Why are private funds always on the lookout for qualified purchasers?
Why are private funds always on the lookout for qualified purchasers?
Funds that exclusively have qualified purchasers on board are exempt from certain onerous Securities and Exchange Commission (“SEC”) regulations (more about this later).
So long as a fund only solicits investments from investors that meet the qualified purchaser standard, that fund can take on an unlimited number of investors (usually, funds have a cap of 100 individuals or fewer).
Accessing more high net worth investors who, in turn, invest more money with a fund allows said fund to earn higher management and compensatory fees.
It’s that simple.
Which begs the question:
As a high net-worth investor, do you meet the criteria for a qualified purchaser? And, when it comes to a qualified purchaser vs accredited investor - is there a difference?
In this post, we’ll provide the answers to all these questions and much more. We’ll start by explaining the difference between a qualified purchaser and an accredited investor, and then we’ll identify and define the three primary investor qualification categories.
Here’s what we’ll cover in this post:
- What is a Qualified Purchaser?
- How is a Qualified Purchaser Different From an Accredited Investor?
- What is a Qualified Client? Is that Different?
- Why is Investor Qualification so Important?
- Verifying Accredited Investor Status
- Simple, Portable Accreditation
What is a Qualified Purchaser?
A “qualified purchaser” is an individual or a family-owned business that owns $5 million or more in investments. The term “investments” shouldn’t include a primary residence or any property used for business.
Notice the benchmark for a qualified purchaser is investments rather than net assets, which is a standard you may be used to seeing for investor accreditation.
The term “investments” is fairly broad here and includes stocks, bonds, futures contracts, cash and cash equivalents, commodity futures contract, real estate, financial contracts and other alternative assets held for investment purposes.
Other qualified purchaser categories include:
- an individual or entity (for example, a fund manager) that invests at least $25 million in private capital, on its own account or behalf of other qualified purchasers;
- a trust sponsored and managed by qualified purchasers; or
- an entity owned entirely by qualified purchasers.
Note - there is a key exception to these rules:
To meet the qualified purchaser criteria, the relevant entity or family-owned business cannot be formed solely to invest in a fund.
Apart from a qualified purchaser, there are two other primary investor qualifications - accredited investors and qualified clients. These qualifications have varying legal and regulatory statuses related to making investments (more about them soon).
Qualified Purchaser Examples
Say, for instance, three investors apply to a private equity fund:
- The first maintains an interest-bearing savings account with $1.5 million in it and a retirement account at a brokerage with $4 million in a well-diversified mutual fund.
- The second is a wealth manager who invests $30 million for his clients, not all of whom are qualified purchasers.
- The third is also a wealth manager who invests $20 million for his clients, all of whom are qualified purchasers.
Of these examples, only the first investor would be considered a qualified purchaser.
Why is that?
The first investor maintains total investments above $5 million in compliance with the definition. While the second investor does meet the $25 million threshold, some of its investments are on behalf of non-Qualified Purchasers, which is not permitted. Finally, the third investor does not meet the criteria at all, as they would need at least $25 million invested on others’ behalf to qualify.
What are the SEC Exemptions for Funds with Qualified Purchasers?
A private fund, hedge fund, or venture capital fund that exclusively accepts qualified purchasers as investors and does not plan to make an initial public offering qualifies for the 3(c)(7) exemption under the Investment Company Act of 1940 (the “ICA”).
Why is this point important?
Primarily because the ICA includes a broad and complex set of regulatory requirements, and most funds are not set up to function under them.
In particular, by qualifying for an exemption from the ICA, the fund issuer will not have to register as an investment company with the SEC and complete onerous ongoing public disclosures regarding its investment thesis and positions.
SEC-registration for a fund is an expensive and time-consuming process most funds prefer to avoid.
Further, funds not exempt from the ICA are severely limited in utilizing leverage, specific trading contracts, or operating under complex corporate structures.
By qualifying for the 3(c)(7) exemption, a fund gains access to an unlimited number of investors while maintaining maximum flexibility regarding its corporate structure and investing methodology.
What is a Qualified Institutional Buyer?
A Qualified Institutional Buyer (“QIB”) is a large, institutional-level investor that maintains, on a discretionary basis, at least $100 million in securities.
Recent trends indicate that the institutional investor has moved from investing only in traditional publicly-traded stocks and bonds to private equity of startups, venture capital and other alternative investment opportunities.
Is a Qualified Purchaser the same as a Qualified Institutional Buyer?
No - while most QIBs qualify as qualified purchasers, the QIB definition relates to the ability to purchase securities on the secondary market under the SEC’s 144A exemption. The qualified purchaser definition, by contrast, relates to whether a fund is exempt from ICA registration and reporting requirements.
How is a Qualified Purchaser different from an Accredited Investor?
Like QIBs above, accredited investors are a special classification of sophisticated investors for whom the SEC deems the protections offered under United States Securities Act less important.
The key differentiator here is that qualified purchasers are a relevant classification for funds who want to maximize their assets under management. By contrast, accredited investors are a relevant classification for the ability to invest in certain types of assets (namely, private market securities).
An accredited investor has lower financial thresholds (measured in terms of net worth and income) compared to the financial threshold that a qualified purchaser needs to achieve (measured in terms of investments).
Eligibility Criteria for Accredited Investors
- For individuals: an accredited investor is a natural person who has either: (1) earned more than $200,000 as income (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year or (2) a net worth of over $1 million - this could be alone or together with a spouse (but excluding the value of the person’s primary residence). Although there are other exemptions based on financial sophistication, these monetary thresholds are the most common benchmark to determine accreditation status.
- For entities: there are several ways for an entity to be deemed an accredited investor. The two most common are maintaining total assets in excess of $5 million or being owned exclusively by accredited investors. Similar to qualified purchasers, the entity may not have been formed for the exclusive purpose of investing in a fund.
On August 26, 2020, the SEC adopted a final rule that will expand the accredited investor definition to allow persons to qualify on the basis of certain professional certifications or designations — including holding certain Financial Industry Regulatory Authority licenses (Series 7, Series 65 or Series 82 licenses, initially) — in addition to the existing thresholds of income or net worth.
The new accredited investor definition also allows a natural person who is a “knowledgeable employee” of the fund to be deemed an accredited investor, when it involves investments in a private investment fund such as a private equity fund, venture capital fund, or hedge fund.
These changes will allow more retail investors access to private investment companies.
Eligibility Criteria for Qualified Purchasers:
As discussed above, the thresholds to qualify as a qualified purchaser are: for individuals and family-owned businesses, $5 million in investments, and, for entities, managing at least $25 million in investments for other qualified purchasers or being exclusively owned by qualified purchasers. There is no calculation of net worth or income.
You’ll notice it is easier for individuals to qualify as an accredited investor than fulfilling the criteria to be considered a Qualified Purchaser.
Why do funds only sell to Accredited Investors?
An issuer must register all securities it offers or sells in the United States with the SEC unless they are exempt from registration.
Since the registration process can be difficult, expensive and time-consuming, issuers often look for exemptions from registration.
The most common exemption from registration is through the sale of securities to accredited investors under Regulation D of the Securities Act.
Funds interests, like common stock in a company, constitute securities under United States law. Therefore, funds are largely limited to selling to accredited investors unless they want to go public.
Separately, the fund would have to register under the ICA if it sells fund interests to more than 100 investors (this is known as the 3(c)(1) exemption). This is where the Qualified Purchaser definition comes in (the 3(c)(7) exemption mentioned earlier).
Here’s the interesting part…
By only selling funds interests to accredited investors that are also qualified purchasers, the fund avoids registration under the securities laws and separate registration as an investment company under the ICA.
What is a Qualified Client? Is that different?
So far, we have covered two of the three main investor classifications: accredited investors and qualified purchasers.
The third term that frequently comes up is that of a “qualified client,” which we will discuss here.
A qualified client is an individual with more than $2.1 million in net worth (either individually or jointly with a spouse) or who maintains at least $1 million under management with an investment adviser.
Since the net worth threshold for a qualified client is higher than for an accredited investor, all qualified clients are, by definition, also accredited investors.
Why are funds interested in Qualified Clients?
Similar to qualified purchasers, the importance of being a qualified client is not related to participation in private markets. Instead, qualified client categorization has particular benefits to investment advisors; in particular, advisors are prohibited from collecting carried interest (compensation in the form of a percentage of capital appreciation) from clients who are not qualified clients under the Investment Advisers Act of 1940.
In other words, qualified clients are more attractive because the advisor placing them in a fund can charge potentially higher performance fees.
Why is Investor Qualification so Important?
As this article has made clear, investor qualification is an integral component of participating in the private market ecosystem and managing an investment fund.
The category of investor affects, among other things:
- whether an investor qualifies to invest,
- whether the fund would be required to register with the SEC, and
- the fee that can be charged.
Understanding the different categories of investor qualifications can enable you to better structure your fund, be legally compliant, and avoid the unnecessary consequences of taking money from the wrong investor.
Now you know the individual investor types and who qualifies as an accredited investor, qualified purchaser or qualified client, plus how and why these terms are so important.
But how do you verify your status as an accredited investor?
Let’s find out.
Verifying Accredited Investor Status
There are two ways to verify your status as an investor:
- You can ask your investment adviser, CPA or lawyer to write you a letter that indicates your accreditation status; or
- You can use Parallel Markets
Parallel Markets provide a seamless accreditation service that enables people and businesses to validate their status and then share it with third parties.
Parallel Markets’ investor onboarding and verification platform - Parallel Passport - provides an end-to-end investor identity solution.
With Parallel Passport, investors can login to each of our partner websites to positively assert their identity and accredited investor status.
Parallel Passport acts as your portable identity custodian that cuts hours spent on navigating cumbersome approval processes, thereby giving you more time to evaluate your investment decision.
As issuers, you can use Parallel Passport to simplify the investor validation process. The software cuts your onboarding times in half and eliminates the need to collect sensitive documents over email.
Even if you need to accredit 100 investors, Parallel Markets can help you track down all that paperwork automatically.
Disclaimer The information contained in this article is provided for informational purposes only and should not be construed as legal advice on any subject matter. You should not act or refrain from acting on the basis of any content included in this article without seeking legal or other professional advice.