Last Wednesday, the SEC announced an expansion to the definition of “accredited investor” to include individuals based on professional certifications and those with certain inside knowledge of private investments, among others. “Accredited investors” are deemed by the SEC to be sophisticated enough to bear the risks of often opaque private investments, which lack the disclosure requirements and some of the investor protections of their public counterparts. Under the accredited investor rule, private companies are limited to soliciting capital from accredited investors.
Before the recent change, accredited investor status required net worth (excluding primary residence) over $1.0 million or an annual income of at least $200,000 ($300,000 for married couples) over at least the last two years and the current year.
The old standard has been criticized over the years.
While intended to protect smaller investors, the old standard has been criticized over the years as it effectively limits investment opportunities for unaccredited investors and potentially adversely impacts capital formation for small companies. Additionally, the wealth and income standards have been criticized as a poor proxy for financial sophistication and ability to bear risk.
Another concern has been that the wealth and income standards have not changed since the rule was established in 1982. After 38 years of inflation, the real purchasing power of $1.0 million today has been significantly eroded. The wealth and income standards also do not consider geography or cost of living, which vary widely throughout the country.
In the updated guidance, the SEC declined to revise the wealth and income thresholds for inflation or geography, saying that doing so would disrupt existing investments and add complexity and administrative costs. However, in an attempt to more effectively identify investors that have sufficient knowledge and expertise to participate in private investment opportunities, the SEC did add new ways to meet the accredited investor definition. The new guidance adds the following persons and entities to the accredited investor definition:
- Natural persons holding in good standing one or more professional certifications or designations or other credentials from an accredited educational institution that the SEC has designated as qualifying an individual for accredited investor status. Initially, the list of applicable professional certifications includes the FINRA Series 7 (General Securities Representative license), Series 82 (Private Securities Offerings Representative license), and Series 65 (Licensed Investment Adviser Representative). Additional professional certifications may be added from time to time by the SEC;
- Natural persons who are “knowledgeable employees,” as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940, of the private-fund issuer of the securities being offered or sold;
- LLCs with $5.0 million in assets and SEC- and state-registered investment advisers, exempt reporting advisers and rural business investment companies (RBICs); and,
- Family offices with assets in excess of $5.0 million and their clients.
Additionally, “spousal equivalents” is added to the accredited investor definition, allowing spousal equivalents to pool their assets for purposes of meeting the net worth threshold.
Will Wealth Managers Need to Vet Private Equity Investments?
For most RIAs, the new guidance probably won’t change much. Under the new definition, RIAs themselves are now considered accredited investors, but RIA clients are not likely to be affected. Notably, although it was considered, the SEC did not expand the definition to include discretionary clients of fiduciary investment advisors.
For most RIAs, the new guidance probably won’t change much.
Since discretionary clients are not automatically accredited investors, the impact on RIA clients is limited to those individuals with the applicable professional certifications or who are “knowledgeable employees” of the issuer who were not already accredited investors under the old rule. The SEC estimates that just over 700,000 individuals hold the professional certifications listed above. Of these, many would have already qualified as accredited investors under the old wealth and income standard. For most RIAs who work predominately with high net worth (HNW) and ultra-HNW clients (who were already accredited investors), the incremental number of clients who now meet the accredited investor definition is likely to be quite small.
For those that are newly-minted accredited investors, there is still the question of whether the types of private investments available to accredited investors would be an appropriate portfolio addition. Financial sophistication and the ability to understand the investment opportunity are just one part of the equation. Private investments often have long expected holding periods, low liquidity, and relatively high probability of permanent capital loss. While these features are often accompanied by higher expected returns, the high risk and low liquidity often make these investments inappropriate for investors who don’t have the capital base to endure substantial losses.
Also, despite the SEC now allowing it, there is still the practical limitation of investment minimums and sourcing investment opportunities that will likely limit the ability of those newly endowed with accredited investor status to participate in private offerings. For now, the impact of the rule on capital formation is likely to be quite small, although the SEC has indicated the potential for continued expansion of the definition into the rank and file of retail investors.