When the Advisers Act allows a share of client gains, the qualified client thresholds raised in 2026, fulcrum fees, private fund rules and how the Series 65 tests them

An investment adviser can charge performance fees only in limited cases. The general rule under Section 205 of the Investment Advisers Act of 1940 is that an adviser may not be paid a share of the capital gains or capital appreciation in a client’s account, but SEC Rule 205-3 allows performance fees for clients who meet the definition of a qualified client.

Since 29 June 2026, a qualified client is a client who has at least $1.4 million under management with the adviser immediately after entering the contract, or whom the adviser reasonably believes has a net worth of more than $2.7 million, excluding the value of their primary residence. Qualified purchasers and certain employees of the adviser also qualify.

This guide explains what counts as a performance fee, why the law restricts them, who qualifies, the other exceptions, how the state rules apply, how performance fees are disclosed, worked examples, the exam traps and five practice questions.

What Is a Performance Fee?

A performance fee is compensation calculated as a share of the capital gains or capital appreciation in a client’s account. A typical example is a fee of 20 percent of any profit the account earns above a set level.

Performance fees are common in hedge funds and private equity, where the familiar “two and twenty” model combines a management fee of around two percent of assets with a performance fee of around twenty percent of profits. They are rare in ordinary retail advisory accounts.

The key feature is that the adviser’s reward depends on gains in the account. An adviser paid this way earns more when the client’s investments rise sharply and nothing extra when they do not.

Why Performance Fees Are Restricted

Performance fees create an incentive for an adviser to take excessive risks with a client’s money. If the adviser shares in the gains but not the losses, a high-risk strategy offers the adviser a large potential reward with little downside.

Congress banned these arrangements for most clients when it passed the Advisers Act in 1940. The concern was that ordinary investors could be exposed to speculative strategies chosen for the adviser’s benefit rather than their own.

Over time, the law has allowed exceptions for clients who are wealthy or sophisticated enough to understand and bear the risks. The qualified client test is the main exception, and it ties eligibility to dollar thresholds that are adjusted for inflation.

Where This Topic Appears on the Exams

Performance fees are tested in the laws and regulations section of the Series 65 and on the Series 66. Questions usually ask whether a particular client can be charged a performance fee, what the qualified client thresholds are, or whether a fee based on average assets counts as a performance fee.

FRC’s Series 65 Exam Preparation course covers adviser compensation rules chapter by chapter, and the Series 65 needs no sponsoring firm. The SIE Examination Preparation course introduces how different financial professionals are paid.

Every FRC course can be spread across interest-free monthly payments, so cost is no reason to delay. Because the thresholds were raised in 2026, it is worth checking that your study materials use the current figures.

What Is Not a Performance Fee

A fee calculated as a percentage of assets under management is not a performance fee, even though it rises when the account grows. The adviser shares in the size of the account, not in its gains as such, and loses income when the account falls.

The Advisers Act specifically permits fees based on the total value of a client’s account averaged over a definite period, or measured at a definite date. A one percent annual fee charged quarterly on the account value is therefore allowed for any client.

Flat fees, hourly fees and fixed fees for financial plans are also not performance fees. The restriction applies only to arrangements that pay the adviser a share of capital gains or appreciation.

The Qualified Client Test

Rule 205-3 lets an adviser charge a performance fee to a qualified client. A natural person or company is a qualified client if it meets the assets under management test or the net worth test.

Under the assets under management test, the client must have at least $1.4 million under management with the adviser immediately after entering into the contract. Assets held elsewhere do not count toward this figure.

Under the net worth test, the adviser must reasonably believe, immediately before entering into the contract, that the client has a net worth of more than $2.7 million. For a natural person, net worth can include assets held jointly with a spouse but excludes the value of the primary residence.

The 2026 Threshold Increase

The SEC adjusts the qualified client thresholds for inflation every five years, as required by the Dodd-Frank Act. In April 2026 it issued an order raising the assets under management test from $1.1 million to $1.4 million and the net worth test from $2.2 million to $2.7 million, with effect from 29 June 2026.

Contracts that met the old thresholds when they were signed remain valid. The new figures are not applied retroactively to existing clients.

A client who enters a new contract, or a new investor added to an existing private fund, after 29 June 2026 must meet the new thresholds. Exam candidates should use the current figures unless a question specifies an earlier date.

Other Qualified Clients

A qualified purchaser is also a qualified client. For a natural person, a qualified purchaser generally owns at least $5 million in investments, a higher bar than the net worth test.

Certain people connected to the adviser also qualify. These include the adviser’s executive officers, directors, trustees and general partners, and employees who take part in its investment activities and have done so for at least twelve months.

The idea is that these people understand the adviser’s strategies well enough not to need the protection of the general prohibition. They can therefore invest alongside clients on performance fee terms.

Comparing the Thresholds

The accredited investor standard used for private placements is a different test. An accredited investor is not automatically a qualified client, and exam questions often use the two terms to test whether candidates can tell them apart.

Performance Fees in Private Funds

Many hedge funds and private equity funds rely on an exemption from registering under the Investment Company Act that applies to funds with no more than 100 beneficial owners. When an adviser charges performance fees to such a fund, Rule 205-3 looks through the fund to its investors.

Each investor in the fund must be a qualified client. A fund cannot be used to give ordinary investors access to performance fee arrangements that they could not enter into directly.

Funds limited to qualified purchasers rely on a different exemption and are outside the general prohibition. Advisers to those funds can charge performance fees without applying the qualified client test to each investor.

Fulcrum Fees for Registered Funds

Advisers to registered investment companies, such as mutual funds, may charge a special type of performance fee known as a fulcrum fee. The fee must rise and fall symmetrically, increasing when the fund beats an appropriate index and decreasing by the same proportion when it underperforms.

The fee is measured over a specified period and against a named benchmark. Because the adviser loses as much as it gains, the fee does not create the one-sided incentive that the general prohibition is designed to prevent.

Fulcrum fees are relatively uncommon in practice, but the concept appears on the exam. The key point to remember is that the fee must work in both directions.

Other Exceptions

The Advisers Act also allows performance fees in contracts with business development companies and with clients who are not residents of the United States. These exceptions reflect the fact that such clients are either subject to their own regulation or outside the scope of US retail protection.

Contracts with registered investment companies, other than through a fulcrum fee, remain subject to the prohibition. Retail advisory clients who do not meet any exception cannot be charged a performance fee.

These exceptions are less commonly tested than the qualified client rule. For most exam questions, the qualified client thresholds are the deciding factor.

How the State Rules Apply

State-registered advisers are subject to their own state’s rules on performance fees. Under the NASAA model rule on unethical business practices, it is unethical for an adviser to enter into a contract that provides for compensation based on a share of capital gains, except as permitted by the SEC’s rule.

Most states therefore apply the same qualified client test as the SEC. Some states set additional conditions or disclosure requirements for state-registered advisers that charge performance fees.

The practical result is that the qualified client rule applies to almost every adviser in the country. An adviser cannot avoid it simply by registering with a state rather than the SEC.

Disclosure of Performance Fees

An adviser that charges performance fees must explain them in its brochure, Part 2A of Form ADV. The brochure has a specific item covering performance-based fees and side-by-side management.

Side-by-side management means managing accounts that pay performance fees alongside accounts that do not. This creates a conflict of interest, because the adviser may be tempted to favor the performance fee accounts when allocating trades or investment opportunities.

The adviser must disclose this conflict and explain how it addresses it. FRC’s guide to what conflicts of interest an investment adviser must disclose covers this and other conflicts the exam tests.

Performance Fees and the Advisory Contract

Performance fees must be set out in the written advisory contract, along with the formula for calculating them. The contract should state the share of gains the adviser receives and how gains are measured.

Common features include a high-water mark, under which the adviser earns a performance fee only on gains above the account’s previous peak value, and a hurdle rate, which sets a minimum return before any performance fee applies. These features help align the adviser’s interests with the client’s.

FRC’s guide to what an investment advisory contract must include explains the other terms every contract must contain. A performance fee contract with a client who is not a qualified client is a violation, however clearly it is written.

Performance Fees and the Fiduciary Duty

Even where a performance fee is permitted, the adviser’s fiduciary duty still applies. The adviser must act in the client’s best interest and must not take risks that are inappropriate for the client simply because the fee structure rewards them.

The duty of care requires that the strategy suits the client’s objectives and risk tolerance. The duty of loyalty requires full disclosure of the conflict that a performance fee creates.

FRC’s guide to duty of care vs duty of loyalty explains how those duties apply in practice. A permitted fee structure does not relieve the adviser of either of them.

Worked Example: The Retail Client

A client has $400,000 invested with an adviser and a net worth of $1.5 million, excluding her home. The adviser proposes a fee of 15 percent of any gains in her account.

She does not meet the assets under management test or the net worth test, and she is not a qualified purchaser or an employee of the adviser. She is not a qualified client.

The adviser cannot charge her a performance fee. It can charge an asset-based fee, a flat fee or an hourly fee instead.

Worked Example: The Wealthy Client

A business owner opens an account with $1.5 million under management with an adviser. His net worth, excluding his home, is around $3 million.

He meets the assets under management test, because more than $1.4 million is managed by the adviser immediately after the contract is signed. He also meets the net worth test.

The adviser may charge him a performance fee, provided it is set out in the written contract and properly disclosed. The adviser must still make sure the strategy suits him.

Worked Example: The Accredited Investor

An investor meets the accredited investor standard with a net worth of $1.2 million, excluding her home. She wants to invest in an adviser’s private fund that charges a 20 percent performance fee and relies on the 100-investor exemption.

Being an accredited investor is not enough. Because the fund charges a performance fee, each investor must be a qualified client, and her net worth does not meet the $2.7 million test.

Unless she qualifies by having $1.4 million or more invested with the adviser, she cannot invest in that fund on performance fee terms. The adviser must check each investor’s status before accepting a subscription.

The Exam Traps

The first trap is treating an asset-based fee as a performance fee. A percentage of assets under management is not a performance fee and can be charged to any client.

The second trap is using outdated thresholds. Since 29 June 2026 the tests are $1.4 million under management or more than $2.7 million in net worth.

The third trap is including the primary residence in net worth. The value of a natural person’s primary residence is excluded from the net worth test.

The fourth trap is confusing accredited investors with qualified clients. The two standards are different, and meeting one does not mean meeting the other.

FRC’s guide to Series 65 ethics and laws questions and exam traps covers more traps in this area. For the full list, see FRC’s guide to Series 65 exam traps and common mistakes.

A Memory Aid

Remember “share of gains needs a qualified client.” Any fee that shares in the client’s gains is prohibited unless the client is qualified or another exception applies.

For the thresholds, remember “1.4 managed, 2.7 owned.” At least $1.4 million managed by the adviser, or more than $2.7 million in net worth excluding the home.

Practice Questions

Question one: is a fee of one percent of average assets under management a performance fee? No, fees based on the average value of assets over a period are permitted for any client.

Question two: what is the assets under management threshold for a qualified client after 29 June 2026? At least $1.4 million under management with the adviser immediately after entering the contract.

Question three: does the net worth test for a qualified client include the client’s primary residence? No, the value of a natural person’s primary residence is excluded.

Question four: what is a fulcrum fee? A performance fee for a registered investment company that increases and decreases symmetrically based on performance against an index.

Question five: is every accredited investor a qualified client? No, the accredited investor and qualified client standards are separate tests.

Related Questions

Performance fees are one of several ways advisers are paid. FRC’s guide to what a registered investment adviser is explains how advisory firms are structured and regulated.

Get Exam-Ready

Performance fee questions reward candidates who can separate asset-based fees from performance fees and apply the current thresholds quickly. Once “share of gains needs a qualified client” and “1.4 managed, 2.7 owned” are fixed, these become straightforward marks.

The FRC dictionary is more than a dictionary. It is a library of explainer videos, written explanations and on-page quizzes covering the FINRA and SEC rules you are tested on, so you can open any term and go deeper whenever a question catches you out.

Study With FRC

FRC’s programs and memberships are open to everyone. Whether you are preparing for the Series 65, the Series 7, the SIE or a combination, structured exam preparation turns topics like adviser compensation into marks you can rely on.

FRC’s Professional Membership adds verified progress and a Digital Profile, so when you apply to advisory firms, hiring managers can see your exam progress and the knowledge you are building, not just read about it on a resume.

Your Next Step

An investment adviser can charge performance fees only to qualified clients and in a few other limited cases. Since 29 June 2026, a qualified client has at least $1.4 million under management with the adviser or a net worth of more than $2.7 million excluding the primary residence, and asset-based fees remain available for every client.

Remember “share of gains needs a qualified client” and “1.4 managed, 2.7 owned,” and you will be ready for every version of this question the exam can ask.