The Securities and Exchange Commission (SEC) recently voted to propose amendments to the definition of accredited investor. This important standard is used to determine who is eligible to participate in private investment opportunities such as investments in private companies and offerings by certain investment funds, including hedge funds, private equity funds, real estate funds, and venture capital funds. The proposed amendments would expand the number of individuals that qualify by adding categories of eligibility based on professional knowledge, experience, or certifications. The proposal would also expand the types of entities that qualify.
If adopted, these amendments would bring meaningful changes to private markets, including private placements in commercial real estate. In this post, I’ll explore the accredited investor definition and share some views on how technology is playing a key role in the evolution of private markets and how they are regulated.
Public versus private offerings: A quick primer
To understand the role of accredited investors, it’s helpful to start with the concept of registration exemption. The Securities Act of 1933 requires that every securities offering be registered with the SEC unless an exemption is available. Registration—which makes an offering “public”—is meant to provide investors with full and fair disclosure of important information so that they can make informed decisions. In certain situations, however, registration isn’t practical or offers only remote benefits to investors, so the Securities Act contains a number of exemptions to its registration requirements. These “exempt” offerings make up the “private” markets.
Each exemption specifies a variety of requirements, investor protections and other conditions. Some offerings are exempt if they restrict sales to certain “accredited” investors. In these cases, the protections of the registration process are seen as unnecessary because accredited investors are presumed to have sufficient financial sophistication and ability to sustain the risk of loss of their investment. Today, a person’s accredited investor eligibility is based on a binary pass-fail test of income or net worth. (We cover the current definition in more detail below.)
A large amount of capital is raised in exempt markets—even more than in registered markets. In 2018, registered offerings accounted for $1.4 trillion of new capital compared to approximately $2.9 trillion raised through exempt offerings. And this is an enduring trend: Over the period 2009-2018, exempt offerings have accounted for significantly larger amounts of new capital versus registered offerings.
Why accredited investor eligibility matters
Of the massive amount of money raised in private markets, a significant portion is available only to accredited investors through Rules 506(b) and 506(c) of Regulation D. In 2018, an estimated $1.7 trillion was raised under the two rules—more than was raised via registered offerings. As such, investors who don’t meet accredited eligibility are shut out of a meaningful swath of investment opportunities. Furthermore, the popularity of exempt offerings means the proposed changes to the definition of accredited investor are more than just regulatory wordsmithing; they stand to impact a significant portion of our country’s capital markets.
SEC Chairman Jay Clayton addressed the importance, noting that many people who don’t meet the income or net worth requirements of the current accredited investor definition nonetheless have the knowledge and financial sophistication to participate in private markets. They also miss out on opportunities to invest in startups that turn into multibillion-dollar companies after an initial public offering.
Accredited investor definition: Then and now
The current definition of accredited investor has been in place without any significant update for decades. Under today’s definition, a person is an accredited investor if:
- Their income exceeds $200,000 in each of the two most recent years (or $300,000 in joint income with a person’s spouse) and they reasonably expect to reach the same income level in the current year;
- Their net worth exceeds $1 million (individually or jointly with a spouse), excluding the value of their primary residence.
In addition, directors, executive officers, and general partners of the issuer selling the securities are accredited investors for the purposes of that issuer. The SEC estimates that 16 million US households (13%) qualify under existing accredited investor criteria. Certain entities with more than $5 million in assets also qualify as accredited investors, while others, including regulated entities such as banks and registered investment companies, are not subject to the assets test.
The proposed amendments would:
- Add new categories that would permit people to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution;
- With respect to investments in a private fund, add a new category based on the person’s status as a “knowledgeable employee” of the fund;
- Add limited liability companies that meet certain conditions, registered investment advisers and rural business investment companies (RBICs) to the current list of entities that may qualify as accredited investors;
- Add a new category for any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
- Add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and
- Add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
How technology is playing a key role in the evolution of private markets and how they are regulated
Most private offerings in the commercial real estate space are exempt under Rule 506(b) or 506(c), making accredited investors key participants in private commercial real estate capital markets. At Cadre, for example, our offerings are made via Rule 506(b).
In our view, the proposed expansions to the accredited investor definition are sensible and represent a positive development, primarily because private markets have evolved from the time the definition was first created. In fact, if the definition was being written for the first time today, we’re confident that it would look more similar to the new proposal than the current definition.
I believe that the evolution of private markets and the associated modernization of the accredited investor definition are closely tied to technology advances, in four specific ways:
- Technology has enabled web-based investment platforms, such that the lines between private placements and public investments are becoming blurred. Individuals are increasingly leveraging these platforms to access differentiated investment opportunities that were previously inaccessible.
- Technology allows private placement offerings to be made at much lower minimum investment thresholds than in the past. At Cadre, for example, we’ve eliminated almost all manual steps from our investor onboarding process, empowering us to scale with a larger group of small investors. This sort of scaling follows a trend we’ve seen in many areas of life, notably political campaign financing, where President Obama perfected the now widely used concept of gathering millions of small donations to add up to a huge war chest. So, the idea that we need to protect individuals from investing a huge part of their assets is a fallacy.
- Technology brings improved transparency and diversification to the private market. With tech-enabled offerings, individual investors have access to a ton of information—they aren’t just relying on a broker telling them whether a deal is good or not. They can judge opportunities for themselves in a very clear way. Plus, they can take advantage of algorithms to determine ideal portfolio construction and manage investments directly online.
- Technology enables secondary markets—like the one we’ve created—which allow investors to seek liquidity for private placements. As these markets grow and liquidity becomes more assured, private placements are positioned to become even more like public markets in that individuals can trade in and out of positions.
Ultimately, I believe the SEC is looking at the landscape of tech-enabled private offerings, now available with all of these enhancements and protections, and determining that more people should have the ability to access these investment opportunities.
The proposal was posted to the Federal Register on January 15th, which opened a 60-day comment period. We’ll continue to monitor relevant developments and keep our stakeholder community updated. To become an investor on our platform, please request access.