The Securities and Exchange Commission pleased and disappointed stakeholders and observers this week when it expanded who is eligible to participate in private capital markets.
SEC commissioners voted 3-2 on Wednesday to amend its decades-old definition of accredited investors, who, historically, needed to meet certain income or net-worth requirements: at least $200,000 in annual income for each of the two past years (or $300,000 with their spouse) or $1 million in assets, excluding their primary residence. Now, new categories of investors can participate in private markets even if they don’t meet those requirements.
The new rules will allow individuals to qualify as accredited investors based on certain professional certifications, designations, or credentials designated by the SEC. The regulator encouraged the public to submit any that might qualify. “This approach provides the Commission with flexibility to reevaluate or add certifications, designations, or credentials in the future,” the SEC said in a statement.
Many stakeholders and observers who submitted comment letters after the rule was proposed were proponents of the change, arguing that certifications, designations, or credentials can “signal a level of sophistication exceeding that of investors who currently qualify as accredited investors under the income or net worth thresholds.”
Some of the designations commenters suggested were the Chartered Financial Analyst (CFA) and certified public accountants (CPAs).
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Other individuals and institutions also are either newly accredited or the SEC’s new rules clarify their qualification. Anyone in good standing with regulators holding a Series 7, Series 65, or Series 82 securities license now qualifies as an accredited investor, as well as “knowledgeable employees” of private investment funds who now qualify to invest in those funds.
“The Commission’s use of income or wealth as the exclusive proxy for an individual’s financial sophistication and ability to assess and bear risk has long been unsatisfactory. Individual investors who do not meet the wealth tests, but who clearly are financially sophisticated enough to understand the risks of participating in unregistered offerings, are denied the opportunity to invest in our private markets,” SEC Chairman Jay Clayton said in a statement about rule changes.
Leaning only an individual’s income and wealth “disadvantages otherwise financially sophisticated Americans living in lower income/cost-of-living areas,” Clayton argued. The chairman, along with Commissioners Elad Roisman and Hester Peirce, voted in favor of the changes, which will become effective 60 days after they are published in the Federal Register.
In a March comment letter, Mercer Advisors, the Denver-based RIA with more than $15.8 billion and 400 employees, supported the proposed expansion of accredited investors and it got that wish. But the RIA expressed concern about amended rules that did not address the current income and wealth requirements.
Those limitations have not adjusted with inflation, the RIA pointed out in its letter. According to the Consumer Price Index (CPI) Inflation Calculator, the purchasing power of $200,000 in 1982 is equal to $547,128 in 2020. But, more importantly, the RIA says, it believes in well-diversified investment portfolios and the proposed rules (which are now final) would fail investors.
Mercer suggested in March that the net worth limitation be changed to liquid net worth and that the SEC limit an investor’s aggregate exposure to private placements to “no more than 20% of their documented liquid net worth, with a limit of 5% to any single private placement.” It said the SEC should consider creating an examination that accredited investors would need to pass to make private placement investments.
In its own comment letter, Morningstar, the investment research and services company in Chicago, largely agreed with Mercer and others.
“The current income and wealth thresholds are a poor proxy for investor knowledge and expertise. In fact, the form of our retirement system makes such wealth thresholds a poor way of determining who is qualified to invest in private markets. As the defined-contribution retirement system has replaced the defined-benefit pension system, millions of workers stand to accumulate more than $1 million. Many of these investors will have little or no investment expertise,” Aron Szapiro, head of Policy Research at Morningstar, wrote on behalf of the company.
Citing research by the Employee Benefits Research Institute, or EBRI, Morningstar said 8.8% of retirement accounts in the U.S. will have over $1 million in 10 years and 21.8% will have over $1 million in 20 years, “making more than one in five Americans with a retirement account today an accredited investor.” Under the current rules, millions of Americans will become accredited investors, regardless of how financially sophisticated they are or aren’t, something Morningstar argued the SEC should address.
The CFA Institute also shared a similar opinion: “Nearly four decades of accumulated inflation have eroded the original thresholds and rendered them ineffective in ensuring that all individuals in the class of accredited investors can fend for themselves. Moreover, the twin public health and economic crises we are currently experiencing have not only highlighted, but also have exacerbated risks to investors that are already inherent in private markets.”
Commenters weren’t the only ones disappointed by the still-stagnant income and wealth limitations. Commissioners Allison Herren Lee and Caroline Crenshaw voted against the rule partly for that reason.
“The most significant policy choice the Commission makes today is the decision not to index the wealth thresholds to inflation going forward. This choice runs counter to widespread support for such a measure, even among groups that often diverge in their views regarding Commission policy,” they said in a joint letter on Wednesday.
Still, some investors don’t feel it is the job of the SEC to protect them from the risks associated with private placements, the market for which is vast and opaque. In his letter to the SEC, one accredited investor appeared to advocate for there to be no income or wealth limitations. “I am an accredited investor now. However the rule should be changed since I could go to Las Vegas and blow ALL of my net worth, why shouldn't I be able to invest in a start up company. This does not make sense. Let adults be responsible for their money, and don't over protect them from themselves.”
Michael Thrasher (@Mike_Thrasher) is a reporter at RIA Intel based in New York City.