February 26, 2007
I think raising the criteria for accredited investor status precludes an even larger number of investors from access to alternative investment opportunities that are afforded only to wealthy investors. Instead, I believe that less wealthy investors should have broader access to alternative investments to give them more equal footing with regard to building and protecting their wealth. As it stands today, the Accredited Investor Rules, while established in the right spirit, actually penalize rather than protect smaller investors. The proposed changes to the definition of an "Accredited Investor" will only make matters worse. There must be a better solution than to raise the bar and exclude even more investors from viable and attractive investments. Let me explain my position.
First of all, I recognize that in establishing these Accredited Investor criteria, "the SEC is being consistent with the mandate they have from Congress. Congress long ago established rules on private offerings, and among them is the requirement that private offerings such as hedge funds are only offered to sophisticated investors who are capable of understanding the risks and have the financial capacity to withstand potentially significant losses."
I also realize that there is no test you can take to prove sophistication and that a net-worth requirement was established under the presumption that someone with sufficient capital was either sophisticated or would have advisors who were capable of doing the proper due diligence on any such offering.
As an investment advisor, I can attest that this presumption is not remotely accurate. First of all, wealthy investors are not necessarily more sophisticated nor do they necessarily have better advisors. Advisors who focus their practices on high networth clients can be as myopic as any advisor who serves smaller clients. Furthermore, in this day and age, smaller investors who are motivated to acquire information can become as sophisticated as any "accredited investor" who pursues information with the same vigor. Finally, it is also a very subjective to presume that any given "accredited investor" can better absorb (financially or emotionally) a loss of capital than a smaller investor. All things considered (i.e. age, time horizon, investment goals, temperament, cash flow needs) some smaller investors that do not meet the strict definition of an accredited investors may actually be quite suited to accept the risk/return characteristics of certain hedge fund strategies.
The message here, is that it's all relative each individual investors circumstances. As investment advisors, we are charged with determining whether an investment is suitable for a particular client almost on a daily basis. We base those judgments on the temperament, time horizon, and objectives of each individual client, not their net worth or income.
What the SEC is proposing only makes the playing field more uneven. Under the strict definition of the rules, I personally would not have qualified to participate in some investments opportunities that have put a lot of distance me and the street. When I looked at these investments, it was quite clear that they offered superior risk return characteristics compared to the typical long-only stock and bond investments to which the masses are relegated. These investments wouldnt have been difficult for anyone to understand, particularly since the investment strategies were well explained by the offering material.
In my opinion, there must be a more effective solution than to arbitrarily preclude everyone except wealthy individuals from what might be suitable investment vehicles for anyone that has enough information to properly evaluate the investments or seek an advisor who does. The solution lies in adequate disclosure and transparency of the investment offering itself and perhaps some moderate regulatory oversight over managers who offer them. If the offering and its associated risks and opportunities are adequately illustrated, prospective investors can make informed decisions about whether to participate. Yes, it can be argued that any unregistered hedge funds can be as abstract, vague, and opaque as they want to be. But, I'm willing to bet that large numbers of hedge fund managers would voluntarily submit to a certain amount of transparency and regulatory oversight if they could offer their funds to smaller investors. The only reason many alternative investment managers don't approach smaller investors is because the regulations say they can't.
I don't have all the answers, but I'm adamantly opposed to the proposed rule change as it is written. I urge another solution. I'm not a proponent of requiring all hedge funds to be registered. I simply think that hedge funds should be encourage to register if they want to offer investments to smaller individuals. The SEC should impose some basic transparency requirement on funds that choose to register. Who knows, this new transparency might cause even unregistered hedge funds to become more transparent. Then we all win. But simply raising the bar for accredited and qualified status is moving the wrong direction.