The SEC Investor Advisory Committee is scheduled to vote on a reform plan from a subcommittee at its Oct. 9 meeting. That plan calls for the SEC to rethink the income and net-worth minimums used to define an “accredited investor.”
Much of the concern about private placements is about risk. They seem to be universally labeled as the most risky of investments. The accredited investor definition is categorized as the class of individuals who do not need the ’33 Act protections in order to be able to make an informed investment decision and protect their own interests. They get to pass the red velvet rope and buy securities through a private placement
It’s not that the ’33 Act protections remove risk. There are plenty of people who have lost money in the stock markets. Prices can fluctuate wildly, fraud exists, the markets get manipulated and we are all being fleeced by high-speed traders.
It’s too easy to label private placements as risky. They cover a broad swath of investments with different levels of risk. Public companies may raise capital through a private placement because its quicker, easier and less expensive than through a public offering. Hedge funds are sold through private placements, but they can be anywhere on the risk spectrum. Of course there are start-ups and crowdfunded firms that are the most risky of investments. This would be true if the capital were raised through a public offering or a private offering.
The risk is incredibly varied for private placements. So labeling them as risky investments is an incorrect categorization.
In my view, it’s not the risk of loss that is the main problem with private placements.
It’s the loss of liquidity.
Whether the investment ends up being a bad one or a wildly successful one, the investor will have limited ability to access that gain or loss and limited ability to time the realization of that gain or loss.
With an investment in the public markets, the investor can sell at any time. With a private placement, the investor may have no ability to sell.
The net worth prong of the accredited investor definition is key because it shows that the individual has other resources and is not reliant on the private placement. Excluding the primary residence was a good change for the definition. Someone who is house rich and cash poor is less likely to be able to deal with the liquidity problem.
Excluding retirement accounts is exactly the wrong thing to do with the net worth requirement. That money is already relatively illiquid. An investor can access it, but is subject to penalty. Retirement money is long term money that will not be subject to liquidity demands and can be invested over the long term.
The current income test is a useful measure of liquidity demands of an investor. A higher income indicates that the investor is more likely to be able to absorb the loss in liquidity from a private placement.
I’m all for expanding the definition to more individuals who can prove their financial sophistication. One recommendation from the sub-committee is to have a test for financial sophistication. That’s a great idea to expand the base, but I’m skeptical that there would be many people lining up to take the test.
Another recommendation is that private placement investments be limited to a portion of income or net worth. That is better aligned with the liquidity risk. However, it would impossible to verify and incredibly intrusive to implement.
That comes back to the compliance aspect. The more complicated the method for determining whether an investor is an accredited investor that harder it is for a company to use private placements or to open them to individuals. Removing the primary residence from the net worth definition was a good idea to address the liquidity risk, but it makes the confirmation more difficult.
The failure to ensure that all investors in a private placement are accredited investors can lead to very bad results. Complicating the definition will lead to a reduction in the usefulness of this fundraising regime.
Sources:
- Agenda: October 9, 2014, Meeting of the Securities and Exchange Commission Investor Advisory Committee
- Recommendation of the Investor as Purchaser Subcommittee and the Investor Education Subcommittee: Accredited Investor Definition
- SEC advisory panel recommends new approach to accredited investor label
- Discussion of the Definition of Accredited Investor from July 10 – SEC Investor Advisor Committee (IEC) Meeting
