Private Market Investing Not Just for the Wealthy Anymore?
September 07, 2020
The Securities Exchange Commission expanded the definition of “accredited investor” by adding new categories of investors that have sufficient investment knowledge and expertise to participate in private investment opportunities. The amendments mark a shift away from wealth as the sole focus of eligibility. The new rule is effective 60 days after publication in the Federal Register.
All sales of securities in the U.S. must either be registered with the SEC (expensive, time consuming and triggers ongoing public reporting) or qualify for an exemption. The most common exemption is under Rule 506(b) of Regulation D, which allows an unlimited number of accredited investors and up to 35 non-accredited investors. If all purchasers in a Rule 506(b) offering are accredited investors, however, the issuer need not satisfy the specific, mandated disclosure obligations of Regulation D, which explains why the vast majority of Rule 506 offerings are sold only to accredited investors.
Until now, the rules for determining accredited investor status used wealth as a proxy for financial sophistication. Specifically, individuals needed to satisfy either an income test ($200,000 in each of the last two years or $300,000 jointly with a spouse) or a net worth test ($1 million without including a primary residence). In its rule release, the Commission stated that it doesn’t believe wealth should be the sole means of establishing financial sophistication of an individual for qualification purposes. Rather, it can be demonstrated by the ability to assess an investment opportunity, i.e., the ability to analyze risks and rewards, capacity to allocate investments so as to mitigate or avoid risks of loss or the ability to gain access to information about an issuer or about an investment opportunity.
Amended Accredited Investor Definition
The new definition creates new categories of individuals and entities that qualify as accredited investors irrespective of their wealth, on the basis that such investors have demonstrated the requisite ability to assess an investment opportunity.
The amended definition adds the following natural persons:
- natural persons holding in good standing one or more professional certifications or designations or other credentials from an accredited educational institution that the Commission has designated as qualifying an individual for accredited investor status; and
- natural persons who are “knowledgeable employees” of a private-fund issuer of securities being offered.
In a separate related order, the SEC designated the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), and the Licensed Investment Adviser Representative (Series 65) as the initial certifications, designations or credentials referred to in the first new category above.
For entities, the amended definition adds the following categories:
- SEC- and state-registered investment advisers and rural business investment companies;
- limited liability companies with total assets in excess of $5 million;
- entities not formed for the specific purpose of acquiring the securities offered and owning investments in excess of $5,000,000;
- family offices (i) with assets under management in excess of $5 million, (ii) that are not formed for the specific purpose of acquiring the securities offered, and (iii) whose prospective investment is directed by a person who has such knowledge and experience in financial and business matters that it is capable of evaluating the merits and risks of the prospective investment; and
- family clients of a family office meeting certain requirements.
In a sign of the times, the amendment allows natural persons to include joint income from “spousal equivalents” when calculating joint income, and defines spousal equivalent as a cohabitant occupying a relationship generally equivalent to that of a spouse.
Interestingly, some commenters during the comment period expressed support for geography-specific financial thresholds that scale for geography and would lower the thresholds in states or regions with lower cost of living, noting that income and cost of living tends to be higher in coastal cities. In its rule release, the SEC did acknowledge that geographical income and wealth disparities may lead to concentrations of accredited investors in large coastal cities, but determined not to add geography-specific financial thresholds because of the complexities they would create for issuers and investors. Nevertheless, the SEC believes the new accredited investor criteria would help mitigate the disparate geographic effects of the current wealth-based criteria by including non-wealth-based alternative criteria for natural persons to qualify.
Although the expanded accredited investor definition will certainly increase the number of qualifying individuals, it’s tough to estimate how many people who hold relevant certifications or designations already qualify under the existing income or net worth tests. Consequently, it’s difficult to predict how many newly eligible accredited investors the amended rule will actually create. The SEC itself stated that it expects the number of newly eligible accredited investors to be insignificant relative to the existing number, and that the amount of capital to be invested by newly eligible accredited investors to have only “minimal effects” on the private offering market. Finally, perhaps the shift away from wealth as the sole focus of eligibility will in fact result in a de-concentration of accredited investors away from coastal cities and the major startup hubs of Silicon Valley, New York City and Boston.
1 Rule 506(c) offerings, an alternative to Rule 506(b), require all purchasers to be accredited investors (because the exemption allows the issuer to use means of general solicitation to find investors) and the issuer must use reasonable methods of verification to determine accredited investor status.