In the world of finance, there is an SEC guideline called the “Accredited Investor” rule that limits the public’s ability to invest in unregistered securities unless the individual meets certain income and/or net worth standards. Or stated more simply, the SEC limits those riskier private investments to more affluent – and presumably more “sophisticated” – investors.
Recently, there has been repeated discussion from the SEC about whether it’s time to update all the income and net worth thresholds of what constitutes an accredited investor. Last month SEC Commissioner Clayton raised the question of whether the rules should be eased further to allow more investors to access today’s high-profile private deals like Uber and Airbnb.
But to understand whether the accredited investor rules need to change, we should look at why they exist in the first place.
Start with the basic principle of capital formation—that businesses must connect with investors who have capital available to invest, and then the businesses can either borrow money from the investor (which we know as issuing a bond), or they can take money in exchange for giving the investor a portion of the business (which we know as “equity,” or raising capital by issuing shares).
For companies that want to do a large issuance of bonds or stocks in the public markets, we have a lot of rules and regulations to make sure that those companies aren’t fraudulent. One of the core roles of the SEC is to regulate capital markets and ensure that while not every stock and bond will work out in the end, they are all at least legitimate stock and bond issuances from bona fide operating businesses.
All these additional layers of regulation and oversight have a cost, though; enough that a lot of midsize businesses can’t realistically afford the time and cost to go through all that regulatory vetting. They need a simpler, more direct way to raise capital, with the caveat that if regulators don’t oversee the process (to reduce the cost), there’s also a greater risk of fraud, either people raising capital when the business isn’t real, or being misleading about the business’s health and growth prospects to get capital, when realistically it’s not a good investment.
So rather than impose greater regulations on small businesses trying to raise capital, effectively eliminating access to outside capital, the SEC instead created the accredited investor rules. These rules state that companies can sell these unregistered, unregulated securities to accredited investors, who are:
Deemed accredited by earning $200,000 a year as an individual or $300,000 as a couple for each of the prior 2 years and the current year,
They have a net worth of $1 million outside of the primary residence.
The (Ideal) Purpose Of Accredited Investor Rules
The primary reason these rules exist is to guard against the greater risk of fraud, or at least being misled, about investing in a flawed business. If you’re going to make such a risky investment, you need to have enough money to be able to afford to lose a chunk of it to that risky investment.
The second is that, given these restrictions, you would presumably either be “sophisticated” enough—thanks to your investment experience in accumulating wealth—that you could effectively vet these opportunities, or at least be able to hire someone to help you vet them.
The whole problem with private unregistered securities is that there’s very limited information. There aren’t (m)any reporting requirements, and so it may be hard to vet a deal and figure out whether it’s really legitimate, or outright fraudulent. Additionally, building a business takes time, which means the investment is relatively illiquid for a significant period, and typically can’t be readily sold to others, either.
Along with the additional risks of investing your money into companies that are opaque and illiquid, there’s also a greater risk of fraud and mismanagement or misleading advertising about the company’s potential.
The upshot for investors of all these concerns is that at least such investments can also provide greater return potential. After all, at the most basic level, it’s difficult for a publicly traded company to grow all that much when it’s already huge and has most of the marketplace, but a small startup can experience substantial and sometimes exponential growth, so the benefit of taking that risk is the potential for the bigger reward.
Accredited Investor Rules Have Gone Wrong
But here’s the problem: At some point, the accredited investor rules seem to have shifted from “You need to have the financial wherewithal because these are really risky illiquid investments, and you need the economic muscle to recover from the loss,” to “you need the insight to vet these investments in the first place.”
The accredited investor rules were supposed to ensure you could meet this financial wherewithal requirement, and the sophistication or vetting requirement. Today, however, the approach is more along the lines of “Here are super-secret investments, the best investment opportunities only available to rich, sophisticated investors. Don’t you want in!?”
It seems that in part, the problem has evolved because the media glamorizes the few mega-deals like Uber and Airbnb, and fails to report that 99.9% of private deals don’t turn out well. There’s a huge swath of them that lose everything, all their investors’ capital. But we only see the visible wins, and nobody talks about all the losers and failures. In essence, a big part of the problem today is that the accredited investor rules have been turned into an exclusive club that actually appeals to people who have maybe significant wealth and meet the accredited investor income or net worth requirements, but do not actually have the time, knowledge, or inclination to vet opaque deals that they’re investing in.
I think a good case point example is the rise of the hedge fund industry over the past 15 years. Those funds present themselves as having access to the best and most exclusive investment opportunities, using strategies only available to those who are accredited investors… when in reality, over the past 5 years, the HFR hedge fund index has generated less than half the annualized return of an S&P 500 index fund.
And it was just last year that Warren Buffett was finally declared the winner of his 10-year bet from 2007 that the S&P 500 would beat any group of hedge funds that any investor wanted to select. Despite the fact that that bet started in 2007, right before it got clobbered by the financial crisis, ultimately the S&P 500 returned 7.1% a year over the decade, and the hand-picked hedge funds returned 2.2%, a third of the return and a more than cumulative 50% difference in growth over a decade.
I think the SEC is right to review the accredited investor rules, because I’m not sure they’re serving their intended purpose anymore. Rather than having unregistered securities get sold to accredited investors, who use their capital and knowledge to vet these risky or opaque deals, the rules have gotten twisted into an exclusivity club, where certain affluent investors seem to actually be doing dangerously less due diligence, because they can afford to get into the accredited investor club without realizing it’s a risk and not a privilege. By gaining access to investment vehicles like private hedge funds, investors feel it’s a good opportunity because they perceive other (affluent) people like them doing it as well, implying a safety in numbers that really isn’t there.
Ultimately, the reason we’ve hit this failing point seems to be that the SEC tried to accomplish two things at once with its accredited investor requirements. The first was to set a threshold where investors would have enough financial wherewithal to afford to take the losses on risky investments. The second was to set a threshold where because someone had enough financial wherewithal, they were presumed to be sophisticated enough to vet the investments. The problem is that ironically, the rules always lagged on the first part about withstanding the losses, and it’s not well-suited to task on the second part, either.
Back in the early 1980s when the accredited investor rules were originally put in place, fewer than 2% of households could qualify. Today, almost 10% meet the required thresholds. $1 million just doesn’t go as far as it once did. In 1982, that was a lot of money, with room to risk and lose some. Today, the safe withdrawal rate on $1 million for a married couple doesn’t even get you to the median household income of a retiree. It’s not money most can afford to lose.
In the meantime, on the second part, wealth and income alone are a terrible proxy for financial sophistication. The way the accredited investor rules now seem to be marketed by solicitors in some circles, again, it’s not viewed as a higher tier of risk to do the extra due diligence on, it’s communicated as, “Special investment opportunities only available to the sophisticated wealthy.” This encourages people to think of themselves as sophisticated, throwing their money at it instead of looking at it with an extra skeptical eye.
Improving Rules To Protect Investors
So how can this be improved? There are a few steps. The first is that I actually do think the accredited investor threshold should be raised. A threshold of half a million of income, or $5 million of net worth, is more appropriate. The Rule is not about limiting great investment opportunities to the wealthy, it’s about limiting a high volume of bad investment opportunities to the people who can afford to lose the money.
The second change, though, is that it’s time to stop pretending that wealth and income are useful proxy for financial sophistication and who does (or doesn’t) have the time, knowledge, and inclination to really vet the deal. Instead, I’d advocate that the SEC needs to create some kind of investor questionnaire, to affirm that the investor actually understands the risks, has some kind of training, education, a degree, a designation, a background in it… or they need to engage a fiduciary financial advisor to evaluate and vet the deal on their behalf (representing the client, not the firm selling its investment opportunity).
This would allow the investor to demonstrate they’re sophisticated enough to evaluate a risky deal, or they can hire an advisor to help, since they should have a financial wherewithal at a half a million of income or $5 million of investable assets. To shift the perception from, “Congratulations, you’re accredited investor, here’s a super special secret investment opportunity that no one else gets,” to “Congratulations, you’re an accredited investor, now you can incur extra costs in time or dollars to consider whether to take the investment risk that comes with these opaque investments.”
Perhaps if someone can demonstrate that they personally are a sophisticated investor, the income and investment limits could be lowered. There’s nothing wrong with letting someone take a lot of risk… as long as they’re truly investing with eyes wide open to the risk that they’re taking.
In the meantime, perhaps the SEC can also revisit the challenges of Sarbanes-Oxley that made it so expensive for companies to IPO in the capital markets that it’s amplifying the problem. Ironically, it was done to help protect against fraud and misleading financial statements after companies like Enron in the late ’90s. But in practice, it’s meant that more and more companies are staying private, which is amplifying the distinction between public market investments available to all investors and a growing volume of lucrative private ones only accessible to accredited investors.
The bottom line is simply that the purpose of accredited investor rules is not to give more affluent or sophisticated investors better investment opportunities than everyone else gets. It’s to allow more affluent investors who ostensibly have investing experience and are more sophisticated to be able to sniff out the high volume of nonsense that comes with private investing. And at worst, if those accredited investors fail to spot the nonsense, at least they have the room to absorb the financial consequences for failing to do so.
So it’s probably time to re-evaluate and realign the accredited investor rules to these goals: raising the bar on what it means to be able to afford to lose the money, and re-evaluating what it really means to be a sophisticated investor with the requisite ability to find the few good private investments amongst a lot of bad ones.