Arizona

While not nearly as prominent as nearby California and Texas with respect to private funds, Arizona is home to satellite offices for a number of prominent financial firms and still has its own fair share of local private fund managers, albeit with an alternative asset skew (as is common on the west coast).  For prospective hedge fund emerging managers based in Arizona, though, Arizona actually has one of the top quartile exemption frameworks available in the country.

At a national level, most (but not all) states provide for an exemption framework, and those that do generally utilize what is called the “NASAA model rule” or a substantially similar ruleset.  The NASAA model rule is explained further below for context.  Arizona used the model rule as a baseline for its own state-specific framework with some substantial modifications that have the net effect of being less restrictive than the model rule, which is favorable for emerging managers.

When does state-specific jurisdiction apply?

One common question from emerging managers is when and whether a given state’s adviser rules apply.  The answer is relatively straightforward, but worth clarifying.  It is not uncommon for first-time managers to think something to the effect of: “I am forming a Delaware hedge fund, so I care about Delaware hedge fund adviser laws”; if that’s you, you are probably mistaken unless you actually live in Delaware.  Instead, it’s most likely the case that if you live in Arizona, you care about Arizona’s regime.

A state’s jurisdiction applies if:

1. The manager is not yet an SEC-registered investment adviser (aka a “federally covered investment adviser”).
2. Any personnel of the manager involved in providing investment advice is based in that state.

Practically speaking, and except for the rare case where personnel both (i) work in an office almost all of the time; and (ii) that office is in a different state than where they live, the simple output is that a state’s jurisdiction with respect to adviser matters applies if personnel of the manager live in that state.  Even simpler: if you are reading this article, probably it’s the case that wherever you live is whatever your applicable jurisdiction is.  Managers literally cannot register as SEC-registered investment advisers until they hit $100m in AUM (and must do so at $150m), and, in any case, the purpose of this article and the goal of most managers is to not register if possible.

For clarity, personnel involved in investment decision making or fundraising are considered to be in the business of providing investment advice.  Additionally, the place of formation of the fund is irrelevant; most funds are Delaware entities, but that does not mean Delaware adviser law applies (this is similar to how most companies are Delaware corporations but subject to the laws and taxes of their state of business).   Similarly, the address of the fund doesn’t matter if it doesn’t represent the actual physical presence of its personnel.  A lease or virtual address in some other place does not make that place the place of business from a regulatory structure; if that were the case, the law would have very little teeth and everyone would opt out of unfavorable states.

The NASAA Model Rule for exempt advisers:

This section is for context.  Feel free to skip to the next section if you wish to read about Arizona specifically.

The most common exemption framework is called the “NASAA model rule.”  This is an exemption framework created by the North American Securities Adminstrator’s Association in collaboration with state-level legislators.  Of the many states with exemption frameworks, a large portion have elected to adopt the NASAA model rule essentially outright and/or on a modified basis.

In the NASAA model rule¹, advisers exclusively to private funds are able to be exempt from being required to become RIAs with their state (note that regardless, non-VC private fund advisers must become RIAs with the SEC/federally once they manage $150m+ in assets, so exemption is not possible indefinitely), subject to certain criteria.  There are a variety of criteria, much of which is important but likely a non-issue for most emerging managers (e.g. it is not available to certain “bad actors” or folks with certain prior securities violations, standard filings need to be completed, disclosures need to be given to investors, etc).

The two most subjectively notable requirements are:

1. Investors in exempt manager-managed private funds must be “qualified clients,” ($2.2m+ net worth) and not merely accredited investors.
2. An annual audit is required per each fund (generally within 120 days of calendar year close) and the results must be distributed to investors.

Both of these requirements match those of RIAs for private funds (i.e. RIAs are also restricted to qualified clients in pooled capital vehicles that charge performance-based fees and must have each of their funds undergo an annual, third-party audit).  However, ERAs have significantly less requirements in other respects, such as record-keeping, custody, policies and procedures, etc.

There are other requirements associated with being an ERA under the NASAA model rule that this article does not consider, but generally speaking, such requirements (such as certain disclosures and reporting to investors) are de facto handled in the course of procuring standard hedge fund back office services such as fund administration or fund offering documents, and don’t require specific pre-launch contemplation as such.

The adviser and fund-level filings with the SEC and/or applicable states are generally outsourced, and, if a provider like Repool is utilized, a relative non-issue.  The disclosures requirements are handled by way of a quality set of standard hedge fund offering documents, such as those that Repool creates in the course of our fund-in-a-box offerings.

Thus, assuming (1) and (2) above can be met, and there is less than $150m at play across the fund(s) in question, a private fund adviser can be exempt under the NASAA model rule and states that follow its framework.

Arizona’s Exemption Framework:

In Arizona, a private fund adviser seeking to be exempt must:

• Limit its fund’s investors to accredited investors
• Not be subject to a disqualifying event pursuant to Rule 262 of Regulation A (17 CFR 230.262).
• Obtain an annual, third-party audit of each private fund, and distribute such audited financials to its investors
• Provide disclosures relating to services and duties rendered by the investment adviser

Regarding the above, the lowest possible investor financial status possible is mere accreditation anyways, owing to other regulatory acts such as the Securities Act, so this is, so to say, as good as it gets.  Under the model rule, and in many other states, exempt advisers are restricted to accredited investors that are also qualified clients, which is generally a higher standard; not so in AZ.

The restriction on no disqualifying event pursuant to Rule 262 is practically the case in other states and with counterparties anyways, so, while Arizona took care to call out that restriction specifically, it’s not really much of an additional restriction.  This article does not aim to delve into bad actor disqualifying events, but most such events are some form of a felony or regulatory restriction or action by the SEC or some other regulatory body, which hopefully does not apply to you, the reader of this article, anyways.  Repool does not work with such bad actors in any case, even if there were some state that technically allowed for it.

The annual audit requirement is much more common than not, and is also a requirement of the model rule.  It’s the exception, rather than the norm, for a state to allow a private fund adviser to not audit its private funds, and even in those such states, most managers will electively opt for an audit.

Lastly, the disclosures are standard; most hedge funds will de facto have regulatory disclosure requirements to investors handled by way of their fund offering documents and their service providers such as Repool or an administrator.  In theory, and from time-to-time, some emerging managers launch a hedge fund without a private placement memorandum to save on cost, but this would pose a potential issue in Arizona and is a riskier method of operating in general.  Repool provides all its clients with a high-quality memorandum as part of all of its launch service offerings, so this would generally be a non-issue for a Repool client.

Conclusion:

Most Arizona-based prospective emerging managers will be able to be exempt until they reach the $150m AUM federal SEC registration threshold and/or if they wish to engage in non-private fund advisory activity, with the uncommon allowance of merely accredited investors.

Outside of these considerations, the process of launching, structuring, and then assembling the required back office functions of a hedge fund is itself a complex process with many moving pieces and traditionally, high costs across a variety of counterparties and vendors that must be independently coordinated.  Done the traditional way, hedge fund launch commonly costs $50-100k year 1, can take 3-6 months, and can be an overwhelming lift for a small first-time manager team or person.

If you’d like to explore launching as an emerging manager in AZ as an exempt adviser (or as a registered investment adviser), Repool can dramatically simplify the process, reduce costs, and accelerate launch timing.  Let us know how you’re thinking about your fund here and someone will reach out.