SEC Proposes to Modernize Performance Fee Rule for Registered Funds, BDCs and Accredited Investors

On October 6, 2026, the Securities and Exchange Commission (SEC) published in the Federal Register a proposal titled Investment Adviser Performance-Based Compensation Modernization (Release No. IA-7022; File No. S7-2026-28). The proposal would amend Rule 205-3 under the Investment Advisers Act of 1940 (Advisers Act), which provides an exemption from the statutory prohibition on registered investment advisers receiving compensation based on a share of capital gains in, or capital appreciation of, a client’s account for certain clients including those who do not meet the “qualified client” standard.

The proposal has two principal components. First, it would enable advisers to receive performance fees from registered management investment companies and business development companies (BDCs) (together, “regulated funds”), subject to a 20% cap, board governance standards and particularized board findings, and would require separate disclosure of all performance-based compensation in the fund’s filings. Second, it would broaden the “qualified client” definition to include any “accredited investor” under Regulation D, while eliminating the rule’s current net worth and assets-under-management tests. The SEC describes the package as an effort to modernize the framework, promote innovation in regulated fund structures and expand investor choice while maintaining investor protections. Comments on the proposal are due by December 7, 2026.

Current Law

The Section 205 prohibition. Section 205(a)(1) of the Advisers Act generally prohibits an adviser registered (or required to be registered) with the SEC from receiving compensation on the basis of a share of capital gains in or capital appreciation of a client’s account. A fee equal to a percentage of an account’s annual gains is a prohibited “performance fee” (sometimes referred to as “performance carry”), while an asset-based “management” fee (e.g., 2% of assets) is not. Compensation based on other performance measures, such as interest, ordinary income or dividends, falls outside the prohibition. The SEC staff has also taken the position that the prohibition reaches “contingent” fees that are waived or refunded if an account fails to meet a performance target. Congress adopted the prohibition in 1940 out of concern that “heads I win, tails you lose” arrangements would encourage advisers to take excessive risks with client assets.

Statutory exceptions. Sections 205(b)(1)-(5) exempts from the prohibition: (1) fees based on average asset value over a definite period; (2) symmetrical “fulcrum fees” with registered investment companies or for accounts of more than $1 million; (3) contracts with BDCs, where the fee may not exceed 20% of net realized capital gains and the BDC has no other incentive compensation structure; (4) contracts with Section 3(c)(7) funds; and (5) contracts with non-U.S. residents. The SEC notes that the inflexibility of the fulcrum fee model has limited its adoption in the industry, and the SEC has brought enforcement actions against advisers whose fund performance fees exceeded what Section 205(b) permits.

The current “qualified client” standard. Under Rule 205-3, an adviser may charge a performance fee to a “qualified client,” which currently means (i) a client with at least $1.4 million under management with the adviser, or whom the adviser reasonably believes has a net worth exceeding $2.7 million; (ii) a “qualified purchaser”; or (iii) certain executive officers and knowledgeable employees of the adviser. For a Section 3(c)(1) private fund, registered fund or BDC, the adviser must “look through” the fund and confirm that each equity owner charged the fee is a qualified client.

Practical consequences. Because regulated funds cannot vary advisory fees across share classes, a registered fund (or a BDC not relying on Section 205(b)(3)) that wishes to pay capital-gains-based performance fees must today restrict its entire investor base to qualified clients. Section 3(c)(1) funds relying on Regulation D face separate, inconsistent eligibility tests: investors must be accredited investors to invest but must also clear the higher qualified client thresholds if the fund charges a performance fee. The SEC observes that this “patchwork” has concentrated performance-fee strategies in private funds and may discourage capable advisers from offering such strategies through regulated funds. This may serve to exclude accredited investors from investment opportunities who are not also qualified clients, a significant population.

Key Proposed Changes

1. Expanded Performance Fee Eligibility for Registered Funds and BDCs

The proposal would add regulated funds to the “qualified client” definition through a new “fund board channel,” without regard to whether each shareholder is individually qualified. The relief would cover advisers to open-end funds (including mutual funds and ETFs), registered closed-end funds (including interval and tender offer funds) and BDCs, whether listed or unlisted. Unit investment trusts and variable annuity separate accounts registered on Form N-3 would be excluded. An adviser could rely on the fund board channel if three conditions are met:

• 20% cap. Performance compensation may not exceed 20% of the fund’s net capital gains or net capital appreciation over a specified period or as of definite dates. Unlike the BDC statutory exception, the fee could be calculated on both net realized and net unrealized appreciation. No minimum measurement period would be mandated.
• Fund governance standards. The fund must satisfy the governance standards of Rule 0-1(a)(7) under the Investment Company Act, including a majority-independent board, independent legal counsel for the independent directors, annual board self-assessments, quarterly executive sessions of independent directors and authority to retain staff and experts.
• Board best-interest determination. As part of its annual Section 15(c) review, the board, including a majority of independent directors, must determine that the performance fee is in the best interests of the fund and its shareholders, supported by written findings addressing (i) the appropriateness of the arrangement in light of the fund’s investment strategy and valuation practices; (ii) the basis of calculation, including the measurement period and whether realized gains, unrealized gains or both are used; and (iii) the adequacy of investor protection features (such as hurdles, preferred returns, high-water marks or loss carryforwards) or, if none exist, why the arrangement is nonetheless adequate.

The SEC emphasizes that these findings are intended to be more particularized than the general Gartenberg reasonableness analysis. It flags specific issues for boards, including fair valuation of illiquid assets, “NAV squeezing,” the disconnect between NAV-based fees and discounted secondary market prices for listed closed-end funds, and the likely difficulty of justifying a performance fee for a passive index strategy. Alternatively, a regulated fund could still qualify on a look-through basis if every equity owner is a qualified client, which under the proposal would include accredited investors (an “accredited investor channel”).

2. Broadened “Qualified Client” Definition

The proposal would amend the definition of “qualified client” to include any natural person or company (other than a Section 3(c)(1) “private investment company”) that the adviser reasonably believes is an accredited investor under Rule 501(a) of Regulation D at the time the contract is entered into. In tandem, the SEC would:

• eliminate the $2.7 million net worth test and the $1.4 million assets-under-management test, together with the five-year inflation adjustment mechanism; and
• retain the qualified purchaser and knowledgeable employee categories, and restructure (without substantively changing) the look-through provision so that a 3(c)(1) fund or regulated fund is itself a qualified client if each relevant equity owner is a qualified client.

The SEC’s rationale is that an investor sophisticated enough to forgo the Securities Act’s registration protections is likewise sophisticated enough to bear the risks of a performance fee. The change would harmonize eligibility for 3(c)(1) funds and would also capture individuals who hold Series 7, 65 or 82 FINRA brokerage licenses.

The SEC estimates that roughly 17.1 million U.S. households qualifying as accredited investors do not meet the current net worth test and would become qualified clients. Conversely, certain entities that currently qualify under the $2.7 million net worth test would instead need to meet the accredited investor $5 million assets or investments tests, and some investors relying solely on the Assets Under Management (AUM) test could lose eligibility; the SEC expects both groups to be small. Contracts entered into before the effective date would generally continue to be governed by the rule’s existing transition provisions.

Because Rule 203A-3 (investment adviser representative definition), Rule 204-3 (brochure supplement delivery) and Form ADV’s “high net worth individual” definition cross-reference the qualified client definition, the proposal would make conforming amendments. As a result, accredited investor clients would become “excepted persons” for purposes of state investment adviser representative registration, and advisers with individual clients would need to reclassify which clients are reported as high-net-worth individuals on Form ADV.

Disclosure Requirements

The proposed disclosure amendments would apply to all performance-based compensation paid by regulated funds, including fees based on income, interest or dividends and existing fulcrum fees, and therefore would reach funds that do not rely on the amended rule.

• Prospectus fee table (Forms N-1A and N-2). A new “performance fees” caption would appear directly below “management fees,” which would be redefined to exclude performance fees. Funds would show the performance fee paid in the prior fiscal year, with a footnote explaining the basis of the fee, warning that it may be substantially higher or lower over time and cross-referencing fuller disclosure. The expense example would reflect performance fees. New funds could show zero; existing funds newly adopting a performance fee would restate as if the fee had been in effect for the prior year. The disclosure would be Inline XBRL-tagged and included in summary prospectuses.
• Management discussion. Funds would describe the fee rate and basis (realized gains, unrealized gains, investment income or a combination); whether it is calculated before or after fees and expenses; the measurement period; any limiting features such as hurdles, high-water marks or loss carryforwards; and provide a graphical illustration of the fee across a range of hypothetical performance scenarios.
• Form N-CSR. Item 11 would require funds relying on the fund board channel to discuss in reasonable detail the board's basis for its best-interest determination, mirroring the required written findings.

The SEC proposes a 12-month compliance period for the form amendments. However, an adviser and fund relying on the new fund board channel would have to comply with the amended forms from the time they first rely on it.

Practical Implications

• New product opportunities. Private fund sponsors could bring hedge fund, private equity and private credit strategies to registered funds and BDCs for a broader, including retail, investor base. BDC advisers could charge fees on unrealized gains, which may make equity-oriented strategies more viable. Existing funds adding a performance fee would generally require board approval and a shareholder vote.
• Heightened board burden. Directors would assume documented, annual responsibility for fee design, valuation risk and investor protection features. Boards and their counsel should expect scrutiny of these written findings, which would be publicly disclosed on Form N-CSR. The fund governance standards, including independent counsel for the independent directors of a fund, could be a friction point for funds that are not sure they need to lower their standards to attract the desired investor base.
• Simplified private fund onboarding. Sponsors of 3(c)(1) funds could rely on a single accredited investor screen, which could broaden their eligible investor pool. Advisers should nonetheless review subscription documents, the treatment of entity investors that relied on the net worth or AUM tests, and Form ADV reporting systems. Similar to SEC Rule 506(b) relating to unsolicited private placements, the fund would only need a reasonable belief that an investor is accredited, but it does not need to take any steps to verify such belief.
• Investor considerations. Institutional and individual investors would gain access to a wider range of strategies but should carefully review the new fee table and scenario disclosure, particularly for funds charging fees on unrealized or fair-valued gains or trading at a discount to NAV. Investors may end up paying more in fees than they would with traditional funds that do not charge a performance fee.

Because the proposal raises many open questions, including whether the 20% cap, unrealized-gain fees and open-end fund eligibility are appropriate, interested advisers, fund boards and investors should consider submitting before the December 7, 2026 deadline. Manatt will continue to monitor this rulemaking and is available to discuss how the proposal may affect your products and governance practices.

See Contingent Advisory Compensation Arrangements, Advisers Act Release No. 721 (May 16, 1980).

Generally, a fulcrum fee is a pricing mechanism where a base fee can move up or down depending on performance relative to an agreed benchmark or target. For example, if a base fee is 1.0%, achieving a certain performance milestone might move the fee to 1.25% whereas falling short of a separate benchmark might lower the fee to 0.75%. As the milestones and base fees are set by the fund manager, they may be prone to abusive practices.

See, e.g., In the Matter of Putnam Investment Management, LLC, Advisers Act Release No. 2547 (Sept. 7, 2006). Cf. Royce Value Trust, SEC Staff No-Action Letter (Dec. 22, 1986) (staff did not object to a fund performance fee that decreased at a greater rate than it increased).

These thresholds have been recently adjusted for inflation by SEC order in 2026, with further adjustments every five years.

It will be interesting to watch this space for state challenges of the SEC asserting federal preemption here absent Congressional action.