Investment Advisers Act of 1940 and Hedge Funds

The Investment Advisers Act of 1940 (often called the “Investment Advisers Act” or the “Act“) is an American act and regulatory regime that governs over investment advisers that provide qualifying investment advice about securities.  As such, fund managers to hedge funds that trade securities generally fall under this act.  Alongside the Investment Company Act of 1940 and the Securities Act of 1933, the Investment Advisers Act could be considered as one of the three most important regulatory considerations for fund managers.

In short, SEC-defined “investment advice” refers to advice or issuing of reports or analysis to third-parties relating to securities and in return for any form of compensation from those individuals.  A longer defintion may be found here.  The charging of a management fee, performance fee, rebates, or any other sort of fee structure you can imagine in return for advice is generally considered qualifying investment advice.

The Investment Advisers Act requires fund managers to securities funds to either register with the SEC and/or state securities regulators, depending on factors such as the amount of regulatory assets under management (“RAUM“) for the manager, or to file as an exempt reporting adviser (“ERA“) if the investment adviser in question is eligible to file as exempt.  Registration at the state level requires, amongst other things, that the investment adviser one or more of the Series 7, 63, 65 and/or 66, depending on the state and the nature of the investment advisory activity.  Registration at the federal level is required once an investment adviser has $150 million or more in RAUM, at which point state registration is generally no longer required.  Federal registration is similar to state registration in some ways, but does not require the registrant to hold any FINRA licenses, unlike most state registration regimes.

As the above sounds, registration is a serious and potentially complex regulatory area that generally requires the advice of legal counsel or certain compliance consultants and service providers.  Costs associated with registration as well as compliance once registered can be substantial.

Accordingly, many fund managers seek to qualify to file as exempt at the state and/or federal level when possible.  An illustrative example as such can be seen in the form of qualifying venture funds – which have particular regulatory carveouts that allow them to potentially remain unregistered regardless of RAUM.  Historically, many of the world’s largest venture funds, often with many billions in RAUM, remained ERAs despite their scale and sophistication, although this trend has seen some change in recent years as many venture funds transition into crossover funds and lose their qualifying venture fund status.

Eligibility to file as exempt varies at the state level.  There are generally – in lay terms, not official classification – three types of state registration/exemption regimes:

1. Exempt filing allowed, lowest standards.  Certain states, such as New York, Florida, and Georgia, allow investment advisers to file as exempt with subjectively minimal requirement.  So long as the investment adviser only advises a certain number of clients or fewer (generally 5-15, state depending, and in this case, a individual fund is likely to be a single client), all investors are accredited at minimum, and other applicable law is followed, an investment adviser can file as an ERA
2. Exempt filing allowed, certain additional restrictions.  Other states, such as Califorrnia and Texas, allow for exempt filing, but introduce certain state-specific additional requirements.  Examples may be that investors must be qualified clients (generally, persons with investable assets of $2.2 million) in order to be charged fees, rather than merely accredited investors.  Such states may also have a mandatory annual audit requirement.
3. Registration required.  Some states, such as Alabama, as of the time of this article (August 2022) currently have no exemption regime, and as such, fund managers with a place of business – generally, wherever the fund manager lives – in such a state generally must register with the state unless they are otherwise able to register with the SEC.

Exemption and/or registration eligibility and compliance can be a complicated topic, and fund managers should conduct thorough diligence to ensure they understand which options are available to them and what those options entail.  Fund managers who do not hold any securities (i.e. certain non-security digital assets, commodities only, non-security and non-commodity alternative assets) are not subject to this Act.

Observationally, like most emerging managers generally, most Repool clients seek to file as exempt if possible.