The Investment Advisers Act of 1940
This and related similar acts (the "Advisers Act") place restrictions on hedge fund managers in terms of what types of investors they may take on, set forth reporting and audit requirements, and may require manager registration at the SEC or state level.
Summary
tl;dr: Private fund managers generally must be one of "exempt," "excluded," or "registered" as an adviser, and there are various requirements and restrictions associated with each.
Read on: Any person or entity that provides "investment advice" to a client is an investment adviser. A hedge fund is a client, and thus the adviser to a hedge fund is an investment adviser. Investment advisers are regulated under the Advisers Act, which sets forth requirements for advisers aimed at protecting investors, and in most cases advisers must be "registered investment advisers" which comes with significant administrative and monetary cost. However, the Advisers Act provides for exemptions or exclusion from being considered an investment adviser in certain situations, and private fund managers generally try to be exempt or excluded when possible. Requirements vary based on location, investor types, and other manager/fund-specific considerations - read on to learn more!
Key topics
The Investment Advisers Act of 1940 was created alongside the Investment Company Act to regulate persons and/or entities that provide “investment advice” and protect investors. Broadly speaking – and this is not a complete definition – anyone who advises on investing in securities in return for compensation of some kind is considered an investment adviser, and therefore subject to the Advisers Act. In the context of a private fund (e.g. a hedge fund), the fund is considered a client, and the person or entity managing the fund (such an entity is often referred to as the “investment manager,” or “manager“) is generally considered to be providing investment advice to the fund. So, no matter how the fund is structured in particular entity wise (LLC, LP, etc), if it trades securities of some kind, there is necessarily some adviser to it that needs to consider the Advisers Act.
The most common form of investment advisers are “registered investment advisers,” commonly known as “RIAs.” And they are registered specifically because the Advisers Act and/or similar state regulation requires them to do so! This broadly encompasses wealth advisors, persons operating “seperately managed accounts”, roboadvisers, and asset managers of most kinds, including hedge fund managers. RIAs are subject to certain reporting requirements to their clients which are administratively intense and costly. There is no one universal output of being an RIA – exactly how an RIA becomes registered, what it does, and what it costs to operate will vary dramatically depending on the exact nature of a particular business, its scale, its clients, and so forth. Some RIAs spend millions of dollars a year in RIA-related compliance costs, while others may spend “only” a few dozen thousand per year.
On the other hand, there is a lesser known type of investment adviser – an “exempt reporting adviser” or “ERA.” The reason ERAs are lesser known is simple – you can generally only be an ERA in very specific circumstances: when advising private funds, subject to certain boundaries. So, while it would essentially never be the case that a retail person would run into an ERA wealth advisor, ERAs are common – or at least a concept that should be understood – in the private funds space.
As the “exempt” part of ERA suggests, ERAs are exempt from certain requirements that would otherwise apply to registered investment advisers, with the practical effect of generally reducing one or many of licensure requirements, reporting requirements, audit requirements, and/or other administrative requirements; in turn, this makes being an ERA . Some ERAs elect to do the bare minimum as required by law, while other ERAs behave in RIA like ways or entirely like an RIA without being an RIA; ultimately, though, it is generally the case that being an ERA is cheaper and less administratively burdensome as compared to being an RIA, with less surface area to make regulatory mistakes, and private fund managers generally seek to be ERAs if they are able to be so.
Whether or not a private fund manager can be an ERA or not is dependent on a variety of factors, such as the state(s) in which they have a place of business, the types of investors that come into the private fund(s), if there are other non-private fund advisory activities occuring, and/or the total assets under management (“AUM”) of the manager. As an example, if and once a hedge fund manager hits more than $150m in AUM, it must register with the SEC as a registered investment adviser.
Ultimately, the Advisers Act is a critical consideration for hedge fund managers of all types on an indefinite basis.
When launching a fund, a manager should figure out if it is in a state(s) that allow for exemption and, if so, what applicable restrictions and and requirements are, and their service providers across launch, administration, and compliance should be extremely well versed in their particular circumstances (a common folly we see with managers is to work with a firm that has never launched a fund in their particular state – you’d be surprised how many firms make mistakes, and the fund manager bears the cost of that!). The manager must also understand what will cause them to need to be registered and what such process entails. Lastly, managers should understand that adherence to the Advisers Act is an indefinite burden and process that will grow and evolve with their business – for example, as they introduce new types of clients or assets – and which may even change from time-to-time at the discretion of regulators, who update and amend the Advisers Act and related laws from time to time.
