The Texas State Securities Board (TSSB) recently adopted amendments to its investment adviser registration exemption rules.¹ The new rules will take effect on March 31, 2014 and generally replace the existing registration exemption for private fund advisers.

These amendments, once effective on March 31, 2014, will allow most hedge fund managers based in Texas to de-register with the TSSB and will place hedge fund managers on a level playing field with most private equity and venture capital fund managers in being exempt from Texas registration in the future.

This client alert briefly discusses the new private fund adviser exemption.

Background

Prior to the amendments, Rule 109.6(c) of the TSSB² provided a registration exemption for private fund advisers when the fund was limited to no more than 100 beneficial owners (all of whom met the $5 million minimum net worth “qualified purchaser” criteria) and the investors in the fund were subject to a two year minimum lock-up on their investment. The minimum investment period effectively meant that this exemption would not be available to any fund that provided early liquidity to its investors.

Prior to the amendments, the lock-up provision had the practical effect of exempting advisers located in Texas to private equity funds and venture capital funds while requiring hedge fund advisers to either register with the TSSB or add a two year lock-up on investor withdrawal rights (which distinction did not exist at the federal level). Following the amendments, this distinction no longer exists, with the Texas registration exemptions now being substantially similar to the federal registration exemptions.

New Private Fund Adviser Exemption

General. Effective March 31, 2014, “private fund advisers” must look to new Rule 139.23 of the TSSB or qualify to grandfather under new Rule 109.6(e). In order to take advantage of the grandfathering option:

• the private fund must have been in existence prior to March 31, 2014;

• the private fund adviser must have qualified for the Rule 109.6(c) exemption prior to March 31, 2014; and

• the private fund must not accept any new beneficial owners after March 31, 2014.

This means an investment adviser to any new private funds formed after March 31, 2014 or to any existing funds accepting new investors after March 31, 2014 must qualify under new Rule 139.23 or register as a Texas investment adviser.

Rule 139.23 is available for “private fund advisers,” which are defined as persons providing investment advice exclusively to “private funds” or, if providing investment advice to others, then the adviser’s activities must qualify for another available Texas investment adviser registration exemption. “Private fund” is defined as “[a]n issuer that would be an investment company as defined in the Investment Company Act of 1940, §3, but for an exclusion from the definition of an investment company in §3(c)(1) or §3(c)(7) of that Act.”

Section 3(c)(1) of the Investment Company Act of 1940 (Investment Company Act) generally exempts private funds from the definition of an investment company if the fund has less than 100 investors, subject to certain “look through” provisions for investors who are entities. Section 3(c)(7) of the Investment Company Act generally exempts private funds when all of the fund investors meet the $5 million minimum net worth “qualified person” criteria and the fund issued securities to the investors in a private offering.

Filing requirements. To take advantage of the Rule 139.23 exemption, the investment adviser must file with the TSSB the “exempt registered adviser” filing (ERA filing) required to be filed with the Securities and Exchange Commission (SEC) under Rule 204-4 of the Investment Advisers Act of 1940 (Investment Advisers Act). The ERA filing is not required to be filed with the SEC for private funds with assets under management of less than $25 million. As a result, a private fund adviser providing investment advisory services in Texas to such a fund may be in a position to make the ERA filing with the TSSB even if he or she is exempt from having to make the filing with the SEC.

“Bad actor” disqualification provisions. Rule 139.23 includes a series of “bad actor” disqualifiers that makes its exemption unavailable for, among other things, convictions, certain judgments, enforcement orders or injunctions involving fraud in connection with the issuance of securities.

Other requirements. There are additional requirements if the private fund adviser is advising at least one private fund relying solely on the Investment Company Act Section 3(c)(1) exemption that does not otherwise come under the Rule 139.23 definitions for a “private equity fund,” “real estate fund” or “venture capital fund.” If this is the case, the private fund adviser must not provide advice to any Section 3(c)(1) fund where all the fund’s investors do not otherwise meet the requirements under Rule 205-3 of the Investment Advisers Act. Rule 205-3 requires that all of the people investing in the fund meet the $5 million minimum net worth requirement and any entities investing in the fund have at least $1 million in assets being managed by the private fund adviser. There are also additional custody requirements the adviser must comply with in relation to these funds.

Exemption exclusions. If the private fund adviser is already registered with the SEC, the Rule 139.23 exemption is unavailable and the adviser must continue to make the Texas notice filings that apply to federal covered investment advisers.

_{1. You can read about the amendments here. You can read the text of new Rule 139.23here.}

_{2. See 7 Tex. Admin. Code §109.6, available at http://info.sos.state.tx.us/pls/pub/readtac$ext.TacPage?sl=R&app=9&p_dir=&p_rloc=&p_tloc=&p_ploc=&pg=1&p_tac=&ti=7&pt=7&ch=109&rl=6.}