criteria:
- An individual with at least $1 million in assets under management with the advisor immediately after entering into an investment advisory contract with the advisor.
- An individual with a net worth of more than $2.1 million, either by themselves or jointly with a spouse, immediately before entering into an advisory contract, excluding the value of their primary residence.
- An individual who meets the definition of a "qualified purchaser" at the time an advisory contract is entered into, which requires ownership of at least $5 million of investments.
- An individual who is an executive officer, director, trustee, general partner, or person serving in a similar capacity, or the advisor.
- An individual who is an employee of the advisor who participates in the investment activities of the advisor, and has done so for at least 12 months.
Is an "accredited investor" a qualified client?
Not necessarily. The opposite is generally true -- that is, a qualified client is typically also an accredited investor.
To qualify as an accredited investor, an individual needs to have a net worth greater than $1 million, or annual earned income in excess of $200,000 ($300,000 with a spouse) for three years. Anyone who meets the definition of a qualified client based on any of the first three criteria listed above generally meets the net worth test for accredited investors. Only the latter two categories -- employees and officers of the advisor selling the investments -- could potentially be qualified clients without also meeting the criteria of accredited investors, although this is rarely the case.
Generally speaking, the criteria for being a qualified client is more strict than the criteria for being an accredited investor. This makes sense, since qualified clients have an additional layer of investor protection removed (they can be assessed performance-based fees), the SEC wants to make sure they know what they're getting into, or at least can afford to absorb a loss.
Examples of qualified clients
An investor decides to invest $500,000 with a hedge fund, which is a relatively small portion of their $5 million net worth. Because their net worth exceeds the $2.1 million qualified client threshold at the start of the investment, they are a qualified client, and the hedge fund can charge them performance-based fees.
