SEC Proposes Framework Permitting Performance-Based Compensation for Regulated Funds

Since August 2025, regulators have been focused on how to increase retail investors’ indirect exposure to private issuers, as part of the implementation of Executive Order 14330, which directed federal agencies to consider how to facilitate greater access to alternative investments, including through retirement accounts.^[1] Securities and Exchange Commission (the “SEC”) Chairman Paul S. Atkins has similarly identified the “responsible retailization” of private markets as an SEC priority, emphasizing the potential for regulated investment vehicles to broaden retail access while maintaining appropriate investor protections.^[2]   In September 2026, the SEC proposed several rule changes. The SEC views these proposals as the first step in a “three legged” process built on access, transparency and incentives that would give retail investors greater access to private-market investment opportunities, including investments in companies before they go public.

This memorandum discusses the first major proposal, which would alter the rules applicable to performance-based fees and relax distribution limitations that prevent some investors from gaining exposure to private funds that pay performance-based fees. The SEC also proposes to update the definition of “qualified client” to include accredited investors, add credentials-based tests and remove the assets-under-management test.

In a second set of proposed rule changes, the SEC would codify existing relief and update the interval fund structure, with specific modifications to liquidity management and repurchase offer timing that could make these funds more desirable to a wider range of investors. The SEC also proposed to codify closed-end fund relief and permit multiple share classes, which would allow fund sponsors to deliver these investment opportunities through different distribution channels.

These proposals reflect the SEC’s efforts to provide retail investors with greater access to non-public investments, enabling a broader percentage of investors to participate meaningfully in the significant growth period that occurs prior to a company going public.

Overview

On September 30, 2026, the SEC proposed a new framework that would substantially expand the circumstances in which registered funds and business development companies (“BDCs,” and together with registered funds, “Regulated Funds”) may compensate investment advisers based on investment performance (the “Proposal”).^[3] The Proposal would expand the exemption under Rule 205-3 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) to permit advisers to Regulated Funds to receive compensation based on a fund’s net capital gains or net capital appreciation, subject to specified conditions. It would also expand the categories of investors that qualify as “qualified clients” eligible to invest in funds with performance-based compensation arrangements under Rule 205-3 and adopt related disclosure amendments.

The Proposal suggests one of the most significant changes in decades to the regulatory framework governing adviser compensation for Regulated Funds. Performance-based compensation has long been common in private funds but generally has been unavailable to advisers of Regulated Funds, except through fulcrum fee arrangements under Section 205(b)(2) of the Advisers Act or, in the case of BDCs, the statutory exception under Section 205(b)(3).  Although the Proposal would provide fund sponsors with substantial flexibility in designing performance-based compensation arrangements, it also raises significant valuation, governance, shareholder equity, and operational considerations on which the SEC specifically requests comment. Comments are due by December 7, 2026.

I. Current Regulatory Framework

Section 205(a)(1) of the Advisers Act generally prohibits an investment adviser from receiving compensation based on a share of the capital gains or capital appreciation of client assets. Congress adopted this prohibition to address concerns that performance fees could encourage excessive risk-taking or create conflicts between advisers and investors. Over time, Congress and the SEC have adopted several limited exceptions.

First, Rule 205-3 permits advisers to receive performance-based compensation from “qualified clients.” Under the current rule, qualified client status generally depends on satisfying specified assets-under-management or net-worth thresholds, although “knowledgeable employees” and “qualified purchasers” also qualify.

Second, Section 205(b)(3) permits BDC advisers to charge incentive fees based on capital gains, subject to statutory limitations.

Third, registered funds may use fulcrum fees under Section 205(b)(2). Fulcrum fees, which are capped at 4%, increase or decrease advisory compensation based on performance relative to an appropriate benchmark. Despite having been available for decades, few registered funds use them. According to the SEC, the existing framework may not adequately accommodate certain private-market strategies and may place registered products at a competitive disadvantage to private funds.

II. Proposed Exemption for Regulated Funds

a. Eligible Funds

The Proposal would modify the existing exemption under Rule 205-3 and expand permissible performance-based compensation arrangements for Regulated Funds. It would apply broadly to   traditional mutual funds, exchange-traded funds (“ETFs”), interval funds, tender offer funds, and BDCs, provided the applicable conditions are satisfied. Although not limited to funds investing in private assets, the Proposal may be particularly relevant to funds pursuing private credit, private equity, venture capital, infrastructure, real estate, and similar strategies.

b. Permitted Performance Measures and Compensation Based on Unrealized Appreciation

The Proposal would permit compensation based on net capital gains or net capital appreciation. Because net capital appreciation includes unrealized gains, adviser compensation could depend in part on fair-value determinations made before portfolio investments are sold. The Proposal would not prescribe a particular methodology or minimum performance period, but advisory contracts would be required to specify the date or period for measuring performance and assessing the fee.

The SEC specifically requests comment on whether compensation should be permitted based on unrealized appreciation and whether additional investor protections should apply. The Proposal would not require high-water marks, clawbacks, loss carryforwards or similar mechanisms to address subsequent reversals of appreciation for which a fee has already been paid. These issues may be particularly significant for funds investing in less-liquid assets, where valuation determinations involve substantial judgment and can directly affect adviser compensation.

c. 20% Limitation

The Proposal would cap performance-based compensation at 20% of a fund’s net capital gains or net capital appreciation. For example, if a fund recognizes $120 million in gains and $20 million in losses during the measurement period, the fund’s net capital gain would be $100 million and the adviser generally could receive no more than $20 million in compensation attributable to that gain.

III. Shareholder Equity and Operational Challenges

The Proposal highlights structural challenges associated with applying performance-based compensation within a Regulated Fund framework. Unlike private funds, Regulated Funds generally cannot maintain investor-level capital accounts or use equalization mechanisms to allocate incentive compensation based on each investor’s particular investment experience.^[4] Performance fees therefore would be assessed at the fund level and reflected in the fund’s net asset value (“NAV”), potentially causing shareholders entering and exiting at different times to bear different effective fee burdens. The SEC calls this the potential “free-rider” issue, because later investors may benefit from appreciation generated before they invested, while bearing only a portion of the associated performance fee. In addition, because the fee would not be finally determinable until the measurement period ends, funds generally would need to estimate accrued performance fees during the period, creating estimation, accrual and overpayment risks, particularly for open-end funds with frequent NAV calculations and ongoing subscriptions and redemptions.^[5]

The operational challenges are not entirely novel, as funds using fulcrum fees have long confronted similar issues involving performance measurement, fee accruals and shareholder flows.^[6] Academic commentators likewise have questioned whether performance-based fee arrangements consistently align adviser and shareholder interests.^[7]

IV. Board Approval and Oversight

The Proposal would require a Regulated Fund’s boards of directors, including a majority of the fund’s independent directors, to approve the fee arrangement and determine, with specified written findings, that the arrangement is in the best interests of the fund and its shareholders. The required findings would address the arrangement’s appropriateness in light of the fund’s strategy and valuation practices, the basis for calculating compensation, the fee structure and measurement period, and any investor-protection features.

The Proposal would not alter directors’ existing obligations under Sections 15(c) of the Investment Company Act of 1940, as amended (the “1940 Act”). Review of a performance-fee arrangement nevertheless would likely overlap with the traditional Gartenberg factors, including the nature and quality of advisory services, fund performance, profitability, economies of scale and comparative fee information.^[8] The required findings would supplement that review by focusing specifically on the structure and operation of the performance-fee arrangement, including matters that may fall outside a traditional analysis of the adviser’s overall compensation.

The Proposal, together with the SEC’s recent Statement on Fair Value Measurement and Disclosure Considerations for Private Assets (the “Fair Value Statement”), may affect how boards approach valuation oversight and related Section 15(c) materials.^[9] Rule 2a-5 under the 1940 Act already establishes a framework for board oversight of fair-value determinations, but performance fees based on unrealized appreciation would create a more direct connection between valuation determinations and adviser compensation. For funds holding illiquid assets, that connection may warrant increased attention to valuation methodologies, data inputs, calibration practices, assumptions, third-party valuation inputs, governance processes and valuation-related conflicts.

Accordingly, boards considering such arrangements may need additional information concerning the fund’s valuation practices; the effect of valuation determinations on performance compensation; the applicable measurement and crystallization periods; potential valuation, estimation and overpayment risks; effects on shareholders; and any investor-protection features. Board materials should enable directors to understand not only the resulting valuations but also the methodologies, assumptions, data inputs and governance processes underlying them.

a. Peer Comparisons

The Proposal also may affect the use of comparative information in the Section 15(c) process. For funds investing in private assets or using performance-based compensation, differences in strategy, liquidity, valuation practices, leverage, fee structures, and repurchase or redemption features may limit the usefulness of conventional peer comparisons. Boards therefore may focus on how a peer group was constructed, why particular funds were included or excluded, and what the comparison does and does not show. Board materials should explain the rationale for the selected peer group, limitations of available data, material differences in fee arrangements and investor protections, and the relevance of the selected metrics to the board’s review.

b. Proposed Changes to the Qualified Client Definition

The Proposal would amend the qualified-client provisions of Rule 205-3 by adding accredited investors to the categories of investors eligible to enter into performance-fee arrangements and eliminating the rule’s assets-under-management and net-worth tests. The rule instead would rely on categorical eligibility standards, including accredited investor, qualified purchaser, and knowledgeable employee status. According to the SEC, this approach is intended to simplify administration of the rule and eliminate the need to adjust the existing dollar thresholds periodically for inflation.

c. Proposed Disclosure Amendments

The Proposal includes disclosure amendments designed to increase transparency regarding performance-based compensation arrangements. Among other things, Regulated Funds would be required to provide enhanced disclosure regarding:

• the existence of a performance-based compensation arrangement;
• the methodology used to calculate performance compensation;
• the material terms of the arrangement; and
• related conflicts of interest.

The Proposal also would require enhanced disclosure regarding the board’s approval of a performance-fee arrangement, including the board’s findings under proposed Rule 205-3 and the basis for determining that the arrangement is in the best interests of the fund and its shareholders. According to the SEC, these disclosures would help investors understand how adviser compensation is determined and how compensation incentives may affect portfolio management decisions.

What Fund Sponsors Should Be Doing Now

The Proposal would significantly alter the regulatory framework governing adviser compensation for Regulated Funds and could make registered structures more attractive for certain private-market strategies. The comment process is likely to focus heavily on the treatment of unrealized appreciation, appropriate investor-protection safeguards, valuation-related conflicts, shareholder equity concerns, and the extent to which performance-based compensation can be administered effectively within a Regulated Fund framework.

As the comment process proceeds, fund sponsors may wish to evaluate whether existing or contemplated products could benefit from a performance-based fee and assess whether their valuation, accounting and fee-accrual systems could support such arrangements. Sponsors also should consider the information boards would need to approve and oversee the arrangements and any related compliance, disclosure, shareholder-servicing and operational implications.

We are available to assist clients in evaluating the Proposal, preparing comment letters and assessing its potential effects on compensation arrangements, compliance programs, board oversight and reporting obligations. Please contact your primary contact in S&K’s Investment Management Group with any questions regarding the Proposal.