If you want to buy a publicly-traded stock, there isn’t much to get in your way. You pretty much need to open a brokerage account and have access to the necessary funds.
The same is not true of many alternative investments. For a number of reasons, many individuals have been all but excluded from investing in particular asset classes, most notably hedge funds, private equity, and venture capital.
The Historical Rules and their Rationale
As one law firm points out, to be an accredited individual investor in the U.S., a person historically had had to have a net worth of $1 million or more, excluding the value of their primary residence. Alternatively, they had to have an annual income of at least $200,000 (or $300,000 for a couple) in the prior two years. Naturally, this has meant that tens of millions of people were all but barred from investing in certain funds.
The reasoning behind these rules has been fairly simple: Alternatives have been thought to be riskier investments, and regulators have been keen to protect individuals who cannot afford to lose much of their principal. Bodies such as the Securities and Exchange Commission have also perhaps tended to associate a certain level of wealth with a sufficient degree of investment knowledge and sophistication.
The reverse has also been true: the SEC and others have basically assumed that if someone doesn’t have at least $1 million in liquid net worth or the necessary income, they aren’t financially sophisticated enough to be putting money into alternatives.
In sum, the rules about accredited investors have been aimed at protecting much of the public from itself.
Other Tiers of Accreditation
In addition to the above, there are two other tiers of accreditation that come into play with alternative investments: Qualified Purchasers and Qualified Clients.
Qualified Purchasers are usually those with at least $5 million in investments. Assuming that a fund’s securities are only owned by such individuals, it can avoid being deemed an “Investment Company” under the applicable 1940 Act.
Qualified Clients are those who may be charged performance fees (which is common in alternative investments). Per Venable LLP, a Qualified Client is any one of the following:
(i) an individual or a company that, after contracting with the fund, has at least $1 million under the management of the investment adviser,
(ii) an individual or company that the manager reasonably believes, immediately after contracting with the fund, has a net worth greater than $2 million (jointly with a spouse if an individual), excluding the value of the individual’s primary residence and any indebtedness thereto, or
(iii) an individual or company that the adviser reasonably believes is a qualified purchaser
Self-Certification vs. Verification (506b vs 506c)
Alternative investment fund managers and platforms, as we detail in another post, typically take advantage of one of two possible exemptions from having to register their securities with the SEC: 506b and 506c of Regulation D. These provisions allow them to raise an unlimited money of money via private placements, so long as (generally) the investors are all accredited. (A 506b offering can have up to 35 non-accredited investors.)
There are important differences, though, in how the certification process works, depending on whether a fund advisor/platform chooses the either the 506b or 506c exemption. Manatt, Phelps and Phillips, LLP explains that:
…the biggest advantage of a 506(b) offering is that a startup may rely on potential investors’ self-certification as accredited investors, which is generally done using a questionnaire provided by the startup. Under a 506(b) offering, startups do not have to implement a costly and time-consuming process to verify the accredited investor status for each prospective investor. This removes a significant burden from the fundraising process.
By contrast, a 506c offering cannot rely on self-certification. Indeed, it is much more intensive and places a burden on the offeror to reasonably establish that an individual is indeed an accredited investor. Aronoff, Rosen and Hunt, LPA, cites SEC rules which mandate that the certification process under 506c involves:
….reviewing specified documentation evidencing the purchaser’s assets and liabilities dated within the prior three months and obtaining a written purchaser representation that all liabilities necessary to make a determination of net worth have been disclosed.
The firm suggests the following (though not exhaustive) should be part of the verification procedures for alternative investment managers:
- Individual (or joint) income tax return for the previous three years
- Personal (or joint) financial statement
- Disclosure of present business holdings
- Signed Purchaser Representation Statement that the purchaser believes they qualify as an accredited investor
It’s crucial to underscore a key trade-off when comparing 506b and 506c offerings. 506b private placements require that a pre-existing relationship exists, either between a potential investor and the issuer, or the potential investor and a broker-dealer/investment adviser. It’s this pre-existing relationship that basically allows for a much easier certification process. But because 506c offerings can be advertised to the public via general solicitation, the regulators have imposed the onus on the issuer to all but prove that a potential investor really does meet the accreditation standards.
Recent Changes to SEC Rules Regarding Accredited Investors
In August 2020, the Securities and Exchange Commission expanded its definition of what constitutes an accredited investor. These changes, as Skadden, Arps explains, “will allow more investors to participate in private offerings by adding new categories of individuals who may qualify as accredited investors based on their professional knowledge, experience or certifications.”
In other words, while some people may not make enough money or have the requisite net worth to qualify under the old standard, there is a recognition by the regulator that these individuals have enough sophistication to be able to understand the nature of alternative investments and the potential risks they may pose.
Who Qualifies Under the New Regulations?
So, who can now be considered an accredited investor, even if they don’t meet the financial test? For one thing, Skadden, Arps notes that those in the financial industry who hold Series 7 (Licensed General Securities Representative), Series 65 (Licensed Investment Adviser Representative), and Series 82 (Licensed Private Securities Offerings Representative) licenses qualify, so long as they are in good standing.
Another group that can know count as accredited investors are so-called “knowledgeable employees” of private funds, such as hedge funds and private equity firms. These include:
- executive officers, directors, trustees, general partners, advisory board members or affiliated persons of the fund who oversee the fund’s investments
- key employees or affiliated persons of the fund (other than employees performing solely clerical, secretarial or administrative functions) who, in connection with the employees’ regular functions or duties, have participated in the investment activities of such private fund for at least 12 months.
The Bottom Line for Investors and Fund Managers
While the SEC hasn’t fully democratized alternative investing, they have improved access to private fund offerings with this expanded definition of an accredited investor. Whereas income and wealth were previously the litmus test, knowledge and sophistication have now entered the equation. For fund managers, this means a greater pool of potential investors. For some individuals, meanwhile, the new rules offer new opportunities for investing in alternatives. And though the documentation involved can be a bit of a pain, the fact that the SEC has increased access to this asset class is a big plus.
PitchBoard is perfectly placed to use the modernized rules to connect emerging fund managers with individuals who can now be considered accredited investors. Read more about our mission here (link to About Page). We leverage your status as an accredited investor to give you exposure to investments that are not available to the general public—and that have previously been the near-exclusive domain of institutions and those with the highest levels of wealth.
