SEC threshold for accredited investor likely to increase in months
The Securities and Exchange Commission (SEC) is likely to re-define the income and net-worth threshold for what constitutes an accredited investor in what could make it harder for early-stage hedge funds and other private funds to solicit capital from friends and family.
At present, individuals with an annual income of $200,000 and a net worth in excess of $1 million qualify as accredited investors and are therefore permitted to invest in private fund vehicles. Section 413(b)(2)(A) of the Dodd-Frank Act requires the SEC to re-examine the definition of “accredited investor” every four years. The last time the SEC reviewed the definition was back in 2010 when it decided to exclude the value of a person’s primary residence from the calculation of their net worth. The latest review is due to happen before the end of this year.
“It is quite possible the SEC could increase the threshold from the $200,000 per year as applied to income to up to $500,000, and the $1 million net worth threshold to more than $2.5 million. While this is unlikely to impact large-scale fund managers which solicit institutional investors writing substantial tickets, it could have a significant effect on smaller managers who are setting up and are devoid of seed capital and therefore reliant on cash inflows from friends and family,” said Steven Nadel, partner at Seward & Kissel, a New York-based law firm.
The cost of running a hedge fund has risen astronomically since the financial crisis. The growing regulation on both sides of the Atlantic and demands from investors for managers to institutionalise their businesses is piling pressure on the industry. Analysis by Citi Prime Finance at the tail-end of 2013 found hedge funds required at least $300 million in Assets under Management (AuM) to enable their 2% management fee to cover their operational and regulatory overheads. “Should the SEC increase the accredited investor income and net worth threshold, the barrier to entry for start-ups will get that ever more elusive,” said Nadel.
The SEC could potentially go further and require prospective investors to demonstrate a degree of financial sophistication and knowledge prior to purchasing units in a private fund. This would bring the US in line with the stance taken by the UK’s Financial Conduct Authority. Some have advised investors with a background in law, audit or banking be automatically deemed as accredited. “It is possible the SEC will want managers to evaluate whether a prospective client is accredited based on their experience in financial services,” said Nadel. Another outcome could see investors subjected to a financial competency examination before they are permitted to allocate into a private fund.
The SEC has made it no secret it wants to tighten up on what constitutes an accredited investor, particularly given the definition was first promulgated more than a quarter of a century ago and has since failed to take into account for inflation. Furthermore, the passage of the JOBS Act has added a further impetus to the SEC’s resolve. The SEC is reportedly nervous that unscrupulous or fraudulent managers could target unsophisticated investors through the relaxed marketing and advertising measures contained in the JOBS Act. “The SEC obviously wants to protect consumers and it would be a disservice to the hedge fund industry should unsophisticated investors get hurt by an individual who turns out to be fraudulent or high-risk. There is some merit to what the SEC is doing,” said Nadel.
Despite the SEC’s fears, hedge fund and private equity enthusiasm for the JOBS Act has been remarkably muted despite some initial fanfare. Many managers are put off by the additional reporting requirements the JOBS Act entails while others are concerned about the risk of arbitrage with the EU’s Alternative Investment Fund Managers Directive, which prohibits any form of marketing by a non-EU firm into Europe if it does not comply with the national private placement regimes being adopted by member states. Taking advantage of the JOBS Act also requires firms to be dually registered with the SEC and the Commodity Futures Trading Commission, a scenario which is fairly uncommon.