SEC Proposes Framework Permitting Performance-Based Compensation for Registered Funds and BDCs

Who may be interested: Registered Investment Companies; Directors of Registered Investment Companies; Investment Advisers

Quick Take: On September 30, 2026, the SEC proposed amendments to Rule 205‑3 under the Advisers Act that would significantly expand the ability of advisers to registered funds and BDCs to receive performance-based compensation. The proposal would permit registered funds and BDCs to enter into advisory fee arrangements that provide for performance fees based on capital gains or capital appreciation. To rely on the proposed framework, performance-based compensation could not exceed 20% of the regulated fund’s net capital gains or net capital appreciation over a specified period, and these regulated funds would be required to satisfy fund governance standards and board oversight requirements. The proposal would also amend the qualified client definition to include accredited investors and would require enhanced disclosure regarding performance-fee arrangements.

Proposed Expansion of Performance-Based Compensation

The proposal would amend Rule 205‑3 to expand the ability of advisers to registered management investment companies and BDCs (regulated funds) to enter into advisory contracts providing for performance-based compensation based on a regulated fund’s net capital gains or net capital appreciation. The proposal is intended to better align adviser compensation with shareholder outcomes while relying on existing 1940 Act protections and additional conditions designed to mitigate the risk of excessive risk-taking by advisers. The proposing release notes that performance-based compensation has historically been present in privately offered funds, and has separately noted that advisers to private funds have better access to participate in the more recent innovative companies, and retail investors are less likely to participate in those developments. To rely on the proposed framework:

• performance-based compensation may not exceed 20% of a regulated fund’s net capital gains or net capital appreciation over a specified period;
• the regulated fund must satisfy the fund governance standards under Rule 0‑1(a)(7) under the 1940 Act; and
• the regulated fund’s board, including a majority of independent directors, must determine that the performance-based compensation arrangement is in the best interests of the fund and its shareholders and make specified findings during the Section 15(c) advisory agreement approval/renewal process regarding the arrangement’s structure and investor-protection features.

Notably, the proposal would permit performance fees to be assessed based on both net realized and net unrealized appreciation.  By contrast, the current exception for BDCs permits performance-based fees to be calculated based on realized gains and income. The proposal would also require performance fees to be calculated over a specified measurement period or as of definite dates identified in the advisory contract, although it would not mandate a minimum measurement period.

The proposal would apply broadly to advisers of registered management investment companies and BDCs, including registered open-end funds, such as mutual funds and ETFs, as well as interval funds, tender offer funds, and closed-end funds, whether exchange-listed or unlisted. However, the proposed framework would not extend to unit investment trusts or variable annuity separate accounts registered on Form N‑3.

Board Findings and Oversight

A key element of the proposal would impose enhanced board oversight.  Currently, aspart of the approval and annual review process for advisory contracts required by Section 15(c) of the 1940 Act, a fund’s board, including a majority of its independent directors, are required to make specific findings to about the reasonableness of compensation payable under the advisory fee arrangements.  Under this proposal, the Board would be required to determine that a performance-fee arrangement is in the best interests of the fund and its shareholders. The board also would be required to make specific written findings regarding:

• the appropriateness of the arrangement in light of the fund’s investment strategy;
• the fund’s valuation practices;
• whether fees are based on realized gains, unrealized gains, or both;
• the performance measurement period used to calculate fees; and
• the adequacy of any investor-protection features, such as hurdle rates, high-water marks, or loss-carryforward mechanisms.

The proposal would not mandate any particular investor-protection mechanism, but boards would be required to evaluate the adequacy of any protections included in the arrangement and, where none are included, address why the arrangement nevertheless adequately protects shareholder interests. The proposal emphasized that these findings are intended to supplement, rather than replace, the board’s existing responsibilities under the 1940 Act.

The proposing release references a number of concerns about valuation practices that could create incentives to amplify valuations in performance-based fee environments. Unlike fulcrum fees, the proposal does not include a component to reduce an advisory fee during periods of poor performance.  The proposal also mentions several areas of inquiry for directors, including how directors draw comparisons to peer funds and what shareholder protections, if any, would be desirable for registered funds using this type of fee structure.

Enhanced Disclosure Requirements

The proposal would amend Forms N‑1A and N‑2 to require enhanced disclosure regarding performance-fee arrangements. Among other changes, funds would be required to:

• include a separate “Performance Fees” line item in the prospectus fee and expense table;
• reflect performance fees in the fee example;
• describe how the performance fee is calculated, including whether it is based on realized gains, unrealized gains, investment income, or a combination thereof;
• disclose the applicable measurement period and any investor-protection mechanisms; and
• provide a graphical illustration showing how the performance fee would operate under a range of hypothetical performance scenarios.

The proposed disclosure requirements are intended to improve transparency and help investors better understand and compare the costs associated with performance-based compensation arrangements.

The proposal includes a 12‑month compliance period for the amendments to Forms N‑1A, N‑2, and N‑CSR. However, a fund that elects to rely on the proposed Rule 205‑3 framework would be required to comply with the related disclosure requirements when it first relies on the rule.

Changes to the Qualified Client Definition

The proposal also would amend Rule 205‑3’s qualified client definition to incorporate the accredited investor definition under Regulation D, replacing the rule’s current net worth and assets-under-management thresholds. The amendments are intended to expand retail access to private funds, most of which use performance-based compensation.  The proposing release projects that approximately 17 million more investors would have access to private funds if the “qualified client” definition is amended as proposed.

The public comment period will remain open until December 4, 2026.

The SEC’s proposed rule can be accessed here.