To purchase certain investments, an investor may need to be accredited—meaning savvy enough or well off enough to play in riskier arenas and weather any losses.
Imagine a 20-year-old investor who would like to buy into a hedge fund. She has done her research on a particular fund and is comfortable with the strategy involved.
The way she sees it, she’s young and now is the time to take that risk.
Not so fast. Even if this investor knows what she’s signing up for, she might not qualify.
First, many hedge funds have high minimums in order to invest. Investment minimums like $100,000 or even $1 million may immediately preclude the average retail investor from participating.
Further, some private investment firms may follow legal guidelines that allow only the participation of accredited investors, those who meet certain net worth or income criteria as determined by the Securities and Exchange Commission.
The qualifications for an accredited investor were expanded in August 2020, most notably to include those with certain professional designations but who do not meet the financial tests.
Read on for the definition of an accredited investor, what it takes to become one, and how to invest if you aren’t one.
The Accredited Investor Defined
An accredited investor is either a person or an institution, like a bank, qualified to invest in certain private investments, like a hedge fund or a venture capital fund.
Individuals must meet financial criteria or have the necessary industry experience to be accredited.
Many private placement investment firms—some of which may take on a high level of risk, use complicated investment products and strategies, or change strategies rapidly—require investors to be accredited in order to circumvent the SEC’s legal requirements.
“One reason these offerings are limited to accredited investors is to ensure that all participating investors are financially sophisticated and able to fend for themselves or sustain the risk of loss, thus rendering unnecessary the protections that come from a registered offering,” according to the SEC’s Office of Investor Education and Advocacy.
If an investment firm sells its product only to accredited investors, it may avoid the SEC’s many rules and regulations.
When an investment is sold to the public, it is under the regulatory authority of the SEC. (For example, a mutual fund that is sold to retail investors falls under the purview of the SEC.) This includes certain disclosures and extensive reporting requirements to the SEC.
Why might an investment firm choose this route? For one, adhering to the SEC regulations can be an expensive and labor-intensive process.
So private investment companies are able to circumvent the arduous filing and disclosure requirements by selling only to accredited investors.
In the eyes of the law, accredited investors are savvier or have the means to take on the risk that such investment opportunities produce.
Who Qualifies as an Accredited Investor?
There are two major categories of accredited investors: individuals and legal entities, which can include trusts, limited liability companies, and businesses.
Businesses like banks, investment broker-dealers, insurance companies, and pension or retirement plans are common examples of accredited investors.
For individuals to qualify as accredited investors, they must prove that they have the means necessary to take the risk involved in such investments. This can be done in one of a few ways:
First, the individual must have earned income that exceeded $200,000 (or $300,000 if married) in each of the prior two years, and reasonably expects the same for the current year.
Or they must have a net worth over $1 million, either alone or with a spouse or spousal equivalent. That does not include the value of their primary residence.
On Aug. 26, 2020, the SEC updated the qualification criteria. Individuals who have Series 7, Series 65, or Series 82 licenses in good standing can now be considered accredited investors.
The SEC said this was done to allow those with knowledge and expertise to invest in private investment markets even if they do not yet meet the financial qualifications.
General partners, directors, and executives with the private fund also qualify as accredited investors.
With the recent expansion of the qualification parameters, “knowledgeable employees” of the investment fund also now qualify as accredited investors.
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For a trust to qualify as an accredited investor, assets must total more than $5 million, and the trust cannot have been formed specifically to purchase the investment.
The trust must also be directed by a “sophisticated” person—someone who the investment company reasonably believes has the requisite experience and ability to understand the risks associated with the investment.
As of the most recent changes, LLCs with assets of over $5 million may also qualify.
Alternatively, an entity can qualify as an accredited investor when all of the equity owners are individually accredited investors.
Because this is not reporting that is siphoned through the SEC, investment companies typically collect the information necessary to confirm that a person is an accredited investor, or may require that potential customers sign off that they are accredited investors.
The Net Worth Requirement
One of the qualifications for being an accredited investor is to have a net worth of $1 million. How do you arrive at net worth?
Generally, individual net worth is calculated by taking a person’s assets and subtracting liabilities.
Assets are things of value that a person owns, and liabilities are debts owed.
For example, imagine a person has the following assets: a primary residence, a checking account, a 401(k) account, and a car.
They also have a mortgage loan and two student loans—those are their liabilities.
To determine their net worth, they would first total the value of the assets and then the liabilities, and subtract the value of the latter from the former.
That said, the SEC has a few specific rules about what is counted in a net worth calculation.
As mentioned, a primary residence is not to be included in the person’s net worth calculation.
A mortgage on a primary residence is also not to count in the net worth calculation, unless the value of the mortgage is greater than the value of the home.
If the mortgage is “under water,” then the amount of the loan that exceeds the fair market value of the home should be included.
When considering other real estate holdings with a spouse or spouse equivalent, it is not necessary that they be held under both names. For example, a property held by just one of the two parties would count.
How Can Non-Accredited Investors Invest?
You don’t need to be an accredited investor to begin building wealth for the future.
There are plenty of opportunities for investors of every level to get involved and earn returns in the stock exchange.
It’s important to understand that all investments carry some amount of risk. Otherwise, there would be no opportunity to earn a rate of return.
It’s always a good idea for investors to familiarize themselves with the risks involved with their desired investments.
To start, investors can open an account at a brokerage or with an online trading platform to buy and sell securities like stocks and exchange-traded funds.
New investors will want to be mindful of investing fees, as those will dip directly into any potential investment returns. This includes account fees, trading commissions, and the fees built into the funds themselves, called expense ratios.
An accredited investor—a person or an entity— is qualified to invest in certain private investments, like a hedge fund or a venture capital fund. Individuals must meet a substantial financial bar or have industry expertise to be accredited.
For investors who don’t meet that definition, there is no shortage of ways to get into the game.
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