Accredited Investors: Everything You Need to Know
An accredited investor is a seasoned participant in non-SEC registered investments. To qualify, they must meet minimum defined wealth specifications, which, in turn, give them entry into investment opportunities with benefits that public offerings find it challenging to match.
Qualified investors have the opportunity to enter an arena reflecting excellent metrics and professional standards. Although ventures of this nature don't require SEC registration, seasoned participants know that "accredited investor" territory comes with many benefits and advantages. The most compelling are two-fold: Firstly, the accredited investor can multiply wealth and open up their investment portfolio in ways public offerings can't. Secondly, the general partners in this category drive viability by ensuring that their proposals offer excellent returns and unsurpassed transparency to stay ahead of the curve.
An accredited investor must display at least one of the following:
- Earned SEC-specified professional certifications/designations/ credentials or hold the title "knowledgeable employee" aligned to a private fund.
- Show a net worth of over $1 million as one person or together with one's spouse, but this excludes the primary residence.
- Reflect earned income of over $200,000 (individually) or $300,000 (as a couple) for the last two years. In addition, prove that the current year's income can exceed or maintain the prescribed threshold.
The general partners of the proposed asset must qualify or disqualify interested investors using the SEC criteria.
What is an accredited investor? (Fully explained)
The modern era has opened the door to so many accredited investor opportunities that it can make you dizzy. It's one thing to make money; it's quite another holding onto it and, indeed, doing what's necessary to make it grow. The arena has many verticals covering traditional asset classes like equities, bonds, REITs and mutual funds. It also embraces the channels and entities that facilitate these investments, like banks, brokers, insurance companies, and stock exchanges (i.e., like the NYSE and the NASDAQ).
Did you know there are nine regulatory bodies overseeing rules and compliance to protect investors from fraud and devious asset management activities in the USA? The most famous of these include the Federal Reserve and Security Exchange Commission (SEC), focusing on streamlining conventional investment transactions pouring through our system every day. They're there as a backup to the investor community, going so far as to insure deposits in banks, and more.
Capitalist economies, encouraging entrepreneurship, inevitably trigger unconventional investment options, loosely categorized under alternative investments. The latter cover:
- Private equity
- Venture capital
- Angel investing
- Hedge funds
- Managed futures
- Art and antiques
- Commodities
- Equity crowdfunding
- Derivatives contracts
- Real estate
- Currencies
- Crypto-currencies
Generally, when the asset class reflects significant illiquidity, the addition of loans (popularly known as leveraging), or involving out-of-the-norm management skills, it adopts a non-regulatory look. Regulators have offset this to an extent by designing structures like mutual funds, ETFs, and REITs to absorb some unconventional assets into a traditional format. Nonetheless, outside of these modified alternative investment channels, the arena is mainly only open to accredited investors - the topic of this article.
Expanding on accredited investors
When a person is allowed access to a complex, loosely regulated investment option that's somewhat intransparent, the SEC regards them as "accredited." However, when you get down into the weeds to see what the term means, a notice/alert emerges. A spokesperson for the SEC may say this to you:
"We, that is, the SEC and associated regulatory bodies throughout the country, have strict regulations to protect your funds from management malpractice. These generally kick in after you decide to place your funds in an asset class under the control of an investment entity. However, we recognize there are numerous verticals within the broad investment scope that we have little say over. Yet, they remain popular and enticing. If you insist on going in this direction, you're more or less on your own if it turns out that your best laid plans come off the rails."
That’s the bottom line, except to say there’s a minimum ground floor level of protection, if you will, designed to moderate the inflow of funds into alternative investments. The SEC requires private fund managers to adhere to an accreditation process. Investors must filter through it before venturing forth into a field that may spell:
- Extraordinary rewards on the one hand.
- Investment collapses with little recourse, on the other hand.
In short, an accredited investor is a seasoned participant in non-SEC registered investments. To qualify, they must meet minimum defined wealth specifications, which, in turn, give them entry into investment opportunities with benefits that public offerings find it challenging to match.
A word on investments where accredited investors participate
From the above, you may be under the impression that any investment outside of the conventional is "iffy" at best. That's not true. There are numerous fields where highly competent management teams with stellar records function effectively generating consistently compelling returns. These appeal to millionaires and billionaires from all walks of life. From my experience, two specific constructs emerge the minute you consider an alternative investment:
- The opportunity is generally open to a relatively small audience, thus cutting off the public from access to it:
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- Aside from the several benefits of being an accredited investor, the immediate disadvantage is an illiquidity issue for any investing party who wants to exit prematurely. A small investment pool implies that finding someone to hand the baton to may be a severe challenge.
- Moreover, midway valuations are not simple calculations. It often results in the exiting party (if the latter can find a willing replacement) accepting zero added value on the original investment or, more likely, a discount in many cases. There's no instantaneous stock price flashing for all to see, similar to what we're used to on publicly traded bourses.
- The limited entry appeal centers on the glow of "exclusivity" - signaling you out as one of the privileged few selected to enter an innovative venture.
- So, it boils down to the investor’s acumen to assess the risk and decide if the alternative investment offers genuine reward or inevitable disaster.
- The second massive consideration is who or what team is at the helm of the proposed project. For example, real estate developments of single-family luxury homes in Florida, Hawaii, Connecticut, and other mainstream suburban or vacation locations are non-regulatory to their core. However, if guided by the right team with an outstanding track record, an invitation to invest may look like a no-brainer. Profiles should reflect vital aspects such as:
- Recent similar projects.
- Metrics that demonstrate success.
- The proposal aligns with the same parameters.
- Depth and breadth of the team conducting the operations behind the project to ensure continuity.
- Reporting frequency and accuracy
- References, referrals, and testimonials.
When entering as an accredited investor, due diligence should be a vital watchword in your thinking. Don’t underestimate the crucial coverage of whom you’re getting into bed with. Also, focus on your exit options, and if the investment time frame extends past your comfort level, heed the warning bells it sets off.
The Dodd-Frank Wall Street Reform and Consumer Protection Act contains sections that cover alternative investments. It highlights that this category is significantly removed from the strict legal oversight that applies to conventional asset classes. They are often subject to some scrutiny by the SEC but have no obligation to register with them. Real estate projects connected to the legislature under 506 C give investors an idea of what to expect if things go wrong. Still, it's a world apart from the strict stipulations mutual funds and REITS must adhere to.
Accredited Investor Requirements
So let's get to understanding what an accredited investor profile truly looks like. The SEC is very specific about this, laying out defined characteristics. An accredited investor must display at least one of the following:
- Earned SEC-specified professional certifications/designations/ credentials or hold the title “knowledgeable employee” aligned to a private fund.
- Show a net worth of over $1 million as one person or together with one’s spouse, but this excludes the primary residence.
- Reflect earned income of over $200,000 (individually) or $300,000 (as a couple) for the last two years. In addition, prove that the current year’s income can exceed or maintain the prescribed threshold.
- In meeting this particular requirement, you can’t switch from individual to joint, or vice versa.
- In other words, the same calculation method must apply for all three years.
- The only exception to the above rule is if marriage intervenes during the three years.
So why all the strict regulations? To understand or even justify these rules, you must appreciate the definition of an accredited investor and what they can and can’t do.
How does a company qualify an Accredited Investor?
According to SEC law, any company that offers its equity (in any shape or form) to investors must register with the SEC. That is unless the regulatory body deems it to be an exception. The one under our focus is the selling of unregistered investments to accredited investors (of which there’s a list above under the Introduction - reiterated here for your convenience):
- Private equity
- Venture capital
- Angel investing
- Hedge funds
- Managed futures
- Art and antiques
- Commodities
- Equity crowdfunding
- Derivatives contracts
- Real estate
- Currencies
- Crypto-currencies
The SEC expects entities that fall under the umbrella of unregistered products to implement their screening methods to determine if candidates meet the standards. It's a process, and it looks something like this:
- The company follows the 2013 SEC guidelines expanded out in 2020
- Accordingly, they produce a questionnaire, requiring you to submit information that covers:
- Financial statements and associated account details
- A credit report
- Reliable confirmation of individual or joint net worth
- Tax returns for the past two years including:
- W-2 forms
- Any other documents pertinent to earnings
- Evidence of a candidate qualifying as a "Knowledgeable employee" of the issuing fund.
- Any professional certifications/designations/credentials that Financial Industry Regulatory Authority (FINRA) administers. Good examples of the latter are FINRA's Series 7, Series 65, or Series 82 designations.
Of course, some companies are compliant, and others are "not quite so compliant." Reputable private funds should fall firmly into the former category. Even if you are a valid accredited investor, any lapse in the company’s process of vetting you should be a due diligence warning sign. In most cases, non-registered funds with impeccable results and resumes have more investors chasing their offers than they can take on. Conversely, those ready to bend the rules to let you in may represent relatively more risk.
The benefits of being an accredited investor and a real-life example
Accredited creditor investments open up a whole new world of opportunity that goes way beyond traditional bonds and equities. The rewards are generally attractive for individuals with the qualifications and the acumen to evaluate more complex options. I've outlined the risks associated with traveling this road. Still, if these don't deter you, there are many private fund managers out there that can yield consistent high double-digit returns for their followers. Also, the private investing arena has advanced along the sophistication pathway, providing baked-in resolutions for exiting investors with reserve funds and other mechanisms. Finally, their reporting meets the highest expected standards. As long as you're entering with your eyes wide open, as an accredited investor, the future looks bright with a stream of innovations and promising developments.
An interesting example of an accredited investment opportunity is the Hawaii real estate development promoted by Kona Development Partners, LLC. In this case, investors can expect over 25% IRR in an unleveraged property portfolio. Moreover, the general partners come with outstanding professional credentials and close to $1 billion in aggregate projects under their belt. They've located their current luxury single-family development in one of the world's hottest location spots. The contractual terms are fully compliant with SEC accredited investor protocols, and the exit clauses create significant comfort for investors. This company is a yardstick against which you can measure any others under consideration.
Are individuals the only type of accredited investor allowed?
Under Section 501 Regulation D of the SEC regulations, entities qualify as accredited investors as follows:
- Any registered banking institution.
- Licensed brokerage firms and RIAs ( Registered Investment Advisors).
- Employer-sponsored retirement plans and specifically defined trusts.
- Any limited liability companies holding assets of $5 million or more.
- Investment advisers under the auspices of the SEC or state.
- Specially exempt reporting advisers.
- Entities with the following focused agendas:
- Rural business investment
- Family offices with $5 million or more of assets under management
- And their separate family office clients as defined under the Investment Advisers Act.
- Under foreign laws - the organizing of funds involving Indian tribe affairs and government bodies
Conclusion
Accredited investor considerations are undoubtedly an enticing ecosystem for many that meet the SEC regulations. It has its checklist of due diligence items that investors should not bypass for any reason. And with that responsibility, your role as an investor will broaden, and your limitations will significantly decrease. You’ll bypass the ceiling available in public offerings and leap into a tier of sophisticated strategic investors.
Although the field can confuse those with little experience, a methodical approach and trusting historical performance and references make the difference between success and failure. Refer to the real-life example (i.e., Kona) above to appreciate how it should work in practice.