Expect a lot of stories to fly under the radar in the coming months, especially here in the US as the mainstream media becomes consumed with social unrest and the presidential election.
Never mind that institutional racism represents a deep protracted problem which require deep changes in social attitudes, police culture and criminal justice reform or that a president is mostly a symbolic figure for the West with little real power beyond one or two domestic policies and foreign policy. Don’t get me wrong, who is in the White House still does matter, but unless the current occupant causes a constitutional crisis by trying to stay after next year or four years after, issues for your money, international trade, investments and macroeconomic policy will remain.
SEC Changes
One of the stories that I had posted about late in 2019 which was confirmed on August 26, was that the SEC was considering changing the definition of what an accredited investor is.
If you don’t know what this status is, let me briefly explain. There is a class of investments that are qualified as “exempt” by the SEC from many of the requirements that a retail bond or equity issuance requires. These are typically called private securities or private markets and are dominated by rich individuals. Private equity, direct real estate deals and investments in artwork are examples of private investments. The difference being in this designation that an issuer can rap this special market of rich individuals for financing that regular people don’t have access to.
Why are the investors always rich? Well because the SEC made it that way. The old definition of accredited by the SEC put a specific income or net worth floor on what you had to make or have to become accredited and qualify to invest in these private markets. The requirement was as an individual you made more than $200,000 a year for the past 2 years, $300,000 if married or you had a net worth of over $1 million excluding your primary residence.
The other important definition was for institutions or qualified institutional buyers. The SEC previously described these investors as follows:
“a class of investors that can be conclusively assumed to be sophisticated and in little need of the protection afforded by the Securities Act’s registration provisions.”
In particular, under Rule 144(a)(1)(i) an investor will be deemed a “qualified institutional buyer” if they meet the $100 million in securities owned and invested threshold and if they fall within one of the limited number of investor types identified in Rule 144A(a)(1)(i)(A) – (I) (e.g. banks, insurance companies, certain benefit plans, etc.).
What this means is that there are a number of institutional buyers that are shut out from private markets. This includes Indian tribes, unions, sovereign wealth funds, 529 educational plans, and quasi government bodies. This is because the definition for entities was much stricter than for individuals, large entities with hundreds of millions were shut out of this market it was only essentially financial companies, large pensions and endowments that were allowed.
The Changes
The changes in the definitions for an individual accredited investor are as follows:
• any individual holding a Series 7, 65, or 82 license in good standing or who holds certain other educational or professional certifications later designated by the SEC; and
• any individual qualifying as a “knowledgeable employee” (as defined in 17 CFR § 270.3c-5) of a particular a private fund, solely with respect to an investment in such private fund
They did not update the income and net worth definitions. $200,000 income per year ($300,000 jointly)/$1,000,000 net worth
the SEC estimates that there are approximately 691,041 FINRA registered individuals with such as of December 2018. They have discussed offering accredited status to CPA’s, lawyers and CFA charter holders as well.
For institutional buyers, these are the changes:
• any entity registered as investment advisers pursuant to Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3; as well as exempt reporting advisers under Sections 203(l) and 203(m) thereof) or applicable state laws;
• any entity qualifying as “Rural Business Investment Company” (as defined in Section 384(A)(14) of the Consolidated Farm and Rural Development Act; 7 U.S.C. 2009cc);
• any limited liability company having total assets exceeding $5 million which was not formed for the purpose of acquiring the subject offered securities;
• any entity which is indirectly owned by another entity comprised of equity owners that are individuals who qualify as “accredited investors;”
• any entity (including Native American tribes, labor unions, government bodies and funds) owning “investments” (as defined in 17 CFR 270.2a51-1(b)) in excess of $5 million which is not formed for the purpose of acquiring the subject offered securities; and
• any “family office” or “family client” (each as defined in 17 CFR § 275.202(a)(11)(G)-1): (a) having at least $5 million in assets under management; (b) which was not formed for the purpose of acquiring the subject offered securities; and (c) whose prospective investments are managed by “a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.”
Finally, the changes to the qualified institutional buyer are:
To correspond to the changes made to the “accredited investor” definition, the final rule adds a new catch-all category to Rule 144A(a)(1)(i) for any entity (including Native American tribes, labor unions, government bodies and funds) which is not already covered under Rule 144A(a)(1)(i) and which owns “investments” (as defined in 17 CFR 270.2a51-1(b)) in excess of $5 million; provided they also satisfy the $100 million in securities owned and invested threshold of course.
What This All Means
Previously, many sophisticated investors who were necessarily wealthy were shut out. In addition, as mentioned previously, there were many large institutional investors that did not meet the strict requirements to be investors.
The changes to the individual requirements open the door to simply taking an exam to be an accredited investor (although you do need a sponsor to become a series 7, 65 or 82 license holder, the sponsor is usually a financial company registered with FINRA). Just including these license holders adds about 700,000 registered individuals to the pool of accredited investors. Of course, many of these license holders may already meet the income and net worth requirements but there also may be many who are younger and just starting their careers who now can qualify.
The individual changes are also significant for who they leave out. It doesn’t seem to make sense that a CFA charter holder, who likely has much more book knowledge than a series 7 license holder, should not qualify as accredited. Same goes for many CPA’s or attorneys, so be on the look out for the SEC to update these definitions soon.
The big change though is in those institutions. Imagine your 529 plan, a union, a family office which covers generations of a family, which were once locked out, now all qualify as institutional buyers in the $2.7 trillion private market. The money in these institutions could be in the tens of trillions and now they have access to a whole new sphere of investing.
You could soon start seeing your kids college fund or your pension offer the option to invest in exotic art, debt restructuring or private equity buyouts. The consequences of this could be massive. They could open up new investments that weren’t accesible previously and increase the liquidity for once hard to trade investments.
More people will have access on an individual level to accredited crowd funding sites for things like real estate and angel investing in start ups. With that in mind, I have compiled a list of a few sites that only accept accredited investors:
Equity Crowdfunding platforms:
AngelList
EquityNet
CircleUp
Our Crowd
Funders Club
Real Estate Platforms:
RealtyShares
Crowdstreet
Prodigy Network
Equity Multiple
YieldStreet
So there will be more access for more people to more investments right away and likely even more in the future. The flip side of that is that the risk is still there. As detailed in this example in Bloomberg recently, private markets enable many, especially those internationally, to skirt a lot of the transparency protocols that the SEC normally requires. Entire loss of principal and outright fraud are not unheard of in these markets.
It also begs the question of whether those figures from private equity can really be trusted as described in The Economist recently. The secretive nature of private equity as well as their reliance on internal rate of return or IRR for their performance figures, which is easily manipulated, is going to come under more scrutiny than ever. Hedge funds faced a similar challenge as they seemed to outperform in the early 2000’s and became all the rage, only for so many investors to pile in and find that hedge funds couldn’t repeat those same returns, let alone even beat the S&P 500 in the last decade.
So the jury is out on whether these changes will help or hurt private markets as well as individual investors. One thing that is more equal now is that there is at least a path, other than money, for small investors to participate in private markets. It’s not ideal, but it’s a start.
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