Washington

Washington’s strong GDP and economic hub of Seattle means there are both major financial firms and many wealth potential investors and, as such – perhaps surprisingly – Washington has a relatively high number of private funds.  Likely, many of these funds are alternative asset funds (as is more common on the west coast generally given market hours), but there are still a decent number of emerging managers and significant hedge funds located in the state.

Uniquely, Washington is one of a small number of states with how it operates its exemption framework, which is a heavily modified version of the NASAA model rule (explained below).   A manager that is exempt from registration is known as an “exempt reporting adviser” (an “ERA“).  While Washington-based private hedge fund advisers can be exempt, they are restricted solely to extremely high net worth investors, and, in fact, 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.

Additionally, Washington’s State Department of Financial Institutions – the state securities regulator – is known to be amongst the most scrutinous and active in the country.  New managers should not be surprised if the WA SDFI contacts them directly shortly after they initially launch for an interview, and should take particular care to deeply understand the restrictions associated with exemption in the state.

The NASAA Model Rule for exempt advisers:

(Washington has a heavily modified version of the model rule; this section is for context.)

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.

Washington’s exemption framework:

Similar to the NASAA model rule, Washington sets forth disclosure, reporting, and other fairly obvious requirements for ERAs; additionally, Washington also requires an annual, third-party of audit of each fund.

Unlike the model rule, however, Washington requires that a private fund (other than certain VC funds) 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 Washington can only advise 3(c)(7) funds rather than the more commonly seen 3(c)(1) fund under the Investment Company Act.  For clarity, whether a state’s specific rules apply is based on a physical presence test: if the manager (or some of its key personnel) physically work out of the state, then that state has provenance; a state cannot be simply opted out of by virtue of having a virtual address or lease in some other place.

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.

Washington’s registration framework:

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 Washington, 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.

Conclusion:

The impact of Washington’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, Washington 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 Washington 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 itself a complex process with many moving pieces and traditionally, high costs.  Repool has worked with WA based emerging managers to help dramatically simplify launch, defray cost, and operate, but the restrictions set forth above are simply hard walls unrelated to a manager’s particular service providers.

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