Kitces: Fixing the accredited investor rule

SEC Commissioner Jay Clayton recently floated several ideas to ease the so-called accredited investor rules in what is ostensibly an effort to increase consumer access to investment opportunities. With a growing number of firms, like Uber and Airbnb, choosing to forego big IPOs, Main Street investors simply don't have access to investments in high-profile, private companies.

However, there's a significant amount of risk and opacity lurking in the world of unregistered securities. There aren’t many reporting requirements, and consequently it can be difficult to figure out whether it’s a legitimate business opportunity or just a money drain. The SEC needs a way to ensure clients can access private companies, but do so in the safest way possible.

The caveat, of course, is that all these additional layers of regulation that protect consumers come at a cost. Many midsize businesses — and especially small businesses and startups — can’t realistically afford the time and cost to go through all that vetting. Rather, they need a simpler, more direct way to raise capital from outside investors, without regulators overseeing the process. So instead of imposing greater regulations on small businesses themselves trying to raise capital — which could increase the costs enough that the businesses get cut off from capital — the SEC instead created the accredited investor rules.

Th rule stated that companies can sell unregistered, unregulated securities to accredited investors, who were deemed accredited by either an income threshold — earning $200,000 a year as an individual or $300,000 as a spouse for each of the prior two years and the current year, or have a net worth of $1 million outside of their primary residence.

SEC jay clayton IAG
SEC chairman Jay Clayton wants to open up private markets to a wider range of investors.

These thresholds are predicated on the recognition that in order to absorb the greater risk of fraud, or at least of being misled about a not very sound business, you need to have enough money to be able to withstand a potentially great loss. The presumption here is that you as an investor are sophisticated enough thanks to your presumed experience in accumulating wealth, which has taught you to vet opportunities and sniff out the bunk. Or you at least have the wherewithal to hire someone to help you sniff out the bunk.

The whole problem with private unregistered securities is that they offer very limited information. There aren’t many reporting requirements, and consequently it may be difficult to vet a deal and figure out whether there’s a legitimate business opportunity or just a money drain.

That’s saying nothing of the fact that small businesses take a long time to scale, so private investments may often tie up dollars for many years in highly illiquid stock and bond holdings. This means that even if the business is run well, the money may not be accessible for a long time. That illiquidity is, unfortunately, another reason why unscrupulous managers may be driven to do something improper while investors have no way to get their money out.

So for startups and small businesses, the appeal of the accredited investor rules is that while they limit the potential pool of participating investors, they give businesses a way to raise capital and save on some really material or impossible costs that would be incurred by going the more traditional, more regulated routes. In other words, it lowers the hard cost of raising capital for small businesses, which is important for supporting entrepreneurship and new business formation.

Notwithstanding the risks of investing money in small companies that are opaque and illiquid, the upshot is that their strategic investments can also provide greater potential returns. Indeed, a small startup can experience substantial and sometimes exponential growth, so the benefit of taking that risk is the potential for an outsize reward.

Along the way, the accredited investor rules seem to have shifted from ensuring the financial wherewithal and acumen of the potential investor (or the investor’s advisors) to, “Here are super-secret investments that are only available to rich, sophisticated investors.”

And an outgrowth of that problem is that — even among our clients — people who may have significant wealth may not actually have the sophistication to vet the opaque deals they’re investing in.

A good case in point is just the entire explosive rise of the hedge fund industry over the past 15 years. These funds market themselves as having access to the best and most exclusive investment opportunities and strategies, things that are only available to accredited investors. In reality of course, over the past five years the HFR hedge fund index has generated less than half the annualized return of an S&P 500 index fund.

And it was just last year that Warren Buffett was finally declared the winner of his 10-year wager from back in 2007 that the S&P 500 would beat any group of hedge funds that any investor wanted to select. Despite the bet having started in 2007, right at the market’s peak and within a year of the financial crisis, ultimately the S&P 500 returned 7.1% per year over the decade. Meanwhile, hand-picked hedge funds returned 2.2%, a third of the return and a more than cumulative 50% difference in growth over a decade.

The point here is not to pick on hedge funds, but to emphasize that a subset of affluent investors got taken in by individuals who sold exclusivity and then completely failed to deliver the results. That’s not to say the accredited investor rules are meant to limit everyone’s access to good returns. Rather, they’re meant to limit most people’s access to lose money they can ill afford to lose.

So at this point I think the SEC is on the right track because I’m not sure the rules are really serving their intended purpose anymore. Instead, they have morphed into a sort of velvet rope, where certain affluent investors seem comfortable foregoing due diligence under the tacit assumption that if they’ve been admitted to this accredited investor club, everything behind the rope must be worthy of their capital.

And for me, the reason we’ve hit this failing point is that the SEC tried to accomplish two things at once.

The first was to set a threshold where investors would have sufficient wherewithal to afford to take losses on risky investments. The second was to set an expectation that someone was presumed to either be sophisticated enough to vet the investments or at least have the ability to hire someone to vet them on their behalf. In practice the rules lagged on the first part, and have not been well-suited to the second task.

The SEC itself has observed that back in the early 1980s, when the rules were originally put in place, fewer than 2% of households qualified. Now almost 10% of households meet the required thresholds. So in a world where limiting these investments to people who could afford to lose the money was the goal, the rules are not actually as limiting as they once were. Today, the safe withdrawal rate on $1 million for a married couple doesn’t even get you to the median household income of a retiree. It’s not money you can afford to lose.

And where satisfying the accredited investor rules was supposed to be some kind of proxy for an individual’s financial sophistication, wealth and income — as any advisor should know — are terrible proxies for financial sophistication. Ironically, the implicit message of the rules — i.e., “special investment opportunities only available to the sophisticated wealthy” — encourages people to think of themselves as sophisticated and throw their money at it, instead of looking at it with a skeptical eye.

ROOM FOR IMPROVEMENT
The first step toward improving this situation is to raise the accredited investor threshold. Frankly, $500,000 of income or $5 million in net worth would be more appropriate because again, this requirement is not about preserving great investment opportunities solely for the wealthy, but rather limiting bad investment opportunities that are too opaque to even be spotted as such to only the people who can afford to lose money.

The second step involves renouncing the idea that wealth and income are useful proxies for financial sophistication. Instead, the SEC should create a questionnaire to affirm that the investor actually understands the risks involved. Barring that, the investor needs to possess some kind of training, education, degree, designation or background or they need to engage a fiduciary advisor. Note that this person would not be the sales agent of the investment, but rather a bona fide third-party advisor, who can dispassionately evaluate and vet the deal.

Then and only then should those who want to invest be able to do so accordingly, with full cognizance of the risk and either the true sophistication to evaluate the deals or the wherewithal to hire someone else to do it.

In the meantime, perhaps the SEC can also revisit the challenges of Sarbanes-Oxley that I think made it so expensive for companies to IPO in the capital markets that it’s amplifying the problem. Ironically, it was done to help protect against fraud and misleading financial statements in the wake of the Enron scandal and others like it. But in practice, it’s meant that more and more companies are staying private, which is amplifying the pressure on this distinction between public market investments and the private ones only accessible to accredited investors.

That’s not just an accredited investor problem, but a regulator problem. Unwittingly making it unappealing for companies to IPO in public markets has carried a real cost — as evidenced by the number of publicly traded corporations having dropped by nearly 50% in the past 20 years.

All these factors suggest that it’s time to re-evaluate and realign the accredited investor rules to these goals: raising the bar on what it means to be able to afford to lose money, and re-evaluating what it means to be a sophisticated investor.

This article originally appeared on Kitces.com.
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