Kentucky

Not exactly a major hedge fund player to begin with, Kentucky also did not, until very recently, provide for the ability for a private fund manager to be exempt from registration.  In 2020, a new order was issued that provides for the possiblity of an exemption, but it is relatively restrictive.

Kentucky is fairly unique in its exemption framework amongst states with an exemption framework, with only Washington having a similar framework.  While Kentucky-based private hedge fund advisers can be exempt, they are restricted solely to extremely high net worth investors, and, in fact, state-registered investment advisers (“RIAs“) are actually able to take on investors that meet a lower standard; however, the cost and administrative burden of being an RIA is higher than that of being an RIA, so there is a trade-off.

The NASAA Model Rule for exempt advisers:

(Kentucky does not use the model rule; this section is for context on how exemptions work more commonly across the country.)

The most common exemption framework nationwide is called the “NASAA model rule”, a model framework set forth by the North American Securities Administrators Assocation, 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) in addition to also being accredited investors.  It is generally the case that a qualified client is de facto also accredited; however, there are some edge cases in which an entity could be accredited without being a qualified client.

A further requirement of the NASAA exemption framework is that an annual, third-party audit of each fund managed by an ERA 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 for launch considerations, as it non-trivially increases operating costs which must be paid out of pocket and/or by fund investors (and thereby drags performance).

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.

Kentucky’s exemption framework:

Unlike the model rule, Kentucky requires that a private fund managed by an ERA be restricted solely to qualified purchasers, a higher standard than either accreditation or being a qualified client.  Put another way, this means that an ERA with its place of business in Kentucky can only advise 3(c)(7) funds rather than the more commonly seen 3(c)(1) fund under the Investment Company Act.

While the terms are similar, it is important to distinguish qualified purchaser from qualified client.  A qualified purchaser means (i) for individuals, persons with investment assets in excess of $5 million, not including the value of their primary residence, if any; or (ii) for entities, entities with investment assets in excess of $25 million in most cases.  Of note, investment assets is a slightly higher standard than mere net worth, which is the standard used for accreditation and qualified client status.

In contrast, qualified client status is achieved by having a net worth of $2.2 million, while accreditation is even lesser at a $1m net worth standard ($5m for entities).  Accreditation can also be achieved by an “income test,” of $200k for the last two years and forthgoing (or $300k for joint spousal investors).  This means that a qualified purchaser is de facto also a qualified client and an accredited investor.

Kentucky interestingly, and somewhat surprisingly, does not impose an audit requirement of funds advised by an ERA, which is the case under the model rule, many non-model rule states, and for RIAs.  That is a small benefit in a vacuum, as the cost of audit is non-trivial; however, it would be surprising for sophisticated qualified purchaser investors to not simply demand an audit as a condition of investment in any case, and the size of a fund that raises solely for qualified purchasers is likely large enough that considerations around cost-saving by way of avoiding audit are moot regardless.  But as an absolute theoretical matter, no audit is required.

Potential benefits of registration:

Typically, most managers seek to be exempt from registration if possible, as registration requires, well, the process and cost and licensure of becoming registered, and then ongoing costs and administrative work to maintain such status.  Put another way, it is both cheaper and easier to be an ERA than RIA.

However, one “benefit” – so to say – of being an RIA, is that an RIA can take on qualified clients into private fund vehicles.  In most states, this RIA investor restriction is either equal to the ERA framework at worst, or more restrictive (i.e. there are a handful of states in which ERAs can take on merely accredited investors).  However, in Kentucky, this is not the case, and an RIA can actually take on a lesser standard of investor than an ERA into a private, non-VC fund.  An RIA can operate funds where the investors are qualified clients, but not necessarily qualified purchasers; to remind, qualified client means $2.2m+ net worth, a substantially lower threshold than qualified purchaser at $5m+ (or $25m+ for entities) in investment assets.

Registration, however, may entail FINRA licensure and certainly entails a situation-specific registration process that would be faciliated by legal counsel, and which can cost dozens of thousands of dollars, not to mention the serious reporting and administrative ongoing work and costs thereafter.

Conclusion:

The impact of Kentucky’s restrictive exemption framework is that emerging managers must generally be capable of raising from a significantly more limited body of investors which many emerging managers do not have.  There are many managers who could successfully raised from qualified clients and achieve their fundraising goal, but who would not be able to do so if they were further restricted to qualified purchasers.

As such, KY based prospective fund managers have to more deeply contemplate if they should instead consider becoming registered investment advisers at the trade off of more cost and work.

Ultimately, in either case, the net effect is that it is less feasible to operate a very small fund in Kentucky as comapared to other states with exemption frameworks, owing to the increased costs of being an RIA requiring a higher minimum viable fund size, or that a person who can viably raise capital solely from qualified purchasers is unlikely to have a very small vehicle in any case.

Outside of these considerations, the process of launching, structuring, and then assembling the required back office functions of a hedge fund is still itself a complex process with many moving pieces and traditionally, high costs.

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