December 16, 2019
You are probably familiar with the qualification standards for investors in investment vehicles that are exempt from public registration. The most famous of these standards is the Accredited Investor standard which has its origins in a 1953 Supreme Court case where the defendant was feed and cereal producer Ralston Purina, the maker of animal chow products.
Ralston was prosecuted by the SEC for offering stock to its employees outside of the public registration process that would have given them investor protections. At stake was whether rank-and-file employees who bought the unregistered stock had the necessary information and sophistication to understand the risk they were taking. The Court ruled that exemption from registration was permissible for offerings to those who were able to “fend for themselves.” This idea lives on in the form of the 1982 Accredited Investor definition of an investor’s sophistication and ability to sustain the risk of loss.
Today, investors can qualify as Accredited based on assets or income. Once qualified, they have access to an expanded investment universe which may include private equity, venture capital, and hedge funds.
In June of this year the SEC sought comments on potential changes to the current rules. Revisions could include adjusting qualification thresholds and adding alternative measures to define sophistication. One of the 138 questions on which the SEC sought responses was “Is the existing framework too complex?”
The SEC admits it does not know the number of Accredited Investors in the United States but estimates there are around 16 million households (13% of the U.S. total) which include one or more Accredited Investors. Three quarters of Accredited Investors are thought to hold a bachelor’s degree or higher. Households in the west and northeast of the U.S. are most likely to contain Accredited Investors. Western households have the highest average net worth at around $900,000. The south comes in at the bottom at just over $600,000.
The SEC’s release also considered the impact on capital formation, recognizing that private investment vehicles provide capital to small and mid-size businesses, which helps drive the economy. Stricter qualifications could stifle businesses’ ability to grow and hire.
Critics of the current Accredited Investor standard, and its cousins the Qualified Client and Qualified Purchaser standards, point out that only a small subset of the investing public have access to the returns from unregistered, early stage investments. Capital providers should also care about the impact of change. The size of unregistered offering channels was $2.9 trillion in 2018, according to the SEC’s estimates, which is about double that for registered offerings. Expanding access to previously restricted investment channels could attract inflows of capital that may dilute returns unless available opportunities rise in proportion.
There is no guarantee that the SEC’s examination of this topic will lead to change. Maybe there will be modifications and a new group of investors will have access to private investments. Or, maybe the political climate will change to the detriment of private investments as a whole.