OT but interesting: Potential new requirements for "accredited investors"
Via John Maudlin's e-mail newsletter (which is interesting, worth subscribing to)
The Securities and Exchange Commission (SEC) has posted a new proposed rule that would raise the minimum net-worth requirement needed to invest in private funds from $1,000,000 total net worth to $2.5 million liquid net worth. This is a major change, and it means that some 7% of American households will no longer be able to invest in private offerings. In my opinion, it is likely to become law in the not too distant future unless there is significant public comment. This week we look at the proposed rule and some of its consequences, as well as a very interesting proposal by SEC commissioner Roel Campos.
Let's start with some background. The current definition of an accredited investor was adopted in 1982 and was set at $1,000,000 total net worth, including your home and other assets. At the time, according to the SEC, some 1.87% of all US households were qualified to invest in hedge funds and other private equity offerings. Due to inflation and the growth in all sorts of assets, including homes, today about 8.5% of US households are eligible. The original rule was proposed to keep supposedly unsophisticated investors from getting involved in investments like hedge funds, which were considered riskier than mutual funds.
If the original amount were adjusted for inflation, the net-worth requirement today would be $1.9 million. The SEC proposes to raise that limit to $2.5 million in investment assets, so your home or primary business real estate would not be included in the $2.5 million. This would reduce the number of investors eligible to invest in hedge funds by about 88%, or to just 1.29% of American households. Since they are proposing that the amount be adjusted for inflation every five years starting April 1, 2012, that would suggest to me they are considering adopting the proposal as early as April of this year, although there is no way to be certain, as comments could alter the proposals.
The SEC is asking for comments as to whether the proposed changes in the net-worth requirement are too much or too little, and more interesting, whether net worth alone should be considered. I will put a link to the proposed rule changes and explain how you can make comments if you should desire to do so, later in this column. But first, let's look at some of the practical and philosophical implications of the proposed rule, and why you should care about this no matter what your net worth is.
First, the SEC is being consistent with the mandate they have from Congress. Congress long ago established rules on private offerings, and among them is the requirement that private offerings such as hedge funds are only offered to sophisticated investors who are capable of understanding the risks and have the financial capacity to withstand potentially significant losses.
Since there is no test you can take to prove sophistication, a net-worth requirement was established under the presumption that someone with sufficient capital was either sophisticated or would have advisors who were capable of doing the proper due diligence on any such offering.
Given that $1,000,000 isn't what it used to be 25 years ago, if you agree that private offerings of unregistered funds should be subject to some level of investor sophistication, then it makes a certain level of sense to raise the bar.
It may surprise readers to know that on a practical level I agree with the thinking that it requires a certain level of sophistication to invest in unregistered private offerings. This is the field I work in, and I can confirm that hedge funds are not for unsophisticated investors. They can be quite complex and involve different sets of risks than other types of investments. There are many reasons for the following risk statement that accompanies nearly all hedge fund offerings:
"When considering alternative investments, including hedge funds, you should consider various risks including the fact that some products: often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees, and in many cases the underlying investments are not transparent and are known only to the investment manager."
I also think it is philosophically wrong to limit the choices of investors based simply upon assets. The rich have advantage enough without limiting the choices of those with less assets. But before we get into that, let's look at some practical implications.
First, the rules are such that private offerings are limited to 99 investors with a net worth of $1,000,000 or more. If a fund agrees to only take investors with a net worth of $5,000,000, then they can have up to 499 investors.
But let's deal with a fund that can take investors with $1,000,000 net worth. Let's assume an investor has $2,000,000. Even if they were willing to invest $250,000, that would be a significant percentage of their assets in one fund. If an investor was worth $1,000,000 including his house, that would be a prohibitively high proportion of his net worth.
If a fund accepted 99 investors for just $250,000 apiece, that would mean the fund would only have $25,000,000, which quite frankly would be a small fund. And while some start-up funds may take smaller amounts, in the long run if the fund becomes successful, the minimum investment they require begins to increase beyond the practical ability (in terms of reasonable diversification) of investors with less than $2.5 million, in any event.
There are some exceptions. As an example, commodity funds, because they are regulated by the CFTC and NFA, can have an unlimited number of accredited investors. There are some hedge funds that will take a limited number of smaller investors, but frankly not many. So, for all practical purposes, raising the limit does not have that much of an affect on the opportunities for most investors, as there are sadly not enough opportunities available under the current rules.
(As an aside, under the proposed rules, it is not clear whether the SEC intends for this rule to apply to commodity funds. While commodity funds are offered as private funds, there are differences in the rules they follow. This is a topic that should be specifically addressed in the final rules.)
I should note that in England there are no real net-worth requirements for investing in hedge funds. Investment advisors are required to determine the sophistication and suitability of potential investors regardless of net worth. And Europe is slowly moving to open up hedge funds to investors within a regulatory framework.
Also, the SEC proposal specifically exempts private equity funds, as they provide a great deal of the funding for new business in the US. I would also note that, in my opinion, equity funds are in general more volatile and harder to understand than most hedge funds. But the commission is right that private equity funds are important for American business.
AI
