Pennsylvania

With its proximity to New York City and with many finance folks passing through Wharton in particular, Philadelphia has a small but not insignifcant financial satellite scene and many former New Yorkers transplant to Pennsylvania.  As such, although not one of the top states, PA has a relatively high number of fund managers and funds, and this is likely further assisted by PA having an accessible exemption framework for private fund advisers.

In PA, there are two different ways that a private fund manager can operate as exempt or excluded (an “exempt reporting adviser” or “ERA“) and not have to register with the state (as a “registered investment adviser” or “RIA“).  This is relatively unique, in the sense that most states with an exemption have just a singular framework for exemption.  This is not a bad thing, and the exemption + exclusion routes offered by the PA Department of Banking and Securities are no more onerous than typical exemption frameworks (in fact, arguably more favorable and more flexible), but it does cause some confusion and can quickly become problematic if requirements are mixed up, as the two routes are not necessarily fully compatible.

The two routes are (1) essentially the NASAA model rule framework, whereby investors need to be qualified clients in addition to be accredited, and an annual audit is required; or (2) a state-specific framework wherein certain private fund advisers can claim to be excluded from the PA definition of “investment adviser” altogether (to be technical, that means any such manager is not really an exempt reporting adviser at all, but rather an “excluded adviser“!), thereby avoiding the qualified client restriction and audit requirement, but subject to certain operational restrictions.  Let’s dive in, first by establishing context on the aforementioned NASAA model rule, and then following by discussing the two PA frameworks thereafter.

The NASAA Model Rule for exempt advisers:

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 states with exemption frameworks, many 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.

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.

Pennsyvlania framework #1: NASAA-model rule exemption:

The first PA exemption framework is essentially just the NASAA model rule, and it can be found at 10 Pa. Code § 302.070².  An investment adviser, as defined by PA law, that advises one or more private funds, can avail itself of being exempt from registration with PA as an RIA if it follows the model rule requirements as described above.

This first exemption methodology is (a) most common for PA based advisers, and (b) fairly straightforward, and, to remind, typical of states with exemption frameworks.

Pennsyvlania framework #2: Exclusion from being considered an investment adviser:

So – to be exact, this is not actually an exemption framework.  This is an exclusion from being considered an investment adviser at all by PA.  And as described above, the exemption is only in play if there is an investment adviser to one or more private funds.  If you aren’t an investment adviser at all, then you don’t need to be exempt, and you don’t need to be registered; PA doesn’t consider you an investment adviser!  Note, though, that SEC jurisdiction still kicks in at $25m, and the SEC will still generally consider any adviser to private funds to be an investment adviser, even if the state doesn’t.  We know – a bit confusing!

By virtue of being excluded, which is a fairly rare circumstance that only a few states have a framework for, then all requirements drop away with respect to investor type and audit.  That said, there are still other regulatory frameworks that apply, such as the Investment Company Act of 1940 and the Securities Act of 1933, which relate to the fund, and, in short, generally has the outcome of still requiring investors to be accredited investors.  This article is not going to contemplate those other frameworks in any deetail, though.

Put another way, if the exclusion route is taken, instead of being limited to qualified clients as per the model rule and also needing to get the fund(s) audited annually, you could take on accredited investors and skip the audit (although most fund managers do not do this).

That said, there are some caveats:

• If you take on accredited investors, but in the future exceed $150m, the SEC registration threshold, you could no longer charge those accredited investors performance-related fees;
• The exclusion criteria only allows for up to five (5) clients.  Each fund is considered a client, so this means that a fund manager could not have more than 5 funds;
• Perhaps most importantly, the adviser cannot hold itself out as an investment adviser, which means no general solicitation and no website.  Now, most funds aren’t able to engage in general solicitation anyways (this means no 506(c) fund would be allowed), but this is still something to be very careful about; and
• When the excluded adviser hits $25m, although the state will continue to consider the adviser excluded under PA law, the SEC will not.  The SEC will need that adviser to meet SEC exempt reporting adviser criteria, which it most likely can, as the SEC does not follow the model rule either and does not require investors to be qualified clients nor for an annual audit.  However, the SEC will require Form ADV to be filed.

If you go down this route and end up exceeding $25m, you will be in the fascinating and uncommon circumstance of simultaneously:

– Not being considered an investment adviser at all by PA, but
– Still being considered an investment adviser by the SEC.

The definition of an investment adviser and exclusion criteria for PA can be found here.

Additionally, many investors may still wish to see a Form ADV filed (which isn’t required if you are a sub $25m excluded adviser), and many investors also will wish to see an annual audit.  Accredited but not qualified client investors are also considered less sophisticated and although permissable, they likely carry slightly higher suitability risk.

Thus, for emerging managers who absolutely need to take on accredited but not qualified client investors to achieve their goals, who are not concerned about the restrictions above, this second route is an option.  However, it is arguably safer and more straightforward to operate under the exemption framework instead of the exclusion framework.  These are tradeoffs that an emerging manager should consider and understand carefully.

Conclusion and summary:

PA is a relatively favorable place to launch as an emerging manager, owing to having both an exemption framework as well as an exclusion framework that is in some senses, more favorable and flexible.  Still, most managers seem to take the exemption route nonetheless.  Adherence to and ensuring correct filings (or lack thereof) in accordance with the given route taken, as well as how that route evolves as AUM grows, is important, and fund managers should be careful to select service providers that have expertise with PA in particular.  Observationally, it is not uncommon for small firms in one state to help a client in another state, and make mistakes; even lawyers are not infallible.  This type of mistake is significantly less of a risk with suitable service providers, more sophisticated counsel, and/or PA-specific investment management counsel.

If you’d like to explore launching as an emerging manager in PA under either the exemption or the exclusion framework, Repool can help.  Let us know how you’re thinking about your fund here and someone will reach out.