Publications

- November 1, 2019: Vol. 6, Number 10

Your credentials, please: Would an expanded definition of accredited investor be a good thing?

by Adam Hooper

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In July 2018, the House of Representatives passed a bipartisan package of bills known as the JOBS Act 3.0 in an effort to catalyze capital formation and IPOs and expand the public’s opportunity to invest. As part of that package, the SEC has been asked to include education and job experience as qualifying criteria for becoming an accredited investor.

The SEC is considering several other methods of opening up the qualification of accredited investor to a wider group of people. Some of these methods include adding inflation-adjusted income and net-worth thresholds without investment limits to the criteria, indexing financial thresholds for inflation on an ongoing basis, allowing spouses to pool their investments in order to qualify, and replacing the $5 million asset test for entities with a $5 million investments test that would include all entities, or expanding the types of entities that may qualify.

The SEC is also considering grandfathering in current accredited investors, expanding the criteria beyond net worth and income, allowing investors who have been advised of the risks to opt in, allowing informed employees of private funds to invest in their employers’ funds, and allowing clients of registered financial professionals — after being educated on the risks — to become accredited.

Essentially, more people than ever before may be able to become accredited investors. The question is, is this a good thing or a bad thing for the investment community?

THE POTENTIAL TO BE GOOD, WITH CERTAIN PROVISIONS

Expanding the opportunity to become an accredited investor has been on the minds of the investment community since the passage of the original JOBS Act in 2012. The definition of an accredited investor is certainly due for an update as it has not changed since 1982, and we can all agree $1 million of net worth and $200,000 to $300,000 of income today is a lot different than it was nearly 40 years ago.

However, given that more people qualify as accredited investors under the original definition, it is interesting that the SEC is considering ratcheting down the income threshold rather than the expected raising of standards to catch up to inflation-adjusted measures of income and net worth.

The fact that the SEC is considering broadening access to this qualification to bring investment opportunities to a greater number of people is a good thing. But, with greater opportunity comes greater risk from a consumer-protection standpoint, and it raises questions. Is testing for accreditation a valid checkpoint? Does acknowledging awareness of certain risks mean an investor can truly bear the actual risk? The answers to these questions are currently unclear.

The concept of a financial professional, ideally a registered investment adviser (RIA), acting as an accrediting gate seems logical and wise. If an investor is working under the guidance of a professional who is acting in a fiduciary capacity, theoretically that professional would have the ability to fully understand an investor’s financial wherewithal to accept certain amounts of risk. This provision may enable more investors to work with knowledgeable professionals and reap the benefits of investment.

However, this authority should also come with certain requirements of the financial professional, whether those requirements are asset class–specific certifications or an ability to properly demonstrate an appropriate standard of understanding of those risks.

EFFECTS ON THE REAL ESTATE INVESTMENT COMMUNITY

The proposed new rules have the potential to benefit the real estate investment community but could also bring with them an increase of risk for unsophisticated investors. They could create a benefit to the community by further increasing access to real estate investment, which is one of the greatest wealth-creation tools of all time. But, no matter how valuable a tool real estate investment is, the point of the SEC and these regulations is to prevent undue risk to people who can’t bear that risk. If the new definition of an accredited investor is created without these precautions, the rules could introduce the potential for harm to real estate investors who don’t fully understand the risks involved with direct investments.

What is needed is a way to understand an asset class on a quantified, risk-first basis, so that investors and financial professionals alike can make more prudent risk-based decisions. The accredited investor rules are founded in investor protections, but just because an investor meets a certain wealth or income threshold doesn’t mean they truly understand the underlying risks of any given investment.

In fact, the objective would be to identify, quantify and communicate risk inherent to real estate investment. Since its inception, the real estate industry has operated on gut feel without any standardized, centralized or objective risk categorization. Even in defining core, value-add and opportunistic investments, there are no real quantifications of risk in each category, so how can you have a risk-adjusted return conversation if you can’t quantify those risks and returns?

When investors understand their risk tolerance and goals by reviewing quantified data, they can remove some of that uncertainty.

As long as the new accredited investor definition requires additional qualifications, such as working with an RIA or financial manager and who has ways to help clients withstand that risk, the effects on the real estate investment community will be a net positive.

Another smart solution for the real estate community is the proposed educational component to the new regulations, the ability to test into being definitionally accredited. This component will help real estate investors to understand more complex financial scenarios and structures that are often found in private investments historically only available to accredited investors.

PROTECTING INVESTORS

At the end of the day, the SEC typically looks at these proposed changes from a consumer-protection angle rather than simply dropping barriers and allowing people who don’t understand the risks to have a field day.

Education is an important factor in decreasing exposure to risk. As it stands now, people without the financial means of an accredited investor who know a lot about the risks and rewards of real estate investment are not allowed to invest in those deals, but someone who has the money can, even if they are not educated. This doesn’t make sense. Investors should be subject to testing and possibly credentialing to demonstrate that they have the necessary understanding to reduce their investment risk.

Adam Hooper is co-founder and CEO of ReAllocate, a RealCrowd company.

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