Tennessee

Tennessee is a middle-of-the-pack state in terms of the number of hedge funds that are based in the state.  It is neither a prominent hedge fund hub nor a totally obscure locale for hedge funds, and it actually has one of the most favorable exemption frameworks for a prospective emerging manager.

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.  However, Tennessee does not, and instead has its own, simpler exemption framework that is amongst the most lenient in the country (see TN Industry Regulation 07080-04-03-.05¹).  In short, so long as a private fund adviser has fifteen or fewer clients (wherein a single private fund would be a single client) and does not hold itself out to the public as an investment adviser, it generally can be exempt.

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 Tennessee, you care about Tennessee’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:

This section is for context.  Feel free to skip to the next section if you wish to read about Tennessee specifically.

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.

Tennessee’s Exemption Framework:

Tennessee has its own exemption framework, and has not adopted the NASAA model rule or a modified version thereof.

In TN, so long as an investment adviser has fifteen or fewer clients (and is not at the mandatory SEC federal registration threshold of $150m) and does not hold itself out publicly as an investment adviser, it can generally be exempt.  For purposes of TN adviser law, a private fund is considered a single client, so most hedge fund managers would be exempt unless operating more than fifteen funds despite having less than $150m AUM (which would be quite strange!).

Additionally, Tennessee law does not require that ERA-managed private funds undergo an annual, third-party audit.  While most managers will still eventually electively opt for audits, this can be a benefit in the initial phases of an emerging fund, where keeping costs low is paramount.

However, that does not mean that a TN-based hedge fund manager has no restrictions to be aware of.  A number of esoteric filings initially, annually, and point-in-time are still rquired.  Further, the Investment Advisers Act and state-level adviser laws are just one of the regulatory acts that govern hedge funds and fund managers, and these other regulatory acts will still impose restrictions.  This article’s purpose is not to delve into those in great detail (though you can read more about them here); however, a few notable call outs:

• Hedge funds operating by TN-based ERAs will still be restricted to accredited investors, owing to the Securities Act, which governs the sale of private securities (investors in funds are technically buying private securities i.e. interests in the fund).  It is a common misconception that non-accredited investors will be permitted, but this is a practical impossibility.
• There will likely be a cap of 100 investors maximum in the fund, as most funds will be 3(c)(1) funds under the Investment Company Act.  3(c)(1) funds are restricted to 100 investors.

Conclusion:

Most Tennessee based emerging managers can be exempt from registration as an investment adviser, and can raise capital from merely accredited investors while still charging fees.

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.  Done the traditional way, hedge fund launch commonly costs $50-100k year 1 and can take 3-6 months.

If you’d like to explore launching as an emerging manager in TN 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.