The Securities and Exchange Commission has three mandates: (1) protect investors, (2) maintain fair, orderly, and efficient markets, and (3) facilitate capital formation. Regulation of private securities transaction through the accredited investor standard falls squarely in the conflict between these mandates.
The general statement about why certain investors can invest in securities subject to less regulatory oversight is that they are able to handle the risk. The standard for handling risk is the accredited investor standard and it’s based on tests of income or net worth. In theory, if you had a certain amount of money you could handle the risk.
The existing thresholds for an accredited investor were created in the 1980s. The big change was Dodd-Frank that excluded primary residence from the net worth calculation. The income and net worth test are not pegged to inflation and therefore have become more inclusionary over the past decades.
Last week, Acting Chairman Michael S. Piwowar quoted William Graham Sumner’s Forgotten Man in adding his view of securities regulation. He gave his view on accredit investors:
“Distinguishing investors who can fend for themselves from those who cannot is a line-drawing exercise fraught with peril. The Commission did just that in 1982 when it adopted Regulation D, dividing the world of private offering investors into two categories: those persons accorded the privileged status of “accredited investor” and those who are not.”
Here he steps into a fallacy. Or at least what I believe is a fallacy. He tags private placements as “high-risk, high-return securities available only to the Davos jet-set.”
First, the tests for accredited investor are not so high that you need to be in the Davos Jet-set.
Second, private placements are not all high-risk, high-return investments.
Perhaps the SEC is suffering from a lack of data on private placements. Private placements are investments that the issuer can sell to a smaller group of investors without having to go through the cost of a public offering.
Congressional mandates, SEC regulation, and shareholder lawsuits have made being a public company less attractive. There are additional costs and risks with allowing your securities to trade publicly. Until a few weeks ago, a public company had to worry about [the resource extraction rule conflict materials in its supply chain] and how to calculate the pay ratio between the CEO and its workers.
The risk for private placements is really not the loss of capital. It’s loss of liquidity.
Private placements have limited opportunities for investors to achieve liquidity. That generally means a long hold period. If the investor needs cash, the investor will have to look for other holdings to sell to get that liquidity. Private placements do not have a market for resale, so the investor needs to find a willing buyer in secondary sale process or wait for the liquidity event, if one ever comes.
Using income and net worth tests make sense because of the liquidity risk associated with private placements. The accredited investor will more likely have the income or capital to address the liquidity.
Within the world of private placements there are very risk investments and low risk investments when looking at an investors likely return of capital.
For example look at hedge funds, they may be more or less risky than a mutual fund depending on the investing style. As an investor, you have limited opportunities to receive back your investment and any returns. Most hedge limits have significant notice periods for redemption and often limited redemption to a few times each year for investors to get their hands on cash.
There seems to be a lot of focus on the high-risk early stage investing associate with private placements. Those are only good investments if you can make lots of them. You see something like 5% of startups making money and rest essentially going to zero. Assuming those odds, you need to make 20 investments. The accredited investor standard ends up being low if you just focus on those risky investments and ignore the more plentiful lower risk investments.
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