After private fund managers were given the right to mass-market their funds over the public airwaves (known as general solicitation), there’s been an interesting debate about who exactly should be allowed to answer their call. It's an important debate, too. At a time when GPs are keen to find new sources of capital, this may give them a channel to reach new LPs – but it depends on how this plays out.
As compliance officers are aware, US federal laws only allows persons deemed “accredited” to invest in most private-securities offerings. Right now, someone earns accredited status if his or her net worth exceeds $1 million (excluding their home), or if their income is $200,000 or more. The idea is pretty simple: only people rich enough should be investing in something risky like private equity or real estate.
And it’s that investor protection angle that keeps arising when people discuss reforming the accredited investor definition – which the Dodd-Frank law now requires the SEC to review every four years, beginning this very year. But when you talk to people inside the industry, many are quick to say that focusing the conversation on risk is somewhat missing the mark. The market for private offerings, they correctly point out, has a wide spectrum of risk, just as the market for public offerings does. The real point of the financial thresholds in the accredited investor standard is to account for something else: the loss of liquidity.
Investors in the public markets have the privilege of being able to sell their investment at any time. But private placements can tie an investor’s cash up for years; often times it's more than a decade before a gain or loss can be realized. Setting a simple test around an investor’s net worth, then, is a smart way to exclude people who shouldn’t be locking their money up in long-term investments.
However, it’s the risk angle that a SEC advisory panel explicitly considered first and foremost when laying out some suggestions earlier this month as to how the accredited investor standard could be upgraded.
Now some of the suggestions make complete sense regardless of whether risk or liquidity is the chief concern. For instance, the committee said the SEC should consider a definition of 'sophisticated investor' that takes into account an individual’s education or professional credentials. Doing so allows, say, junior industry professionals (who make under $200,000 a year) to back funds in a market they clearly understand inside and out.
But in other areas, the investor protection objective makes less sense if one ignores the (more appropriate) liquidity argument. More specifically, one idea being kicked around is to exclude retirement assets from the $1 million net worth standard. In a blog posting, Doug Cornelius says that would be “exactly the wrong thing to do”: his argument is that retirement nest eggs are already relatively illiquid, meaning it’s the perfect kind of capital for long-term private equity or real estate investment.
To its credit, most of the advisory panel’s suggestions don’t run into this problem and are pretty sensible. For example, restricting the percentage of assets that someone could invest in private offerings – instead of setting an arbitrary net worth cut-off point – could lessen the risks for investors without further limiting the pool of accredited investors. Another suggestion of letting individuals take a financial literacy test in order to qualify as an accredited investor seems fair-minded too.
A last point to make is that complicating the definition too much raises compliance concerns. GPs are already confused about what steps need to be taken to verify that someone is in fact accredited. Adding an extra layer of complexity to the equation would only exacerbate that problem.
Fortunately, however, the market is beginning to respond. Already companies like VerInvest are offering GPs services to certify accredited investor status. But the demand for these services will in part depend on general solicitation becoming a viable marketing strategy in the industry. At a time when GPs are on the hunt for new LP partners, let’s hope then that the SEC gets this right.