When Senator Dodd recently trotted out his detailed plan to reform the financial markets, most pundits overlooked two proposals that would potentially reduce the number of individuals who are permitted to invest in hedge funds, venture capital and private equity.It’s about time.
First of all, Dodd wants to increase the financial threshold for defining an “accredited investor,” which determines who can invest in a private placement under Rule 501 of the Securities Act of 1933. The current requirement is $200,000 of income for an individual or $300,000 for a couple, in each of the two most recent years, and are reasonably expected to earn at least the same in the current year. Or, they must have at least $1 million in total assets. These hurdles were set back in 1982.
Dodd wants to raise these thresholds by calculating the rate of inflation since 1982. As a result, widely used calculations bring the thresholds to $450,000 and $674,000 in income for individuals and couples, respectively, and $2.25 million in assets.
The second provision in Dodd’s proposals has seemingly stirred up the blogosphere, especially when it comes to investing in venture capital funds. It would scale back federal preemption in exempted offerings under Regulation D of the Securities Act. As a recent report from law firm Fulbright & Jaworski explains it, currently, state blue sky registration is preempted for “covered securities”, which includes offerings exempt from federal registration under Regulation D.
Dodd wants to scale back federal preemption by allowing the SEC to designate certain securities as “non-covered” based on the size of the offering, the number of states in which the securities are offered, and the nature of the investors. He would then designate a security as “non-covered” if the SEC does not review any filings within 120 days. If the SEC does not review the filing, the security would no longer be considered a “covered security” exempt from state regulation, thus sending the filing back to the state, which must then approve the filing, the law firm explains. “These changes could have the effect of increasing the time and costs associated with exempted offerings,” Fulbright & Jaworski concedes.
Critics are predicting doom and gloom for the VC business. In a letter fired off to Dodd, Scott Walker, founder and CEO of law firm Walker Corporate Law Group, calculates there will be 77 percent fewer angel investors if the new threshold is enacted. In addition, he asserts that startups will have to wait up to four months (or more) while the SEC and/or State securities commissions review the merits of their angel investment. “With all due respect, Senator, this is f...ing nuts!” he adds.
No it’s not, Scott. Dodd is on the right track.
Sure, the far right will argue that this is yet more government intrusion into the daily lives of individuals, who have the right to make lousy investments. That they don’t need the government to save themselves from themselves.
However, Congress is looking to head off systemic risk. And one of the key factors contributing to the recent financial meltdown were unsuspecting individuals making very risky purchases of real estate and homes with money they did not have or could not afford to lose.
The SEC’s job since it was created nearly 80 years ago is investor protection.
VC angel investments by definition are made with fledgling, shaky companies with dubious prospects and perhaps incomplete or scantly detailed financials. And I’m assuming there is no intentional fraud. “Will this kill start-ups because they can’t raise money? Maybe that’s not so bad,” says Peter D. Greene, Vice Chair of Investment Management at the law firm Lowenstein Sandler PC.
I have also long believed that the threshold for accredited investors should have been raised years ago. Given the rise in real estate prices since 1982—even accounting for the sharp pullback of the past two years—it is not very difficult for the average hard-working person to amass $1 million in assets. Remember, 1982 was the bottom of a long real estate bear market.
Most people should not be investing in start-ups or hedge funds. As in the case with any other investment, you should be able to withstand the loss of the entire investment before jumping in. “Maybe a guy with $200,000 can’t afford to lose all of his nickels,” says Greene.
Don’t think that could happen? Remember 2008, when even so-called superstar hedge fund managers fell about 40 percent to 50 percent?
But, in reality investors with just $50,000 or $100,000 to spare can’t get into the well known hedge funds with the eye-popping long-term records.
Rather, they must take a chance with the very small, fledgling funds with little or no track record, and brief, vague descriptions of their investment approach. These are the funds that run maybe $10 million, $20 million and are desperate for new investors.
They are more likely to open and shut two years later after a bad year, or commit fraud. Again, the SEC cares about investor protection.
In fact, several years ago the SEC itself tried to alter the definition of accredited investor by also requiring them to own at least $2.5 million in investments. It then called for adjusting this figure for inflation every five years.
The SEC’s Office of Economic Analysis at the time estimated that about 1.3 percent of U.S. households would have qualified for accredited status based on owning $2.5 million in investments. When the current thresholds were set in 1982 when Regulation D was adopted, about 1.87 percent of U.S. households qualified for accredited investor status. By 2003, however, that percentage increased to 8.47 percent of households.
In proposing its additional requirement, the SEC asserted it met its goal of “providing an objective and clear standard to use in ascertaining whether a purchaser of a private investment vehicle’s securities is likely to have sufficient knowledge and experience in financial and business matters to enable that purchaser to evaluate the merits and risks of a prospective investment, or to hire someone who can.”
I always found it odd that an accredited investor was deemed to be a sophisticated investor just because they earned $200,000 or had $1 million in net worth because their home’s value soared. In fact, the long-held joke in the investment community is that the worst investors are doctors and dentists, even though they are among the wealthiest.
Even Dodd senses a complete overhaul of the definition might be needed. As part of his proposed bill, he would require the Comptroller General to conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds, and submit a report one year after a financial reform bill is enacted.
The goal: Improve investor protection, which lessens systemic risk.
Stephen Taub, who has covered the hedge fund industry for 30 years, is a contributing editor to Institutional Investor and Absolute Return-Alpha magazines and former editor of Financial World magazine.
