In what is ostensibly an effort to increase consumer interest and access to investment opportunities, SEC Commissioner (and Chairman) Clayton has recently floated several ideas to ease the so-called “Accredited Investor” rules and limitations, which have come into sharp relief with a growing number of high-profile private companies like Uber and Airbnb that have chosen for various reasons not to make an Initial Public Offering that would make their stocks available to the average “Main Street” investor. Yet ultimately, it’s not clear whether the Accredited Investor rules really need to be changed, or if consumers (and the media) have distorted the perceived opportunities of private investing by focusing on the few biggest successes, and not the amount of risk and opacity that otherwise lurks in the world of unregistered securities (with ‘disasters’ only rarely occurring as publicly as Theranos did).
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1 PM EST broadcast via Periscope, we discuss the original objective and purpose of the “Accredited Investor” rules, where they might have possibly gone awry, and ways to re-align the Accredited Investor requirements so that they can accomplish their original goals.
At first blush, it’s not difficult to understand the desire to make capital markets even more egalitarian than they already are, by giving “mom-and-pop” the ability to get in on the ground floor with companies with tremendous growth potential like Airbnb and Uber (or Facebook and Twitter from several years ago). But, like every single other investment opportunity, greater potential reward always carries increased risk, and it’s the elevated risk that these Accredited Investor rules were intended to address in the first place.
Accordingly, the SEC’s “Accredited Investor” rule states that, in order to purchase unregistered (and less regulated) securities, an investor must have either $200,000 per year of earned income (or $300,000 with a spouse) for each of the prior two years and the current year, or have a net worth of over $1 million (excluding the value of their primary residence).
These requirements help ensure that investors who tie up their capital in unregistered securities should at least have the financial ability to absorb any losses should the venture go south, and ideally will have the financial sophistication to be able to evaluate whether the investment opportunity is really a good deal in the first place (or not).
However, $1 million in net worth isn’t the same hurdle it one was in 1982 (when the rules were first formed), and in today’s world that nest egg can’t even generate a median household income in retirement! Moreover, these investment opportunities – the vast majority of which will never actually pan out – are often marketed in a way that highlights the “special opportunities available only to the super-wealthy” aspect of the Accredited Investor limitations, while downplaying the fact that they are extremely risky and require extensive due diligence and that the real purpose of requiring “financial sophistication” is because it’s so hard to sniff out what’s actually “BS” in the first place (as even “sophisticated” Theranos investors discovered too late).
Accordingly, perhaps it’s actually time to increase (not lower) the thresholds for Accredited Investors to purchase unregistered securities – to ensure they’re limited to those who really can afford to take the risk and the potential losses – but at the same time, separate out the pretense that having a certain amount of money in the bank or via a paycheck automatically makes the investor “sophisticated” enough to evaluate potentially opaque private investment opportunities, and instead evaluate financial sophistication more directly (e.g., via a questionnaire or by requiring a third-party fiduciary advisor’s involvement).
Of course, the ultimate the problem with many companies building wealth in private markets and shunning public markets and isn’t about “accredited investor” rules at all, it’s about cumbersome regulations that have made going public overly restrictive and unappealing for many businesses in the first place. But to the extent that the Accredited Investor rules may be modified and recalibrated, it’s time to get real about what it really takes to evaluate the risks of private investments, beyond a presumption that how much an investor can afford to lose has any relationship to being “sophisticated” enough to understand the investment risks involved for the potential rewards that may (or may not) be available.
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Well, welcome, everyone. Welcome to Office Hours with Michael Kitces.
So for today's Office Hours, I want to talk about the so-called accredited investor rules that limit the ability to invest in unregistered securities unless you're an accredited investor. Because this is a topic that's been back in the news lately. First, some repeated discussion in the past few years from the SEC about whether it's time to update all the income and net worth thresholds of what constitutes an accredited investor, and then again just last month when SEC Commissioner Clayton raised the question of whether the rules should be eased further to allow more investors to access today's high-profile private deals like Uber and Airbnb.
But to understand why the accredited investor rules really are maybe or not in need of some change, it's necessary to take a step back and just look at why they really exist in the first place. So it's basic principle of capital formation that businesses in search of capital must connect with investors who have the capital available to invest, and then the businesses can either borrow money from the investor, which we know as issuing a bond, or they can take money in exchange for giving the investor a portion of the business, what we know as equity or raising capital by issuing shares.
Now, for companies that want to do a large issuance of bonds or stocks in the public markets, we have a lot of rules and regulations to make sure that the companies raising the capital are actually legitimate operating businesses, aren't fraudulent, you know, in a world where it wouldn't be feasible for every one of thousands or millions of individual shareholders to each go to the company and individually vet the business, its business model, talk to its leadership, etc. So one of the core roles of the SEC is to regulate capital markets and ensure that while not every stock and bond will work out in the end, they all at least are legitimate stock and bond issuances from bona fide operating businesses.
The caveat, though, is that all these additional layers of regulation and oversight have a cost, and the cost is high enough that a lot of midsize businesses with even millions or sometimes tens of millions of revenue, and especially small businesses and startups, can't realistically afford the time and cost to go through all that regulatory vetting. They need a simpler and more direct way to raise capital from outside investors, with the caveat that if regulators don't oversee the process, there's also a greater risk of fraud, either people raising capital when the business isn't real or not using the capital for its intended purpose, or being misleading about the state of the business and its health and growth prospects to get capital, when realistically it's not a good investment in a growing business, it's just throwing money down the drain of an already failing business.
So rather than impose greater regulations on small businesses themselves trying to raise capital, which could increase the costs enough that the businesses get cut off from capital, the SEC instead created the so-called accredited investor rules, which state that companies can sell these unregistered, unregulated securities to accredited investors, who are deemed accredited by either an income threshold, earning $200,000 a year as an individual or $300,000 as a spouse for each of the prior 2 years and the current year, or they have a net worth of $1 million outside of the primary residence.
The (Ideal) Purpose Of Accredited Investor Rules [03:19]
The basic principle of the accredited investor rules is simply that, first and foremost, recognizing the greater risk of fraud or at least being misled about a not very good business, you need to have enough money to be able to afford to lose a chunk of it on risky investments. The second is that, with these requirements, you either be sophisticated enough, thanks to your investment experience in accumulating wealth that you could vet the opportunities in the first place and sniff out the BS of bad companies, or at least you'd have the financial wherewithal to hire someone to help you sniff out the BS of bad companies.
Because, again, the whole problem with private unregistered securities is that there's very limited information. There aren't many reporting requirements, and so it may be hard to vet a deal and figure out whether it's really a legitimate business opportunity or just a money drain, or outright fraudulent. And at best, small businesses take a long time to build and to sell, so private investments would often tie up dollars for many, many years into highly illiquid stock and bond holdings, which means even if the business is run well, the money may not be accessible for a really long time. And the fact that it would be so illiquid is, unfortunately, another temptation for managers to do something improper while investors have no way to get their money out.
So for startups and small businesses, the appeal of the accredited investor rules is that while it limits the number of people that can raise capital from, it gives them a way to raise capital and save the business on some really material or impossible costs that would be incurred by going the more traditional and more regulated routes. So in other words, it lowers the hard cost of raising capital for small businesses, which is important for supporting entrepreneurship and new business formation.
And notwithstanding the additional risks of investing your money into small companies that are opaque and illiquid, where there's greater risk of fraud and mismanagement or misleading advertising about the company's potential, the upshot for investors is that those investments can also provide greater return potential, right? Classically, additional risk has the potential to generate additional rewards. Now, obviously, not all greater risk automatically entails greater reward, sometimes it's just a bad dumb investment, but taking greater risk does at least have the potential for greater rewards, right? At the most basic level, it's difficult for a publicly traded company to grow all that much when it's already huge and has most of the marketplace, but a small startup can experience substantial and sometimes exponential growth, so the benefit of taking that risk is the potential for the bigger reward.
How The Accredited Investor Rules Have Gone Wrong [05:44]
But here's the problem, at some point along the way, the accredited investor rules seem to have shifted from, "You need to have the financial wherewithal because these are really risky investments, they're really illiquid investments. At best your money is tied up for years, at worst you lose it all. And you have to be a sophisticated investor or at least be able to afford advisors who can vet the deals, because it's really hard to figure out what's a real deal, what's a risky opportunity, and what's total BS where you're virtually certain to lose all your money." So the accredited investor rules were supposed to make sure you could meet this financial wherewithal requirement and this sophistication or vetting requirement.
How are the accredited investor rules often framed today? "Here are super-secret investments, the best investment opportunities only available to rich, sophisticated investors." It seems that in part, the problem has evolved because the media, and sometimes investors themselves, focus on and glamorize the few mega-deals like Uber and Airbnb and fail to ever report on the fact that 99.9% of private deals don't turn out that well, and a huge swath of them lose everything, lose all their investors' capital. So we see the wins, we don't see the huge number of losses, it seems like the investment opportunities are more glamorous than they are.
But in part, the problem is also that the accredited investor rules have been turned by some into a form of basically exclusive club that actually appeals in what I see even amongst our clients is that sometimes a very predatory manner on people who have maybe significant financial wealth and meet the accredited investor income or net worth requirements but do not actually have the sophistication to vet opaque deals that they're investing in.
I think a good case a point example is just the entire explosive rise of the hedge fund industry over the past 15 years which often markets themselves as having access to the best and most exclusive appealing investment opportunities and strategies only available to those who are accredited investors, when in reality, over the past 5 years, the HFR hedge fund index has generated less than half the annualized return of an S&P 500 index fund.
And it was just last year that Warren Buffett was finally declared the winner of his 10-year bet from back in 2007 that the S&P 500 would beat any group of hedge funds that any investor wanted to select. And despite the fact that that bet started in 2007, like, right at the market's peak, right before it got clobbered by the financial crisis, which is when these strategies were supposed to hedge and excel, ultimately, the S&P 500 returned 7.1% a year over the decade, and the hand-picked hedge funds returned 2.2%, a third of the return and a more than cumulative 50% difference in growth over a decade.
Now, the point here is not specifically to pick on hedge funds, but just to point out that the limitations of the accredited investor rules were supposed to limit access to private investments to those who have the wherewithal to both lose the money if it didn't work out, and more importantly, to be able to vet or hire someone to vet the opportunities in the first place. And instead, it seems to have resulted in a subset of affluent advisors getting taken in by those who sold exclusivity and then completely failed to deliver the results, while a small number who actually succeed get promoted to other investors, make more people want to get in the exclusive club, even though it's not actually a very good club to be in the first place. Not because there aren't additional opportunities for return in private investments, but simply because this stuff is really risky. And the accredited investor rules aren't meant to limit everyone's access to good returns, they're meant to limit most people's access to lose money they can't afford to lose on bad deals that they don't have the time or money to spend in order to vet them in the first place. That's the actual point, and that's how a lot of these turn out.
So at this point, I actually do think the SEC is on the right track to at least revisit some of the accredited investor rules because I'm not sure they're really serving their intent and purpose anymore. Rather than having unregistered securities get sold to accredited investors who use their capital and wherewithal to vet these risky or opaque deals, the rules instead have gotten twisted in this weird form of exclusivity club where certain affluent investors seem to actually be doing less due diligence on what they invest in, under the auspices that if they can afford to get into the accredited investor club and access things like hedge funds, it must be a good opportunity because they perceive other people doing it as well.
And to me, the reason we've hit this failing point is that the SEC tried to accomplish two different things at once with its accredited investor requirements. The first was to set a threshold where investors would have enough financial wherewithal to afford to take the losses on risky investments. The second was to set a threshold where someone would have enough financial wherewithal that they were presumed to either be sophisticated enough to vet the investments or at least have the financial ability to hire someone to help vet the investments. And the problem is that ironically, the accredited investor rules actually always lagged on the first part about having the wherewithal to lose the money, and it's not well-suited to task on the second part, to begin with.
As the SEC itself has observed in some of its recent analyses, back in the early 1980s when the accredited investor rules were originally put in place, fewer than 2% of households could qualify, now almost 10% of households meet the required thresholds. So in a world where limiting these investments to people who can afford to lose the money was the goal, they're not actually as limited as they used to be. I mean, $1 million just doesn't go as far as it once did. In 1982, that was a lot of money. Today, the safe withdrawal rate on $1 million for a married couple doesn't even get you to the median household income of a retiree. It's not money you can afford to lose.
And in the meantime, on the second part, where the accredited investor was supposed to be some kind of proxy for financial sophistication to evaluate what you're investing in, simply put, wealth and income alone are a terrible proxy for financial sophistication. And the way the accredited investor rules now seem to be marketed by solicitors in some circles, again, it's not viewed as a higher tier of risk to do the extra due diligence on, it's communicated as, "Special investment opportunities only available to the sophisticated wealthy," that encourages people to think of themselves as sophisticated, throw their money at it, instead of looking at it with an extra skeptical eye.
Improving The Accredited Investor Rules To Actually Protect Investors [11:55]
So how can this be improved? I think there are a few steps. The first is that I actually do think the accredited investor threshold should be raised. People should not be tempted to put their $1 million retirement savings into a hedge fund. That is not money that most people can afford to lose. And I'm not trying to bash all hedge funds here or all private investments as being bad, but for most millionaires who qualify under the accredited investor rules, it doesn't mean they have 1 million bucks to lose. And they may need the whole million just to support a median household income on retirement stacked on top of Social Security benefits. So in this regard, I think frankly, something like half a million of income or $5 million of net worth is more appropriate in that context. Because again, part of this requirement is not about limiting great investment opportunities to wealthy, it's limiting bad investment opportunities that are too opaque to even spot as being bad to only the people who can afford to lose the money.
The second change, though, is that it's time to stop pretending that wealth and income are useful proxy for the financial sophistication of the individual. Instead, I'd advocate that the SEC needs to create some kind of basically investor sophistication questionnaire to affirm that the investor really actually understands the risks involved, or the investor needs to have, you know, some kind of training, education, a degree, a designation, a background in it, or they need to engage a fiduciary advisor, not someone selling the investment, but a bona fide third-party advisor, to evaluate and vet the deal.
So the investor can save themselves the money by actually demonstrating they're sophisticated enough to evaluate a risky deal, or they can hire an advisor to help, since they should have a financial wherewithal at a half a million of income or $5 million of investable assets, or perhaps the business that's raising capital itself can engage a firm that does third-party vetting and then helps them find the investors, as long as it's clear that the firm represents the investors and not the company raising the capital. To get us away from this world of, "Congratulations, you're accredited investor, here's a super special secret investment opportunity that no one else gets," and instead to something that better reflects reality, which is, "Congratulations, you're an accredited investor, now you can incur a whole bunch of extra costs in terms of your time or your dollars to consider whether you maybe sort of kind of want to take the investment risk that comes with these opaque investments."
And then let those who want to invest do so accordingly with full cognizance of the risk and either the true sophistication to evaluate the deals or the wherewithal to hire someone else to do it, who has their own fiduciary backside on the line to make sure that they vet it properly. And perhaps the possibility that someone can demonstrate that they personally really are a sophisticated investor that maybe the income and investment limits could be lowered. Because if you're really a sophisticated investor who truly understands the risks and knows how to dig into companies and evaluate them at the ground level and you still want to go for it, I'm all for letting someone do so eyes wide open to the risk that they're taking. While recognize that most people realistically do not have that level of financial knowledge and the ability to analyze companies, and so they should really only be either investing dollars they can afford to lose, leveraging outside advice or expertise they can afford to hire, or simply following the existing regulated markets.
And in the meantime, perhaps the SEC can also revisit the challenges of Sarbanes-Oxley that I think made it so much more expensive for companies to IPO in the capital markets that it's amplifying the problem. Ironically, it was done to help protect against fraud and misleading financial statements after companies like Enron and the like in the late '90s and early 2000s, but in practice, it's meant that more and more companies are staying private, which is amplifying the pressure on this distinction between public market investments and the private ones only accessible to accredited investors. But that's really not an accredited investor problem, it's a problem of regulators that have unwittingly made it too unappealing for too many companies to IPO into public markets at all, as evidenced by the fact that the number of publicly traded corporations has dropped by nearly 50% in the past 20 years.
The bottom line, though, is just to recognize that the purpose of accredited investor rules is not to give more affluent or sophisticated investors better investment opportunities that everyone else gets, it's because more affluent investors ostensibly either have the experience with investing and were more sophisticated to be able to sniff out the BS, or at least had the resources to hire people who could help them sniff out the BS. And at worst, if they failed to be good investors to spot the BS, at least they had the room to absorb the financial consequences for failing to do so. Which means it's probably time to re-evaluate and realign the accredited investor rules to these goals: raising the bar on what it means to be able to afford to lose the money, and re-evaluating what it really means to be a sophisticated investor with the requisite BS smell detector for finding the few good private investments out amongst a lot of bad ones.
So I hope that's helpful as food for thought. This is Office Hours with Michael Kitces. Thanks for joining us, everyone, and have a great day.