A New Back Door Into The Private Stock Market

Laws and regulations have built a fence around high-risk, and potentially high-earning, private investments that keep many individual investors out. The U.S. Securities and Exchange Commission is thinking of adding a new back door for financially sophisticated professionals.

In late December, the SEC proposed changes to the definition of an “accredited investor.” Under the current rules, this term applies to investors who earn an annual income over $200,000 (or $300,000 shared between spouses) or who hold at least $1 million in assets excluding their home. Investors must meet the annual income threshold for three consecutive years to qualify. The proposed changes, if adopted, would permit investors to become accredited through an alternative route “based on professional knowledge, experience, or certifications.” The SEC would also consider professional licensing or relevant work experience in its determination.

To understand why regulators might want to increase the number of accredited investors, it is important to understand what being an accredited investor means. Most private security offerings, including private stock or hedge funds, can only be sold to special classes of investors. Accredited investors are one of these classes. The other, “qualified purchasers,” is also financially determined and involves a higher threshold. Private offerings are riskier than publicly traded securities, since private companies do not face the same requirements for reporting and transparency. At least in theory, accredited investors and qualified purchasers should be better equipped to assess the risks involved.

The SEC has expressed concern since 2017 about the number of companies opting to stay private even as they grow. The newly proposed rules would allow some individuals who don’t meet the wealth requirements to participate in these riskier investments. In a press release announcing the proposed rule changes, the commission stated, “The proposal seeks to update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in our private capital markets.”

The proposed rules would not affect the definition of a qualified purchaser. This means that any private offerings that are only available to qualified purchasers would still be closed to newly accredited investors. Investors should also bear in mind that a lower threshold to become an accredited investor will not grant investors access to funds which are uniformly great. In fact, in my personal experience as our firm’s chief investment officer, almost all of the investments that we have reviewed for accredited investors have been seriously flawed. Opportunities that are restricted to qualified purchasers, who must meet a higher standard, have been likelier to make it through our due diligence process, though like any other asset class, private investments include a wide mix of good, bad and ugly. Letting more people invest in lackluster funds will not make them better.

Private investment funds also typically limit the number of investors who can own shares. As Matt Levine observed in a column for Bloomberg, many of the best funds do not want just any accredited investor; they hold out for those that can write large (institutional-size) checks. Some of the very best funds do not take new investors at all, because they are already at full capacity. When investors consider particular private equity funds, they should ask why the fund is willing to let them invest in the first place, especially a fund with low investment minimums. Said another way, if a private fund will accept your $2,500, or your $10,000, this alone can be a red flag.

Much like the recently proposed changes to advertising rules for investment advisers, the proposed changes to accredited investors are not inherently bad. But they strike me as potentially unnecessary, and they don’t do much beyond satisfying some skilled professionals who lack the income or assets to qualify. As long as the SEC sets reasonable parameters for determining relevant knowledge, I think the proposed changes will do little harm. Even so, it is not clear there was an urgent need to expand the pool of accredited investors in the first place. As SEC Commissioner Allison Herren Lee noted in a statement, “the release wholly ignores the flip side of the problem with the wealth thresholds—they are indisputably over-inclusive, capturing investors with little to no ability to assess or bear the risks of private offerings.”

Despite the risks, other commentators think the SEC’s proposal does not go far enough. In his Bloomberg column, Levine suggested a new definition of accredited investor. In his system, “anyone can be accredited just by acknowledging, in writing, to the SEC, that (1) they know they’re going to lose their money and (2) they are not allowed to complain when they do.” The language is somewhat tongue in cheek, but the broader idea is that anyone who says they understand the risk should be allowed to shoulder that risk without the SEC’s interference.

Using wealth as a proxy for sophistication is obviously imperfect. Individuals who have passed tests such as the Financial Industry Regulatory Authority’s Series 7 or Series 65 exams are more likely to have the necessary knowledge to approach private equity with the appropriate caution. Even supporters of the proposed changes acknowledge that they are moderate as written. But whatever the SEC decides, the answer to the growth of private companies is not to get rid all investor requirements. As I observed in this space more than a year ago, limits on private equity investments have their origin in the Great Depression. We would do well to remember why they were necessary in the first place.

In a column for Morningstar, John Rekenthaler observed that the problem with Levine’s proposal to open private equity to all comers lies in the opacity of these investments. Private funds aren’t required to disclose anything. While most do provide at least some data for investors, what they disclose is selective. “Generally, the more desirable the fund, the less it divulges, and the wealthier the potential investor, the more the fund will co-operate,” Rekenthaler observed. And as high-profile disasters like the failed WeWork initial public offering prove, even large investors can sometimes get burned.

The SEC is primed to let a few more investors into the “accredited” club, and this time the change is likely to do little harm. But the commissioners should be wary of letting enthusiasm for providing more private investment access carry them beyond the boundaries of good sense.

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