Maryland

While a bit overshadowed by nearby states like New Jersey, New York, Pennsylvania, and Virginia in terms of hedge fund prominence, Maryland has its fair share of known hedge funds, as well as many high net worth individuals and family offices.  Maryland also has an exemption framework available to prospective hedge fund managers by way of a lightly modified adaption of the common “NASAA model rule” utilized by many other states.  Although there are a number of states with subjectively more favorable exemption frameworks, Maryland’s is typical and far from the most restrictive.

In this article, a number of topics, such as when Maryland’s laws apply, what the NASAA model rule is, what Maryland’s state-specific modifications are, and miscellaneous other considerations, are considered.  Read on:

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 there.  Instead, it’s most likely the case that if you live in Maryland, then Maryland law applies; however, if you substantially commute to and work from an office in another state (or DC), then that state’s laws may apply instead.

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:

Maryland has generally adopted the model rule, with some minor (but impactful) adjustments.  We suggest reading this section before proceeding to the Maryland specific section below.

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.

Maryland’s Exemption Framework:

As mentioned, Maryland largely follows the above described NASAA model rule; however, it has made the following two minor changes:

1. Audited financials must be delivered to investors within 120 days.  Technically, the model rule doesn’t specify a time limit; it just asserts than an annual audit per fund is required.  That said, almost all funds (and fund operating documents) operate under the 120 day time window anyways, and it would be strange from an investor perspective otherwise, so this is practically a non-modification.
2. The “bad actor” exclusion has a different definition.  This wasn’t discussed above, as it’s not a common consideration for emerging managers, but certain “bad actor” disqualifying events prevent a manager from claiming an exemption from registration.  This article will not delve into the details, but the definitions are directionally similar; if the adviser (or its personnel) has been subject to a felony, certain SEC and other regulatory judgements and rulings, and other somewhat self-evident criminal or crime-adjacent activity, then an exemption cannot be claimed.  If you (or your anticipated colleagues) have ever run afoul of the law or been under regulatory scrutiny, you should contact legal counsel directly for further information.

So, as mentioned, in effect, these two modifications don’t matter in a practical sense for a vast, vast supermajority of prospective emerging hedge fund managers, which is good news.  Certainly, other states with modified variations of NASAA tend to have more substantial modifications.

Conclusion:

Most Maryland-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 (e.g. seperately managed accounts, general wealth advisory services, etc).

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 MD 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.