The Equal Opportunity for All Investors Act, a bipartisan bill passed by the U.S. House of Representatives in May, could significantly relax qualifications to become an accredited investor, giving more people the ability to invest in private markets regardless of their wealth or income levels.
But some advisors are raising a red flag, saying that while changes are needed to the accredited investor rules, those proposed under the House bill would make a big swath of investors more vulnerable to losses or fraud.
Only accredited investors are permitted to invest in private market vehicles such as venture capital, private equity, and hedge funds. Unlike publicly traded stocks and bonds, private investments are not registered with the Securities and Exchange Commission.
Under current rules, investors qualify as accredited if they meet one of three criteria: Have a net worth of more than US$1 million excluding the value of a primary residence; earn annual income in the current year and each of the two prior years of US$200,000 for singles or US$300,000 for couples; or hold professional investment designations, titles or licenses, such as the Series 7, Series 82, or executive officer of a securities firm.
The thresholds are meant to ensure that only investors who are more sophisticated and are more likely to be able to absorb losses will devote capital to private investments, which are generally riskier than public securities and difficult to analyze. Minimal reporting requirements for private firms means little transparency for investors.
“It’s a system intended to provide capital to early-stage companies and to allow sophisticated investors the opportunity to provide that funding,” says Michael Finke, a professor of wealth management at the American College of Financial Services, which is based in Pennsylvania. “The assumption is that if you have a lot of money, you probably possess the ability to navigate these private markets.”
The House bill would allow investors who can demonstrate a certain level of investment competency to be deemed accredited, regardless of their net worth or income.
If passed, the bill would require the SEC to create an exam that would be used as a measure of investors’ knowledge in areas such as financial statements, types of securities, and issues surrounding conflicts of interest. Any investor who passed the test, regardless of income and wealth, would qualify as an accredited investor.
The exam would be free and administered by the Financial Industry Regulatory Authority (FINRA). Investors above the current thresholds for net worth and income would not be required to pass the exam.
The proposed bill has yet to be taken up by the Senate. But with both Republicans and Democrats backing revisions to qualifications for accredited investors—the House bill passed with a 383 to 18 vote—it seems likely that change is coming, Finke says.
Lawmakers backing the rule change say they are trying to democratize the private investment marketplace. “We should unlock opportunities for knowledgeable investors,” Rep. Mike Flood (R-Nebraska), one of the co-authors of the House bill, said in a statement.
This is a positive step in the right direction, says John Bowman, executive vice president of the Chartered Alternative Investment Analyst Association. “We are firm believers that a long-term pool of capital such as an endowment or a retirement nest egg should have more diversification beyond the public markets,” Bowman says.
But education—not just of investors, but of advisors—deserves more emphasis to ensure that investors are matched with sound private investments, he says. “I believe working with a fiduciary advisor or plan sponsor should be required to ensure proper fit and portfolio construction.”
Bowman says he would like to see the wealth and income thresholds—which have been the same since 1982—updated and indexed to inflation, along with rigorous education requirements for advisors recommending private investment.
Finke says that while an exam may screen out more vulnerable investors, it should apply broadly to all investors, including those whose wealth or income exceeds the accredited thresholds.
He points out that in recent years, prior to the proposed changes, mainstream investors were already becoming overly exposed to the temptations of the private markets because the qualifying wealth and income thresholds haven’t been updated for decades.
Throughout the era of 401(k)s and other defined-contribution plans, “you could have invested in a target date fund for your entire career, and by the time you reach 65 you’ve saved enough to pass that accredited threshold, but you may not know the difference between a stock and bond,” Finke says.
He would also like to see more requirements for private investments to disclose details about their underlying businesses. “In the market for these products there isn’t enough information about risk or historic performance for even someone like me with a PhD in finance to make truly effective decisions about what to invest in or what not to invest in,” Finke says.
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