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.