California

According to data from Preqin, California has the second most hedge fund managers and funds in the country.  In terms of private funds generally, California may have the most in the country thanks to its massive venture capital industry and strong presence in alternative asset private funds generally.

California has adopted a modified version of the NASAA model rule (explained further below), with some additional special carveouts for certain qualifying “venture capital companies” such as “venture capital funds;” these terms have specific (relatively self-explanatory) definitions that are essentially irrelevant to hedge funds.  The modified NASAA rule framework that California has adopted is arguably more favorable than the standard model rule, and this makes California a strong location for emerging managers.

The NASAA Model Rule for exempt advisers:

(California has a modified version of the model rule; this section is for context.)

The most common exemption framework is called the “NASAA model rule”, and, of the states that have exemption frameworks, the most popular framework is the NASAA model rule or a substantially similar adaptation of it.  In this rules framework, it is possible to be exempt, but underlying investors in funds managed by such exempt advisers must be “qualified clients,” ($2.2m+ net worth) and not merely accredited investors.

Additionally, an annual audit is required, even if the fund is only operational for part of a year (e.g. if it launches in July). This is not particularly restrictive, as investors in hedge funds should be sophisticated to be suitable and typically are qualified clients, but in some cases, some emerging managers desire to raise from accredited investors that are not qualifed clients, and this can be restrictive.  The annual audit is perhaps of greater import, as it affects operating costs which must be paid out of pocket and/or by fund investors (and thereby drags performance).

California’s modified framework¹:

California allows investment advisers to be exempt specifically in the context of being “private fund advisers” (e.g. the information herein does not apply to general wealth advisors).  The definition of a private fund adviser is an investment adviser that solely advises “qualifying private funds,” which means pooled capital vehicles that are operate as a 3(c)(1), 3(c)(5), or 3(c)(7) vehicle under the Investment Company Act of 1940.  This article does not go into depth on those topics, but you can read a comprehensive guide to them here.  In short though, hedge funds are by definition always operating under 3(c)(1) or 3(c)(7), so, put another way, a properly constructed hedge fund is a qualifying private fund.

Key modification #1

Unlike the model rule, which restricts investors in funds advised by exempt private fund advisers (commonly referred to as “exempt reporting advisers” or “ERA(s)“) to exclusively being “qualified clients” – persons with a net worth of at least $2.2m, a higher standard than accreditation, at least for individuals – California does allow accredited investors that are not also qualified clients to invest (we’ll call them “merely accredited investors“).  However, merely accredited investors cannot be assessed any sort of performance-based fee or proxy thereto, which means that they can only be charged a management fee.

CA-exempt manager operated hedge funds that wish to charge performance based compensation can only do so for accredited investors that are also qualified clients.

A fund can in theory operate multiple “share classes” and allow in both merely accredited investors alongside qualified clients, and still operate in good standing.  However, this does introduce some complexity administratively and investors may dislike this set up, as it could be perceived as “unfair” that some investors – who would definitionally likely be investing less – are also effectively paying less in fees.  Observationally, in most cases, CA based managers tend to restrict investors to being qualified clients despite this technical allownace.

Key modification #2

The second major modification to the model rule relates to audit requirements, and in an arguably favorable sense.  Typically, in most states, an annual audit must be conducted on every fund, regardless of how long the fund has been operational.  So, a fund that launches in calendar Q3 or Q4 must still receive an audit.  That audit will likely be somewhat cheaper than a full-year audit, but not on an absolutely pro rata basis.

However, in California, a fund that launches more than 180 days into the calendar year (essentially, in calendar Q3 or Q4) can skip an audit for that initial partial year and then roll that period into its first audit the following year, effectively allowing for an up to 18 month initial operational audit window.  This can simplify the administrative burden and reduce the initial expenses of an emerging manager in California, which is potentially significant.

Conclusion:

CA is, of the NASAA model rule framework (and modified variation) states, somewhat more lenient, owing to the above two items.  It is still not quite as generous in its exemption framework as states like New York, Illinois, or Connecticut, which do allow emerigng managers to charge performance based fees to merely accredited investors, but those such states are relatively uncommon.  California also does not impose any restriction on the number of qualifying private funds that can be advised, whereas most other states with a similar framework cap the number of funds at 5 or fewer.  That said, operating more than 5 funds and still being under the SEC investment adviser registration threshold of $150m is fairly uncommon, so this is a relatively small benefit.

Most CA-based emerging managers launching with less than $150m will be able to take advantage of CA’s exemption framework.

If you are thinking about launching a hedge fund as a CA-based manager, Repool’s deep expertise and fund-in-a-box can help; let’s get in touch.