Definition
Performance-Based Fee
Compensation based on capital gains or appreciation of client assets, generally prohibited for investment advisers EXCEPT for qualified clients. Qualified client = At least $1.1M under management with this adviser OR in excess of $2.2M net worth (excluding primary residence). Creates conflict of interest by incentivizing excessive risk.
An adviser managing a $1.5M portfolio can charge 1% base fee plus 20% of returns exceeding the S&P 500 (fulcrum fee) because the client meets the $1.1M AUM threshold. A client with $2.1M net worth does NOT qualify ($2.2M exactly is too low: must be "in excess of" $2.2M).
Students confuse qualified client thresholds ($1.1M AUM / $2.2M net worth) with accredited investor thresholds ($1M net worth / $200K income). Also confusing "at least" $1.1M (inclusive) with "in excess of" $2.2M (exclusive: $2.2M exactly does NOT qualify).
How is Performance-Based Fee tested on the exam?
- Determining if a client qualifies for performance-based fees based on AUM or net worth
- Identifying whether a client with exactly $2.2M net worth qualifies (they do NOT: must exceed $2.2M)
- Distinguishing qualified client from accredited investor or qualified purchaser thresholds
- Understanding that primary residence is excluded from net worth calculation
- Recognizing that performance fees based on average AUM are NOT performance fees (no benchmark comparison)
Regulatory limits
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Qualified client: Assets under management | At least $1.1 million | With THIS investment adviser after entering contract (inclusive) |
| Qualified client: Net worth | In excess of $2.2 million | Before entering contract (exclusive: $2.2M exactly does NOT qualify). Excludes primary residence. |
| Threshold adjustment frequency | Every 5 years | SEC adjusts for inflation based on Personal Consumption Expenditures Chain-Type Price Index |
| Fulcrum fee averaging period | At least 12 months | Performance must be averaged over minimum 12-month period against benchmark |
Think "PAY FOR PERFORMANCE = PROVE YOU'RE WEALTHY": Only qualified clients can pay performance fees. Remember "1-1-2-2" for thresholds: 1.1M AUM (at least, inclusive) OR 2.2M net worth (in excess of, exclusive). Primary residence? OUT (excluded from net worth). Mnemonic: "Performance = Permission from Wealth".
Practice questions
Test your understanding with the questions below. Pick an answer to reveal the explanation.
Marcus, age 55, has $950,000 under management with his investment adviser and owns a home worth $800,000 with a $300,000 mortgage. He has $1.3 million in other investments (401(k), brokerage accounts) and $150,000 in cash savings. His adviser wants to charge a performance-based fee. Does Marcus qualify as a qualified client?
C is correct. Marcus does NOT qualify. He has only $950K with THIS adviser (below the $1.1M threshold). For net worth: Primary residence ($800K value) and mortgage ($300K) are both excluded. His qualifying net worth = $1.3M (other investments) + $150K (cash) = $1.45M, which does NOT exceed $2.2M.
A is incorrect because it includes the primary residence in net worth. The rule excludes both the home value AND the mortgage from the calculation. B is incorrect because the $1.1M AUM threshold applies only to assets managed by THIS specific adviser, not total investments elsewhere. D is incorrect because performance fees ARE permitted for qualified clients.
The Series 65 exam tests your ability to calculate qualified client status using both the AUM test (at least $1.1M with THIS adviser) and the net worth test (in excess of $2.2M excluding primary residence). Understanding that these are two separate pathways and knowing to exclude the primary residence from net worth is critical.
Under SEC regulations, what is the minimum net worth (excluding primary residence) required for a client to qualify for performance-based fee arrangements?
D is correct. The qualified client net worth threshold is "in excess of $2.2 million" (excluding primary residence). This means $2.2 million exactly does NOT qualify. the client must have MORE than $2.2 million.
A ($1.0M) is the old accredited investor net worth threshold, not the qualified client threshold. B ($2.1M) was the previous qualified client threshold before the 2022 inflation adjustment. C (exactly $2.2M) is a common trap: the rule uses "in excess of," meaning $2.2M exactly is insufficient.
The Series 65 exam specifically tests the distinction between "at least" $1.1M (for the AUM test, which is inclusive) and "in excess of" $2.2M (for the net worth test, which is exclusive). This subtle phrasing difference catches many test-takers who assume $2.2M exactly qualifies.
A client has the following financial profile: $600,000 investment portfolio, $450,000 in retirement accounts, $1.5 million primary residence with a $400,000 mortgage, and $200,000 in cash. A home equity line of credit (HELOC) of $75,000 was drawn 30 days ago for home improvements. What is the client's net worth for determining qualified client status?
C is correct. Calculate qualified client net worth:
Included assets: $600K (portfolio) + $450K (retirement) + $200K (cash) = $1.25M
Excluded: Primary residence value ($1.5M) and mortgage ($400K) are both excluded
HELOC adjustment: $75K drawn within 60 days MUST be counted as debt (exception to primary residence exclusion)
Net worth = $1.25M - $75K = $1.175M
This does NOT exceed $2.2M, so the client does not qualify via the net worth test.
A and B incorrectly include the primary residence value. D ($1.250M) forgets to subtract the HELOC drawn within 60 days, which is a tested exception to the primary residence exclusion rule.
The Series 65 exam tests the HELOC exception: if a home equity line of credit is drawn within 60 days of the investment, it counts as debt even though the primary residence itself is excluded from net worth. This catches candidates who think ALL primary residence-related debt is excluded.
All of the following statements about performance-based fees for investment advisers are accurate EXCEPT
D is correct (the EXCEPT answer). Fees based on average AUM are NOT performance fees. Performance fees must be tied to capital gains, appreciation, or performance against a benchmark. A fee calculated as a percentage of average assets under management is a standard asset-based fee, not a performance fee.
A is accurate: Qualified purchasers ($5M+ in investments) automatically qualify as qualified clients because the threshold is higher. B is accurate: All compensation arrangements, including performance fees, must be disclosed in Form ADV Part 2A. C is accurate: State administrators may authorize performance fees even for non-qualified clients in certain circumstances (though this is rare).
The Series 65 exam tests your understanding that not all fee structures tied to account value are "performance fees." Only fees based on gains, appreciation, or beating a benchmark are performance fees. A fee based on average AUM (e.g., 1% of average quarterly balance) is a standard asset-based fee, not subject to the qualified client restriction.
An investment adviser wants to charge performance-based fees to a prospective client. Which of the following would qualify the client for this fee arrangement?
1. The client has $1.1 million in assets under management with this adviser
2. The client has a net worth of exactly $2.2 million (excluding primary residence)
3. The client is an officer of the investment adviser firm
4. The client has $1.5 million in total investments, with $800,000 managed by this adviser
A is correct. Only statements 1 and 3 would qualify the client.
Statement 1 is TRUE: At least $1.1M under management with THIS adviser qualifies. The client exactly meets this threshold ("at least" is inclusive).
Statement 2 is FALSE: The net worth threshold requires "in excess of $2.2M" (exclusive). Exactly $2.2M does NOT qualify. This is a critical distinction the exam tests repeatedly.
Statement 3 is TRUE: Officers and directors of the investment adviser firm automatically qualify as qualified clients, as do experienced IARs (12+ months in the industry).
Statement 4 is FALSE: The $1.1M AUM threshold applies only to assets managed by THIS specific adviser ($800K), not total investments elsewhere. The client does not meet the AUM test.
The Series 65 exam tests your understanding of multiple pathways to qualified client status: AUM with this adviser (at least $1.1M), net worth (in excess of $2.2M), officer/director/experienced IAR status, or qualified purchaser status ($5M+ investments). Understanding the exact phrasing. "at least" vs "in excess of". is critical for avoiding common traps.
What concepts relate to Performance-Based Fee?
This term is part of this cluster :
Where does Performance-Based Fee appear on the Series 65 exam?
This term is tested in the following Series 65 exam topics: