Michigan

Michigan was historically not a particularly favorable locale for emerging managers – although viable – but, beginning in 2021, it has become a very favorable state for prospective emerging hedge fund managers.

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.  Michigan used the model rule as a baseline for its own state-specific framework, but has made some significant changes to investor restrictions and audit requirements 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 Michigan, you care about Michigan’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:

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

Michigan’s Exemption Framework:

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

1. Investors can be just accredited.  Instead of being restricted to accredited investors that are also qualified clients ($2.2m+ net worth), Michigan has dropped this requirement to allow for 3(c)(1) funds (the most common emerging fund type) to be allowed to take on merely accredited investors that are not also qualified clients.
2. Audit can be waived in certain circumstances.  Like the model rule, exempt adviser-managed funds do generally need to undergo an annual, third-party audit; however, if the fund’s investors are all qualified clients, the audit requirement is dropped.  So this (2) is a bit incompatible with (1); if you wish to take on merely accredited investors, the fund would need to undergo an audit.

This is, to use a phrase, more or less as good as it gets.  Registered investment advisers are restricted to qualified clients if they wish to charge performance fees as well, and there is no practical circsumstance in any state which taking on non-accredited investors is possible (owing to the Securities Act).

Do note that this exemption is exclusively in the context of private fund managers; should a prospective emerging manager also wish to engage in other investment advisory activity on a compensated basis (e.g. seperately managed accounts), registration is likely required.

Conclusion:

Most Michigan-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 being able to take on 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 MI 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.