Accredited 2.5

Those private investment firms that rely on the marginally wealthy for investment capital may be in for some hard times if a proposed US Securities and Exchange Commission rule goes into effect.
In December, the SEC, as long expected, proposed a rule change to the criteria for how accredited investors get involved in private investment vehicles. The proposed change would, among other things, add an additional requirement of $2.5 million for a “natural person’s” portfolio of investments needed for such an investor to be deemed “accredited,” and therefore able to invest in most private investment pools that rely on section 3(c)(1) of the Investment Company Act of 1940. The current definition of accredited investor is $1 million of net worth, or meeting certain income levels.
“This proposed rule, if enacted in its current form, will limit the scope of who can participate in the private equity and hedge fund space as a passive investor,” notes Michael Wolitzer, a partner in the New York office of law firm Simpson Thacher, and a fund-formation expert.
Wolitzer stresses that increasing the definition of an accredited investor to $2.5 million from $1 million will have little effect on most major private equity firms.
Many of these firms invest from vehicles that only accept “qualified purchasers” as defined by the Act, meaning an investment portfolio of at least $5 million for individuals and $25 million for institutions. As such, a narrower definition of accredited investors would have no effect on these fund managers with respect to thirdparty investors.
The groups that might be most affected are at the lower end of the hedge fund and private equity spectrum—fund managers that manage $50 million to $100 million or less, as well as manage capital from investors with investment assets of less than $2.5 million.
Similarly affected may be managers of funds of funds that cater to high-net-worth individuals. Certain funds of funds managers have long offered the service of placing the capital of moderately wealthy individuals—so-called “millionaires next door”—into private equity funds that require high minimum commitments. Under current rules, a pooling of less than 100 3(c)(1) investors into a vehicle with a total value of more than $25 million allows non-qualified purchasers to participate in aggregate as a single qualified purchaser in a private equity or hedge fund. A change to the accredited investor wealth threshold would drastically shrink the population of potential clients for these types of fund management services.

Employee benefits
The SEC will accept comments from the financial community on the proposed rule for 60 days, after which a final set of rules will be released. Among the areas of most concern for legal professionals who represent private equity firms
is how the new rules will affect employees—a topic about which the SEC has specifically asked for comments.
According to Wolitzer, there is a “flurry of activity” among legal professionals seeking to clarify what the intentions of the SEC are with regard to employees investing in funds of their employers. As the private equity market has matured, more firms have instituted co-investment programs for employees of all stripes, including those that serve in non-investment positions, such as the back office. The inability of such employees to invest alongside the firm they work for might reshuffle alignment-of-interest structures already in place. The SEC previously adopted a rule that allowed certain investment professionals and executive officers (called “knowledgeable employees”) to be deemed to be qualified purchasers.
“Let’s just say there are some people within private equity firms that are allowed to invest now who would be unable to invest under the proposed rules,” says Wolitzer. For years the SEC has pondered ways of better protecting individual investors against hedge fund fraud. The SEC’s reasoning in raising accredited investor wealth requirements is that $1 million is no longer a level of wealth likely to imbue investors with sophistication sufficient to avoid fraudulent fund managers. It remains to be seen how the SEC will define “hedge funds and other pooled investment vehicles” for this proposed amendment. Interestingly, venture capital funds are exempt from the SEC’s accredited investor proposals.