What is an Accredited Investor?

Recently I received the following email from a reader:

In large part to your valued advice, my wife and I are approaching the SEC definition of an accredited investor.  We expect to surpass the $1MM threshold within the next 6 months and I’ve started to research the possible opportunities resulting from this achievement.  Of course, the first place I started was on your site but I wasn’t able to find anything.  There is a good chance that I may have missed it.
 
I was hoping that you had some insight since, based on many of your posts, it seems that you are an accredited investor.  Any thoughts or guidance would be greatly appreciated and highly valued.

To be honest, I had no idea what an accredited investor was. So off to Google I went...

I ran into the same info at the SEC's website as I found at Wikipedia. Here's the overview from Wikipedia:

Accredited investor is a term defined by various countries' securities laws that delineates investors permitted to invest in certain types of higher risk investments including seed money, limited partnerships, hedge funds, private placements, and angel investor networks. The term generally includes wealthy individuals and organizations such as banks, insurance companies, significant charities, some corporations, endowments, and retirement plans.

The piece then details the requirements to be an accredited investor in the U.S., Canada, and the European Union.

The SEC's commentary is a bit more formal (as you might imagine). Their thoughts:

Under the Securities Act of 1933, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. The Act provides companies with a number of exemptions. For some of the exemptions, such as rules 505 and 506 of Regulation D, a company may sell its securities to what are known as "accredited investors."

The federal securities laws define the term accredited investor in Rule 501 of Regulation D as:

1. a bank, insurance company, registered investment company, business development company, or small business investment company;

2. an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;

3. a charitable organization, corporation, or partnership with assets exceeding $5 million;

4. a director, executive officer, or general partner of the company selling the securities;

5. a business in which all the equity owners are accredited investors;

6. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;

7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or

8. a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

Given the above, the requirements in #6 or #7 would be the most likely way FMF readers could qualify as accredited investors. Old Limey would for sure, but I'm guessing there are many more that would as well.

So after this investigation, I now know what an accredited investor is. But a bigger question now emerges: "So what's the benefit?"

I'm guessing is that the advantage of being an accredited investor is that you get the chance to put money into some higher return investments. Of course these come with higher risks as well, so depending on your investment style and philosophy you may or may not want to invest in these opportunities.

But how do you even get the chance to discover these options? Do you contact a money manager of some sort, say you now meet the criteria, and ask what he offers? That seems like an awkward and likely unproductive way of finding a good investment.

So I Googled "benefits of being an accredited investor" and found some reasons it may be worthwhile. Here's a summary from Financial Web:

As an accredited investor, you gain the right to participate in certain investments that would not be open to you otherwise. The hedge fund is the most common example of this. A hedge fund, is an investment vehicle that is not bound by the restrictions of the SEC and utilizes a number of different investment strategies to achieve large returns for its investors. Most hedge funds require that you are an accredited investor in order to be involved because they are complicated and risky.

A couple other pieces talked about the opportunity to invest in small companies that need capital to grow their operations. You can read Investing in Private Offerings and One Reason the Rich Get Richer: Accredited Investors if you want more information.

Still, I'm not sure how you take advantage of being an accredited investor. Is it networking? It is cold calling hedge funds? (Surely not). I'm really in the dark on this one.

So I thought I'd open up the topic to FMF readers. I'm betting there are some of you out there who either know how to take advantage of this status or have actually done so yourself. Either way, please share with us what you know about being an accredited investor.

Comments

[Matt]

Interesting topic.

Hopefully someone out there is one and willing to share.

[Mike Hunt]

I view it as a way to protect the person running the fund. I have contacted different fund managers and it seems like they are looking for "accredited investors" (and I am one by these definitions) but my sense is that this protects them more than anything. Of course they still need to perform and for our philosophies to be in alignment.

Maybe I am missing something and another more informed reader would be able to weigh in.

-Mike

[[email protected]&More]

I remember learning about this in one of my business classes in college but they didn't say how it benefits the individual. It does give you some more opportunities but you have to know the right people to fall into the opportunities is my guess.

[so]

As a recovering securities lawyer, the point of the "accredited investor" definition is (1) for the company, who doesn't have to file a full registration statement and basically conduct an IPO so long as the security is offered only to accredited investors -- so the disclosure requirements regarding what the company must disclose to investors are reduced and their liability is also reduced in many cases; and (2) for the investor, the theory is that they have the capacity to assume greater risk.

In short, very little benefit to the investor, but a lot of additional protections to the company offering the securities.

[Rick Franics]

>I'm guessing is that the advantage of being an accredited investor is that you get the chance to put money into some higher return investments. Of course these come with higher risks as well, so depending on your investment style and philosophy you may or may not want to invest in these opportunities.

Given that you have grown your wealth well already: Do you really need to take the risk of these more exotic investments to meet your financial goals?

If you do need higher returns- are these investments a reasonable risk?

Do they have a track record of being better than stock and bond index funds? I believe hedge funds do not in part because they have much higher expenses, but you should do your own research. Also, many of these are relatively new investments, so they may not have sufficient history to fairly judge them. The last thing you would want to do is buy into an exotic investment that performs like mortgage backed securities.

-Rick Francis

[Brian]

The definition has everything to do with the type of investment and nothing to do with the investor. Under SEC rules, a company cannot sell stock unless it is registered with the SEC. Registration is very costly and involves extensive disclosure of company details. There are a few exemptions to this registration requirement and most but not all require the investors to be accredited investors. By claiming you are an accredited investor (net worth requirement plus statements that you are a sophisticated investor) you are basically saying that you don't need the SEC's protection and can fend for yourself. As stated above, this only benefits the company and not the investor.

[Double A]

One thing that's missing is that being an accredited investor, in most cases, isn't sufficient enough to invest in a "high risk" investment like a hedge fund. Generally, most hedge funds require some sort of minimum investment in the million dollar (or more) range, and there are liquidity requirements that are extremely strict, and can range from three months to two years.

Since this reader JUST reached the accredited investor status, it's unlikely that he will be able to invest in a hedge fund, because of their high minimum investments. Plus, he wouldn't want to put his entire nest egg in one investment in one company.

FWIW, I think the $200,000 for two years part of the accredited investor rule exists to allow employees of hedge funds to invest in their company's offerings (subject to much, much less minimum investments).

[Ken]

It allows you to become an angel investor. The Keiretsu Forum is one that I know of.

It is in my plans to eventually make it to this level but it is probably 15 years away.

[JimL]

For me, I am presented with these opportunities by my network and they are mostly in my field of work. The risk level really varies and most have a 5 to 7 year period in which you are invested until there is a planned liquidity event. I have reviewed about 50 to 60 opportunities and have invested in 2 of these.

[retirebyforty]

Yeap, it allows you to become an angel investor. You can invest in start ups and private companies before they go public. The risk is very high but and I don't think it's a good idea to invest in start ups if you just crossed the threshold. The investors depends on having a few huge home runs to offset the many losses. If you can only invest a little bit, you'll most likely strike out.

[Rob G.]

Great post! Thank you FMF.

[Tyler]

I haven’t been on FMF for a while and thus I missed this post. Let me try to help.

First, Hedge Fund does not equal more risk. Angle Investing does not equal risk. Higher return does not equal higher risk. These blanket statements are wrong and demonstrate a misunderstanding of risk and investing.

Accredited Investors are defined above. It is an investor class that was created by the government to “protect” common investors from more complex investments. This was not created to protect the fund managers. This is a regulation investment firms in that class have to follow- it makes their job harder. It does not protect the financial firm. It’s a structure that limits who they can have as clients (Institutions and ‘rich’ people). It limits who the fund can solicit as clients.

The advantage of being an AI is that you gain legal access to a number of additional investment vehicles. (You could argue how much of an advantage this really is.) For example: Private investments such as hedge funds/PE where the fund manager can share in the profits; commodity funds/futures; Private investments/placements/PIPES; or what are categorized as Alternative Investments. This rule/benefit has eroded over the last ten years as REITS, 1940 Act Futures, and fund of funds have allowed the masses access to this alternative space.

Investment firms/products that are still covered by the AI laws will not even talk to anyone who is not an AI. They are not allowed to market to anyone who is not an AI. You have to sign documents stating that you are an AI before they will give you any investment materials or discuss their investment firm.

The $200k for two years was not put in there to help hedge fund employees. The investment firm has other exemptions to the AI rule. The law is not a line in the sand.

Minimum investments are decided by the firm. One of the major reasons for the minimum investment is because the number of investors in some structures limited to around 100. 1940 Act funds (traditional mutual funds) also have minimum investments. Another is the administrative costs of each investor are fixed so it’s better to have investors that invest more.

[Tyler]

If you are a strong believer in the cult of diversification, access to non-correlated asset classes should be your desire. AIs get far more access to these non-correlated assets. This being said, you can get some access to these asset classes even if you are not a AI.

[Sheeple Herder]

In an effort to protect the average investor, congress created a special class of investor that is by definition sophisticated, experienced, and has the means to perform a higher level of due diligence. It has ramifications for the entities creating and offering for sale certain opportunities. The basic definition of AI is net worth excluding primary residence of $1m, or $200 k annual individual income past 2 years and reasonable expectation of same in future ($300k joint income.) OR institutions that qualify. Usually, pension funds, endowments, and wealthy investment groups. These “institutional investors” are generally risk averse stewards of a larger trust. They desire to avoid risk and maximize returns. They generally seek out non-correlated assets and hedge their positions. (Search for information on the investment strategies of endowments for insight.) As it pertains to your question: “What does it mean to me the investor?” It means that you can invest in similar opportunities as large pension funds, the Harvard Endowment, The Pew Charitable Trust, Warren Buffet, and Bill Gates. What can you invest in: Limited Partnerships with 40 year track record of 10% plus returns; Gas and Oil partnerships that have significant tax advantages and 40 year track records of 10% plus returns; Hedge funds that have significant returns; certain REITs; and other investments where the Offering Firm does not want the hassle, complication, and regulatory entanglement. (Legal costs for filings can approach $1,000,000.) The AI is NOT protected at the same level as the non-accredited investor CAVEAT EMPTOR, therefor, the offering firm is not burdened by extraordinary liability, investor education costs, etc. Fraud and theft protection is always in place. I hope this answers your question.

My question to you is that if these “alternative investments” are good enough for Elite University endowments and large pension funds, why are they not available in your 401k? Why are the “common” investors limited to mutual funds and their market risk, volatility, poor performance, and expenses?

Disclosure: I am a registered securities representative that has sold these offerings to accredited investors. I am concerned about writing this missive on a public board. I have possibly created liability to myself and exposed myself and my firm to regulatory action. That is most likely why no broker has posted. In the name of consumer protection, you are prevented access and I am prevented from providing you information. However, you have presented that you are or you believe you are an accredited investor, based on that information, I am providing this information. THIS IS NOT A SOLICITATION FOR ANY KIND OF BUSINESS. THIS INFORMATION IS NOT TO BE RELIED UPON FOR ANY KIND OF ANYTHING. THIS IS FOR ENTERTAINMENT PURPOSES ONLY AND SHOULD NOT BE USED FOR ANY PURPOSE INTENTIONAL OR UNINTENTIONAL. SEEK THE ADVICE OF A PROPERLY LICENSED PROFESSIONAL THAT HAS REGULATORY AUTHORITY TO SELL YOU THE PRODUCT THAT PAYS THEM THE HIGHEST COMMISSIONS AS SANCTIONED BY THE APPROPRIATE REGULATORY AGENCY. I AM FAR TOO STUPID TO OFFER AND YOU ARE FAR TO STUPID TO RECEIVE ANY INFORMATION CONTAINED HEREIN OR EXTRAPOLATED HEREFROM.