Rules of the road for newly eligible accredited clients

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For decades, the SEC’s criteria for an accredited investor — one allowed to participate in private capital markets — has been akin to the story of Goldilocks — both too broad, and too specific. Until last summer when the commission expanded the pool of investors and fixed the definition to one that approached “just right.”

The good news for your newly eligible accredited client is that private capital markets can be quite lucrative — McKinsey reported that the value of global private markets has grown by $4 trillion since 2009, which significantly outpaced growth in the public market in that period.

Under new SEC rules expanding the definition of an accredited investor, advisors now have to help even more clients understand the risks and rewards of the private markets, writes Sophia Duffy.

Bloomberg News

However, because the Securities Act exempts private issuers from certain disclosure and registration requirements under Regulation D, investors have access to less information about these investments, which makes the private market riskier and less transparent. It is a bit like the old Wild West — rife with opportunities to strike it rich, but at the same time fraught with risk. As an advisor, you want to help your clients who qualify as accredited investors to maximize their opportunities in a safe and reasonable manner.

Let’s start with some history. In August 2020, the commission adopted amendments to the definition of an accredited investor under Regulation D. The “private market” refers to investment opportunities that are not traded on the public exchanges. This includes venture capital opportunities, early investment options in private companies before they go public, private equity offerings and private alternative investments. The accredited investor provision was originally intended to allow wealthy, financially sophisticated individuals the opportunity to pursue riskier investments because they could presumably better understand risks and withstand financial losses than less knowledgeable and less wealthy investors. The SEC used wealth and income to define an accredited investor: any person with $200,000 annual income for a single investor ($300,000 jointly with a spouse) or $1 million net worth (excluding the primary residence).

The recent change to the definition is notable because despite criticism of the wealth and income thresholds over the years, the definition has not materially changed since the early 1980s. Critics point out that relying on wealth and income to identify financially savvy individuals is problematic because wealth and income do not necessarily correlate to knowledge, and because some knowledgeable individuals may not meet the wealth and income thresholds.

New rules
The recent amendment shows that the SEC is now willing to consider change by adding a new category to the definition of an individual accredited investor. Under the new expanded definition, an individual who holds professional certifications that relate to investments and financial products, such as the Series 7, 65, and 82, will qualify as an accredited investor, even if they do not meet the wealth and income thresholds. The wealth and income thresholds were not adjusted in the current amendment.

In addition, the definition has been clarified and expanded to include knowledgeable employees of a private fund who wish to invest in the fund, for example, directors, officers and clerical staff who have participated in management of the fund; LLCs with at least $5 million in assets; as well as family offices with at least $5 million in assets under management and their family clients. A family office must have at least $5 million in AUM and must have another business purpose (other than acquiring the securities). Another significant change is that “spousal equivalents” (a cohabitant that is not legally married to an accredited investor, such as a domestic partner) can now qualify as accredited investors by pooling their assets with their partner.

So what does all of this mean for you and your clients? Clearly, more individuals are eligible as accredited investors. An advisor should be aware of which clients may qualify as accredited investors and educate these clients on private market opportunities. Proper education starts with communication. Do not assume that just because your client may be knowledgeable, they need less information. Clients should understand what the private market is and how it is different and less regulated than the public market. Of course, this education must include a frank discussion about the risks involved.

Because Regulation D does not require any disclosures to accredited investors, your clients may have to make the decision to invest with less information than they normally would have. However, remember that disclosures are still required under the anti-fraud provisions and fiduciary standards of the 1933 Act, so they should have some information available to make the investment decision.

Complex offerings
Beyond education, a critical service you can provide to your client is to recommend guidelines for safer investing.

Analyze the quality of the client’s assets, perform a liquidity analysis to determine how much loss can be safely absorbed without putting your client’s financial security or retirement plan at risk and recommend investment caps to your client based on this analysis. Periodically review the client’s portfolio and make changes to your investment cap recommendations as appropriate. This way, if a loss occurs due to the riskier nature of the private market, the client’s essential funds will be protected, and they will still be financially secure.

Another obvious, but important, point is to educate yourself about private market offerings. Some of these offerings can be quite complex, such as the recently created “qualified opportunity zones” under the Tax Cuts and Jobs Act of 2017.

Knowledge is the key to serve your client responsibly: successful advising can only be achieved with accurate, reliable, and consistent communication.