SEC’s Review of Accredited Investor Definition: Implications for Private Funds

For private funds, the Securities and Exchange Commission’s (SEC) recent review and staff report of the accredited investor definition merits careful attention. It presents both potential benefits and challenges for your fund’s investor qualification procedures and compliance program.

The SEC is mandated by the Dodd-Frank Act to review the accredited investor definition every four years to help ensure that it protects investors and reflects market realities. During the most recent review in 2020, significant amendments expanded the accredited investor definition. The staff report is an indication that the SEC is now considering additional changes.

Current Accredited Investor Definition

Securities offerings for private funds can be exempt from SEC registration if only offered to or purchased by accredited investors allowing for simplification of the fundraising process. Qualifications for accredited investors are based on criteria such as income, wealth and financial market sophistication.

Investors typically qualify as accredited if they meet one or more of the following:

• Net worth over $1 million, excluding primary residence (individually or with spouse or partner); or
• Income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, and reasonably expects the same for the current year; or
• Investment professional such as a securities representative (e.g., Series 7, Series 65), general partner (GP) of the company offering the security or a knowledgeable employee of the provide funds among other criteria available within the definition.
• Directors, executive officers and general partners of the issuer or of a general partner of the issuer
• Individuals who are “knowledgeable employees,” as defined in Rule 3c–5(a)(4) under the Investment Company Act of 1940 (the “Investment Company Act”), of the private-fund issuer of the securities being offered or sold under Rule 501(a)(11); or
• Individuals who are “family clients,” under Rule 501(a)(13),43 which cross references the definition in Rule 202(a)(11)(G)-1 of the Advisers Act,44 of a “family office” meeting the requirements in Rule 501(a)(12).

Certain entities, including corporations, trusts, and 501(c)(3) organizations, can also qualify if they have assets of $5 million. Investment advisers and financial institutions such as banks, insurance companies, SEC registered broker dealers and others as defined in current regulations also qualify^[1].

The accredited investor definition has been amended four times since 1982:

• 1988: Added new types of entities, a joint income test, and eliminated a net worth-based qualification.
• 1989: Included state government employee benefit plans with over $5 million in assets.
• 2011: Excluded primary residence from net worth calculation for natural persons.
• 2020: Significantly expanded the definition with:

• Fifteen new categories for natural persons, including professionals with certain credentials and knowledgeable employees of private funds.
• Inclusion of SEC- and state-registered investment advisors, rural business investment companies, and certain family offices and clients.
• A “catch-all” category for entities with over $5 million in investments.

Private funds, such as hedge funds and private equity funds, typically are open only to accredited and qualified clients^[2]. These types of investors have traditionally been viewed as better able to understand the complexity and risks associated with private funds.

Contemplated Revisions

The staff report indicates that the SEC believes the existing definition, based primarily on income and net worth, may not be the best indication for acceptance of and ability to sustain loss of investments.

It addresses some potential changes, including adjusting minimum thresholds to reflect current market conditions and expanding the definition beyond income and net worth thresholds as well as excluding retirement assets.

Considering further adjustments to the accredited investor definition will impact the type of investors that may invest in private funds. If amended, the filtering and verification processes for exclusion of investors who no longer meet the accredited and qualified requirements currently administered by private funds will need adjustments, creating compliance and operational complexity with potential authentication and qualification errors.

The SEC is seeking public comment on the following key potential changes to the definition of an accredited investor, which determines who can invest in private offerings without certain investor protections. The SEC is considering these examples based on industry feedback:

Financial thresholds: Adjusting the income and net worth thresholds for inflation or replacing them with alternative measures of sophistication.

Professional credentials: Whether the use of professional credentials and/or experience in financial and business matters as a qualifier for accredited status is justified, as this still leaves some with concerns about both suitability and potential loopholes.

Investor protection: Balancing access to capital with investor protection is a key concern, with some arguing the current definition is over-inclusive and others arguing it excludes financially sophisticated individuals who lack wealth.

Disparities: Some commenters raise concerns about geographic and racial/ethnic disparities in access to accreditation and propose changes to address them.

While the SEC considers industry feedback and determines whether updates to the definition are warranted, advisers to private funds should proactively consider potential changes by monitoring the review process for definition updates. Advisers should consider their specific investor types (e.g., institutional investors, endowment family offices) and thoughtfully review for changes to their placement process.

Weaver Can Help

Weaver’s dedicated investment adviser compliance practice supports private funds in navigating the evolving regulatory landscape. Let us work with you to help ensure your compliance program remains effective and adaptable in the evolving regulatory landscape. We can assist with:

• Policy Review: Assess current investor qualification procedures and ensure alignment with evolving regulations.
• New Verification Methods: Review and incorporate alternative verification methods for improved efficiency and accuracy.
• Enhanced Due Diligence: Regardless of the definition, we will help implement robust due diligence processes enhancing and identifying proper investor suitability standards and risk mitigation.
• Communication and Training: Update your team on the SEC’s review and potential impacts to ensure seamless adaptation.

For more information and to find out how Weaver can assist private funds advisers prepare for examinations, review disclosures, analyze their compliance programs for conflicts of interest and adherence to SEC requirements, contact us. We are here to help.

©2024

^[1] The SEC has a full list of accredited investor types in the frequently asked questions about exempt offerings found here

^[2] Rule 205-3 of the Advisers Act permits investment advisers to receive performance-based compensation when the client is “qualified client” allowing for performance fees and distributions of carried interest. A qualified client will be a client that has at least $1.1 mission in assets under management with the investment adviser immediately after entering in the advisory contract or has a net worth that an investment adviser reasonably believes to be in excess of $2.2 million immediately prior to entering into the advisory contract. https://www.sec.gov/files/rules/other/2021/ia-5756.pdf

A qualified client also includes a “qualified purchaser” as defined in the Investment Company Act of 1940 section 2(a)(51)(A).