Nouveau Accredited

“Every day brings new choices” -Martha Beck

That it does, Martha Beck. While each day we may get to decide between basic choices we’ve always had – like what to eat for lunch or what clothes to wear – sometimes our available options materially change because our legal framework evolves.

There are three distinct qualifications in the US (under the SEC) that determine who can invest in what type of investment offerings: the accredited investor, the qualified client, and the qualified purchaser. I believe the idea is to protect the average person (aka retail investor) from more “risky” offerings, like private equity, venture capital, and hedge funds. And maybe the intent is good, but – as we’ll see in exploring this issue in more detail – it’s built mainly on the premise that wealth is the same thing as investment sophistication, and that is simply not true.

 

Accredited Investors

Just like with the more familiar notion of accredited colleges and universities, being an accredited investor is a sort of official recognition or standing. It can be achieved in several different ways, but only requires one of the following to be true (for more lengthy definitions and examples, see the SEC website):

  • Earned income of $200k (or $300k jointly w/spouses or spousal equivalent) in the past two years and expecting the same for the current year
  • Net worth over $1 million (excludes primary residence)
  • Current holder of the Series 7, 65, or 82 license (aka a financial professional)
  • For entities (like trusts, LLCs, and family offices), the total assets have to be more than $5 million, or all of the owners must be accredited investors themselves.

Interestingly, the financial professional, spousal equivalent, and family office aspects weren’t added until August 26, 2020! And, as outlined in this short history, the income/net worth requirements haven’t changed since the accredited investor rules were first established in 1982. I regard that as a good thing since it means more people qualify as accredited investors, and the income/net worth hurdles are still high enough to serve the original purpose of keeping these certain investments beyond the reach of average retail investors.

Qualified Clients

Qualified Client (QC) is the least prominent of these three categories. That notion is reinforced by the fact that I can’t even locate the official QC definition via the SEC.gov website (feel free to try and find it yourself and then send me a note to make fun of my subpar Googling abilities). It does exist, however, and additional information can be found in this easy-to-follow Nasdaq article (or item “(d)” in this more arduous piece from Cornell Law School).

Essentially, being a QC requires a higher net worth hurdle ($2.1 million) than the $1 million accredited amount, or it can be achieved with a $1 million investment into one fund. QC rules also allow for qualification via association with the fund. For instance, an executive role (director, officer, trustee, GP, etc.) or employee involved in “investment activities” of a fund for at least 12 months can also qualify, regardless of net worth. To me, these latter provisions get more at the heart of the “sophistication” element of what these rules are attempting to accomplish in the first place.

[Note that the specific QC-qualification language will reference executive/employee roles as part of an “investment adviser.” Although that may sound like the same thing as a financial advisor, it really can include many things, like money managers and hedge funds that also have to register as investment advisers. It can be confusing, but it’s not worth going into more detail for today’s purposes.]

Qualified Purchasers: The Trump Card

If you’re a qualified purchaser (QP), you’re automatically also a QC and accredited investor, and you can pretty much invest in whatever you’d like. That’s because, to qualify as a QP, the hurdles are even higher than the other categories. This list from Practical Law lays out the details nicely, but the following are typical (not all of the ways) QP investors:

  • A person or couple with investments valued at $5 million or more
  • A “family company” with investments valued at $5 million or more (this can be owned by siblings, spouses, descendants, estates, or other entities of family members/entities)
  • A trust where the trustee and each settlor (contributor) is a QP
  • A company, foundations (non-family/personal), or endowment with investments valued at $25 million or more

[Again, there isn’t a straightforward government webpage to reference on this (that I could find); however, if interested, here is a 94-page document from the SEC on the creation of section 3(c)(7) of the Investment Company Act of 1940 (aka “the ’40 Act”) and the related implications for qualified purchasers]

Why Does Any of This Matter?

From the investor’s perspective, these qualifications increase the menu of what is available to them. Being accredited is the first step beyond standard investments available to retail investors, QC recognition opens the door to funds that charge performance fees, and QP status is required for yet another swath of the alternative investment universe.

From the fund manager’s perspective, there is a crucial decision to be made regarding fund structure because it has implications for a) what investor qualification is needed to participate and b) how many investors can participate. We’ll explore this briefly in the next section.

The Accredited Menu vs. the QP Menu (aka 3(c)(1) vs. 3(c)(7) funds)

Perhaps no financial services jargon is worse than referencing specific sections of The ’40 Act, but please bear with me, as I promise to keep this light. Simply put, these provisions allow funds to operate specifically for investment by accredited or QP investors, BUT they come with some rules.

  • 3(c)(1): Funds that require accredited investor status (aka “3(c)(1) funds”) cannot publicly market their “wares” and only allow for 100 investors to participate.
  • 3(c)(7): Funds that require qualified purchasers (aka “3(c)(7) funds”) also cannot publicly market their strategies BUT can accept 1,999 investors.

The Manager’s Dilemma

The above implies that structure is vital to a given investment strategy and the ultimate success of a fund (as we covered in Framing the Solution). If the goal is to raise a lot of money, perhaps an “accredited fund” won’t cut it. Suppose an average accredited investor has $2 million to invest, and they want to limit their investment to about 5% of their portfolio ($100k). In that case, 100 of those investors would only raise $10 million – not enough for a viable strategy. Of course, the fund will still want to target larger investors to help raise more money. There are also ways around the 100 slots, such as “feeder” structures (a group of underlying investors that technically only count as one investor for the purposes of the fund). Still, you get the idea: allocation to smaller accredited investors has to be carefully managed.

On the other hand, the same example in a QP structure where the investors have an average of $5 million to invest would potentially raise almost $500 million (5% of a $5 million portfolio would be $250k, and 1999 of these investors => $499.75 million) – a very viable outcome (but good luck finding 2000 QP investors).

For managers with deep networks of potential investors, the QP structure (“3c7”) is the obvious choice. But for managers with some large institutional anchor investors (that may invest $50 or $100 million into a given fund), and relationships with advisory firms (where a “feeder” may be constructed that can hold all of that firm’s clients, but only counts as one investor at the fund level), then the 3(c)(1) could be perfectly adequate while allowing accredited investors to round out their capital raise. Another consideration is that of charging performance fees, which (as above) may require at least QC status.

Flawed Framework?

It’s easy to see that the accredited, QC, and QP requirements can miss much of the nuance of what they’re intended to accomplish – i.e., that only “sophisticated” investors should take part in these potentially riskier offerings. Let’s think through a few examples:

  • A person with a $5 million home, no mortgage, $999,999 of cash in the bank, $199,999 of annual income, and substantial financial experience would (technically) NOT be accredited. And, until last year, this person could have even been a licensed financial professional and still not qualified!
  • A person with $1 million of cash, no income, and no investment experience WOULD be accredited.
  • A person who just sold a textile company for $5 million (after-tax) would be a QP, even if they have never made a single investment.

Believe it or Not

Another odd implication of the investor qualifications is how an otherwise wealthy QP family can use estate planning to disqualify itself from certain investments. As a real-life example, we had a $30 million+ family who did some pretty extensive estate planning (prior to working with us) where several family companies and irrevocable trusts were formed that no longer qualified as QP. Now, maybe there are some legal loopholes to get around situations like that, but the attorneys in that particular situation believed that the estate entities didn’t qualify, so it limited the investments available to each of those. It’s a good reminder of why your financial advisor should play a role in your estate planning conversations, especially before making any irrevocable decisions.

Bringing this full circle to the quote with which we started, as investors build certain levels of wealth, they unlock additional choices for putting their money to work. I believe that access to private investments will continue to become more democratized, and we’ve already seen some developments on this front (e.g., interval mutual funds, crowdfunded direct private equity). For the time being, though, investing remains a game of more money, more choices.

Until next time, this is the end of alt.Blend.

Thanks for reading,

Steve

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About the Author

Steven Tresnan, CAIA®, CFP®

Private Wealth Advisor

Steve is a Certified Financial Planner as well as a Chartered Alternative Investment Analyst®. He is also an Accredited Investment Fiduciary, which helps him offer guidance to clients with fiduciary responsibilities, such as board members of trusts, foundations, and endowments. Steve earned a Bachelor of Science degree in Industrial Engineering from Penn State University.

Steve serves on the board and finance committee of New Music USA – a national nonprofit devoted to the development and appreciation of new music in the U.S. – and volunteers as the Treasurer for Campus Fun & Learn, a child development center on the campus of Rockland Community College in New York. 

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