By Jason Zweig | 12:49 pm ET Jul 18, 2014
Image Credit: Christophe Vorlet
Who should get to invest in deals that aren’t available to the general public?
That is a question the Securities and Exchange Commission will have to address in the next year or so. Private offerings—everything from energy partnerships or shares in your community bank to hedge funds—can sometimes yield lucrative returns, but their financial disclosure is limited, they can be almost impossible to trade and you can lose ungodly amounts of money if something goes wrong.
That is why, at present, you can buy them only if you are an “accredited investor.” To be accredited, you must have annual income exceeding $200,000 or have more than $1 million in assets net of debt, not counting the value of your house.
Known as Regulation D offerings or “Reg D” deals after the SEC rule that permits them, these private securities rival the public markets in size and popularity. If you have $1 million and a pulse, you probably have had deals like these pushed at you lately.
In 2012, the latest year for which data are available, 31,471 of these offerings raised approximately $900 billion, compared to 2,427 public debt and equity offerings that raised $1.2 trillion, the SEC estimates. More than three-quarters of the assets raised privately went into hedge funds, venture-capital funds, private-equity funds and commodity-trading pools; the rest went into private businesses.
The Dodd-Frank financial-regulation law of 2010 requires the SEC to review the accredited-investor standard every four years, but an overhaul is decades overdue. The dollar thresholds to be accredited haven’t changed since 1982, although the value of an investor’s primary residence was excluded from the definition in 2011. Back in 1982, the Dow Jones Industrial Average was around 800. Today, it hovers around 17000.
Being out of date isn’t the only problem; money and brains simply don’t always come in the same package.
“Joe Sixpack could inherit $1 million or win the lottery and not have any sophistication at all,” says Roger Walter, a former securities regulator for the state of Kansas who is a partner at the law firm of Morris, Laing, Evans, Brock & Kennedy in Topeka.
Unfortunately, there isn’t a formal definition of “sophistication” in the securities laws, says Robert Robbins, a partner at Pillsbury Winthrop Shaw Pittman in Washington. “It’s kind of like pornography,” he says: “You know it when you see it.”
Under the existing rule, a person with just over $1 million in net worth is free to invest 100% of it in a single private offering, while someone with $999,999.99 can’t invest a penny in any private deal.
“The principle here is that [millionaires] ’can afford to lose their shirt,’ but they can end up losing their entire wardrobe,” says Mercer Bullard, a former SEC regulator who teaches securities law at the University of Mississippi. “You’re just as broke if you start at $1 million or $10 million and end up with zero as you would be if you started with under a million.”
So raising the minimum dollar amount of wealth or income to be accredited probably won’t solve the problem. And Marianne Hudson, executive director of the Angel Capital Association, which helps individuals develop best practices for investing in new businesses, estimates that 28% of her organization’s more than 12,000 members would no longer qualify if the income and wealth standards were raised to take into account the approximate rate of inflation since 1982 to $400,000 and $2.5 million, respectively.
“That would pull back a lot of capital from startups,” she says.
One idea is to exclude some assets from the net-worth calculation. “If you pull out the nonliquid assets, you raise the odds that investors will have the liquidity to be able to withstand a loss,” says Barbara Roper, director of investor protection at the Consumer Federation of America. Counting only readily marketable securities like stocks, bonds and mutual funds, while excluding assets like farmland or equity in a family business, would make sense, she says.
Investors, Mr. Bullard suggests, also could be limited to a maximum of no more than 10% of their liquid financial assets in private offerings or required to keep a minimum of $500,000 in diversified investments like mutual funds.
Kevin Hogan, president of the Investment Program Association, a trade group for issuers and distributors of nontraded securities, worries that “people who have millions to invest don’t really want to be told where and how to invest their money.”
But federal law bars pension plans from investing more than 10% in the stock of their own company, so there is precedent for this kind of prudence, Mr. Bullard says.
The SEC is unlikely to finalize a new rule until 2015 at the earliest, according to people familiar with the matter.
In the meantime, before you invest in a private placement, it might be a good idea to try accrediting yourself.
Can you fully understand even the limited financial disclosures you will receive? If it takes five years to sell the investment, can you wait that out? Are you prepared to lose every dollar you put into this investment? Can you afford to?
If your answer to each of those questions is yes, maybe you are a sophisticated investor. If not, you aren’t—no matter how much money you have.
Source: The Wall Street Journal