Illinois

While not as prominent as other states like New York and California in terms of total hedge fund count, Illinois, by virtue of Chicago, bats disproportionally when it comes to major asset managers.  Industry titan firms like Citadel and Balyasny Asset Management are headquartered there, and there is a significant amount of sophisticated talent with trading desk experience in the state as a result.

Illinois is also a friendly jurisdiction for emerging managers owing to its relatively favorable exemption framework, which provides straightforward and relaxed requirements for operating without becoming a registered investment adviser (an “RIA”).  This is known as being exempt from registration and such an adviser is commonly referred to as an “exempt reporting adviser” (an “ERA“) and also has the effect of reducing minimum operational costs due to the lack of an audit requirement.

That means that funds can launch at slightly smaller sizes in Illinois compared to many other states while having comparable economics, and, perhaps equally as important, with less administrative hassle.

The NASAA Model Rule for exempt advisers:

(Illinois does not use the NASAA model rule nor a modified version of it; 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. 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).

Illinois’ state-specific exemption framework:

Instead, Illinois simply allows for investment advisers with five (5) or fewer clients to be exempt from needing to register with the state as a registered investment adviser¹.  In this context, a private fund is considered a single client.

Note that once an adviser/manager hits $150m in aggregate regulatory assets under management (“AUM”), it must become a registered investment adviser with the SEC (i.e. a “federally covered investment adviser”).  Therefore, most private fund managers in Illinois will be able to operate as exempt until they hit the federal registration limit, as it is exceedingly unlikely that a manager would have six (6) or more funds but still be under $150m anyways.

Illinois hedge fund investor type restrictions:

Although IL’s exemption framework does not specify a restriction on the types of investors that may invest into a private fund managed by an exempt manager, as is often the case in other states, that does not mean that such funds can freely accept any investors regardless of their financial status.

Because of the <a href=”https://repool.com/guides/securities-act/”><span style=”text-decoration: underline;”>Securities Act of 1933</span></a> (the “Securities Act“), which governs the sale of private securities/private placements (i.e. bringing on investors to a hedge fund), all hedge funds by definition are engaged in selling securities.  With that being the case, the Securities Act provides for certain allowable “safe harbor” private placement types called 506(b) and 506(c).  In short, in either case, investors must generally be accredited at a minimum.  There are some common misconceptions about taking up to 35 non-accredited investors, but this article will not contemplate the reasons behind that and that notion should generally be disavowed.

Put another way, although IL-specific adviser related law does not impose a restriction on investor types, advisers that manage hedge funds are subject to multiple regulatory frameworks, and some of these other regulatory frameworks, such as the Securities Act, apply concurrently and impose investor-type restrictions.

A ridiculous but hopefully digestable analogy is, say, rules relating to jaywalking.  Nothing about those rules specifies that you can’t mug someone while crossing the street (or so let’s just assume; we are not actually jaywalking-law experts or counsel…); nonetheless, it would be a crime to do so, because there are other laws that concurrently apply.

Illinois Form ADV filing requirements:

There is no requirement to notice file with IL by way of Form ADV when exempt, although it is still common for managers to do so, especially depending on who their investors are (certain investors may not wish to invest in a fund manager whose Form ADV has not been filed).  However, exempt managers must still begin filing Form ADV even while exempt once they hit the SEC’s exempt reporting adviser filing threshold at $100m.  If an exempt manager became registered, it would also need to file, as registered investment advisers must file Form ADV.

Illinois private fund audit requirements:

In the context of exempt and registered investment advisers, an audit typically refers to an audit of an underlying private fund’s financials, and not of the manager itself.  When required, an audit typically must be completed on an annual basis and have its results distributed to underlying investors.  Additionally, the auditor must be a licensed auditor that is distinct from the fund’s third-party administrator.

When an audit is required, the requirement typically stems from the Investment Advisers Act and/or similar state level adviser law, such as a state’s exemption framework requirements.  In many states, even when an exemption framework exists, funds must be audited.

In Illinois, there is no such requirement.  Therefore, funds managed by exempt IL-based managers do not need to undergo an annual audit, although, much like filing Form ADV, many managers will still electively opt for an audit for marketing and investor assurance purposes.  That said, the flexibility to not get audited is a useful administrative and cost-cutting tool for an emerging manager, especially if they launch part-way through the year and their initial investors don’t require one; it is often the case that managers who electively opt for audits will roll their initial partial year into their first full year (e.g. an 18 month audit instead of a 6 month and 12 month audit).

Conclusion:

IL is amongst the most favorable places to launch as an emerging manager, in the sense that it has a relatively relaxed set of rules and restrictions around who may be and how they may be exempt from registration as an investment adviser.  Most IL emerging managers launching with less than $150m will be able to take advantage of this exemption framework.