When Congress passed the Dodd-Frank Act, there was a provision that said the SEC would examine the accredited investor definition every four years. Why does this matter? Per the report (with our emphasis):
“The “accredited investor” definition is a central component of Regulation D. It is
“intended to encompass those persons whose financial sophistication and ability to sustain the
risk of loss of investment or ability to fend for themselves render the protections of the Securities
Act’s registration process unnecessary.” Qualifying as an accredited investor is significant
because accredited investors may, under Commission rules, participate in investment
opportunities that are generally not available to non-accredited investors, such as investments in
private companies and offerings by hedge funds, private equity funds and venture capital funds.
Issuers of unregistered structured finance products and debt securities also may rely on
The exemptions in Regulation D are the most widely used transactional
exemptions for securities offerings by issuers. Issuers using these exemptions raised over $1.3
trillion in 2014 alone, an amount comparable to what was raised in registered offerings.”
The definition change also matters because of the ease of investing in private offerings via crowdfunding using online platforms today. Many sites popped up offering access deals from real estate to technology startup companies and much more.
Since 1982, the accredited investor requirements have been the same – $200,000 of individual income, $300,000 of joint household income, or $1 million net worth (excluding primary residence).
Here is what the SEC recommends from its report issued in December 2015:
- Grandfather in the previous income and net worth requirements, but subject to 10% investment limitation in any one issuer
- Increase income threshold to $500,000 and net worth to $2,500,000 (no percentage limitation)
- Index the threshold requirements for income and net worth to inflation
- Grandfather issuers’ existing investors that are accredited under current definition
In addition, the SEC also recommends the accredited investor definition be expanded to include individuals with the following attributes:
- Certain professional credentials (Series 7, CPA, CFA, etc.)
- A minimum amount of investments of $750,000
- A minimum amount of experience investing in exempt offerings
- Individuals who pass an accredited investor examination
The SEC estimates there are currently about 12.4 million accredited investor households. The new inflation-adjusted requirements would impose a limit (10%) on 4.4 million households, which could lessen funds available for issuers under Regulation D. The limit is probably a pretty good idea to prevent people from “putting all their eggs in one basket.” Including all of the new expanded definitions, the pool of accredited investor households would expand to 14 million.
All of these changes would have a big effect on the private capital markets over time. Record amounts of money flowed into venture capital (VC) the last few years. Given easy capital access and lower levels of due diligence on crowdfunding platforms, I suspect there will be many failures and few winners of those using the VC platforms (like any portfolio of VC investments). When VC investments hit though, they will be big, but a huge gamble rather than an ‘investment’ in the end. Far more interesting to me are the real estate and private equity opportunities with more tangible businesses and quality cash flows. While not knowing anyone personally, my inclination that those who fail to build a quality peer network of lenders or investors will be the ones using the platforms as sources of capital. This could result in negative selection bias. At the same time, the pure convenience of the platform and quick execution may make crowdfunding platforms a viable solution for all or a portion of capital raising.
In the future, online crowdfunding platforms could become the norm rather than the exception. Hopefully there will be an increase in quality and greater due diligence standards on a self-imposed basis by the industry. Will more qualifying individuals consider crowdfunding as part of basic asset allocation? Could this be offered in 401(k) plans in the future?
It will be really interesting to see what, if any, of the SEC recommendations become law and the subsequent impact on crowdfunding and individual investors. Keep an eye on this, we sure will.