President Obama just signed into law a sweeping set of financial reforms contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act. One significant change is the modification of the definition of an "accredited investor."
Accredited investors are a minority in the United States, as the description imposes high-net-worth thresholds. There are many details in the definition, but broadly speaking, the historical accredited investor standard meant investors had to earn $200,000 during the previous two years with the likelihood of earning the same during the forthcoming year. Alternatively, investors not meeting this income test could qualify for accredited investor status by having at least $1 million of net worth, which included all investments and, critically, one's home.
Accredited Growth
These income and asset rules were put into place in 1982. In that year, the SEC estimated that only 1.87% of US households would pass either of those financial tests. With the march of time, inflation and asset appreciation increased incomes, home prices, and the value of other investments. Take for example incomes: Government statistics show that in 1982 the top 5% of households earned just more than $60,000 and by 2008 the income level was $180,000--an increase of 200%. Average home prices rose 237% in the same period, and in some metropolitan areas the appreciation was much more.
The SEC estimated that the percentage of accredited investors increased by 350% from 1982 to approximately 8.47% of households in 2003. In 2010 the percentage was likely higher despite the recent housing and 2008 equity market correction. Like many things that do not adjust for inflation, the old definitions got easier to meet and more investors, even though they may not have felt rich, were now members of the top investment club.
An individual who meets the definition of an accredited investor has access to a group of investment products unavailable to the retail masses, namely private partnerships that can invest in private equity, real estate, commodities, and hedge fund strategies. It is common sense that legislation put in place net-worth tests to limit access to these types of strategies, which typically have poor transparency, intermittent pricing, and episodic liquidity. However, more sophisticated investors who understand the greater risks could potentially benefit from greater return from these investments.
But as net worth increased over time, many investors found themselves technically eligible to be accredited investors, though their own investment proficiency was less than a perfect match for these complicated products. It is easy to imagine a pensioner or school teacher, not able to meet the $200,000 income threshold, but who owns a home in an affluent area, where the housing bubble lifted their net worth more than $1 million. Are they really an accredited investor, able to judge complex trading strategies, partnership tax treatment, or esoteric securities such as a collateralised debt obligation?
Wealth Redefined
The new legislation immediately removes the value of a home when calculating the $1 million net worth limit. Newly minted accredited investors must have true investments in excess of $1 million. The $200,000 income threshold remains unchanged. Additionally, after four years the SEC has the ability to increase the $1 million bar to account for inflation, eliminating the problem of having a fixed net worth hurdle that gets easier to jump with the passage of time. Existing investors who no longer meet the newer accredited standards may not be forced to redeem, but no new money will be permitted to be added unless the investor qualifies.
The most immediate impact of this legislation will be felt on those operating investment products that are limited to accredited investors, namely private partnerships, including hedge funds. The tighter standards will shrink the number of prospects, forcing these partnerships to target larger qualified and institutional clients. Additionally, there will be more scrutiny on partnerships to ensure their accredited investors really meet the new standards. Ultimately, an investment partnership is responsible for ensuring compliance with all securities laws, particularly Regulation D of Rule 501 in the Securities Act of 1933, commonly known as "Reg D." This is where the definition of accredited investor is detailed and the rules of private fund investor solicitation are laid out.
"No one conducts financial audits or demands absolute proof of net worth," says Rory Cohen, partner at the law firm Venable LLP. "But clients typically attest to their net worth through subscription documents, on which broker-dealers and funds rely. Ultimately, the investment partnership is responsible for its ability to assert compliance with the Reg D safe harbour. Partnerships ought to show some reasonable level of diligence in confirming that an investor meets the eligibility requirements."
For funds that target accredited investors, the responsibility to meet the new standards falls to the fund and its general partner. Adds Cohen, "Funds should have a pre-existing substantive relationship with each investor, through which they could gain sufficient information about an investor's occupation and financial circumstances to better assess whether they are accredited. When in doubt, it would be prudent to ask for a tax return."
What are the penalties for failing to meet the Reg D requirements? "Failure to adhere to the private placement requirements could lead to fines and potentially far more punitive measures," says Cohen. The ultimate sanction would be closing a fund and liquidation. The high fees charged to investors by hedge funds means many funds are wealth-creation machines for their fund managers. For a fund manager charging a 2% management fee and a 20% performance fee, closing a partnership is the equivalent of taking the Golden Goose to a barbeque.
For retail investors, it can be argued that the new higher standards to become an accredited investor provide additional protection. Investors can be better matched to investment products that suit their level of understanding and sophistication. For clients and financial advisers, once again, suitability reigns supreme.
One other possible outcome from the new definition could be an increase in the number of mutual funds and exchange-traded funds that attempt to mimic the same strategies as these private partnerships. If you run a private partnership, the new definition means there are fewer prospects; asset raising is more difficult and more costly.
One option is to scrap your partnership and open a mutual fund, where there is no net-worth threshold for investors. The numbers of these alternative mutual funds are growing, and include such hedge fund styles as long-short and market-neutral. Morningstar's last count was 153 funds, with more in the pipeline. For retail investors, the benefits include daily liquidity and pricing, a 1099 tax form instead of a K-1, and no minimum net-worth requirements.
We are encouraged by these changes as they provide additional investor protections. Time will tell if this legislation will be the catalyst for new financial product innovation, nudging private money managers to open mass-appeal products. We are hopeful and very watchful as innovation brings new but not always enduring products. The lasting lesson is something we've known all along, that client suitability is timeless, and knowing your client (and their limits) is a protection that legislation can never universally provide.
Data Sources:
Census.gov (housing data) http://www.census.gov/const/uspricemon.pdf
Census.gov (top 5% income) CPS data
U.S. Congress conference report for HR4173
Federal Register / Vol. 72, No. 2 / Thursday, January 4, 2007 / Proposed Rules (SEC) stats on numbers of accredited investors
