The current state of Accreditation
Hi everyone,
Welcome to the Alts Sunday Edition 👋
Today we have a timely and important issue on investor accreditation.
We'll discuss:
Note: This issue is free for everyone. Enjoy!
The new standard for financial sophistication
In this issue, we talk about the SEC's rules for accredited investors.
While their new rules take a step towards education, there is still no single definition of financial sophistication.
This is why our friends at Doriot Venture Labs developed QAI: A rigorous exam and simulation that puts your investing knowledge to the test.
QAI is designed to test and accelerate your knowledge of venture funding principles. Candidates who get a passing score earn the coveted QAI certification.
Who is it for?
This program isn't easy. But it's not meant to be. See for yourself.
Alts readers get $100 off the next cohort (starts Feb 15), and save $50 on the self-study option
America’s unfair investing rules
Here’s a fun fact about American financial regulation: It's effectively illegal for poor people to put their money into the best investment opportunities.
Now, there’s no specific law on the books saying that only rich people can access good investments.
But explicit or not, there are three reasons why America (and most of the world) essentially has a two-tiered investing system.
Private markets outperform public markets
This isn't a hard and fast rule, there are exceptions galore.
But consider the following:
Now, one argument is that the perception of private market outperformance is because asset values are simply updated less frequently, which gives the illusion of higher returns.
Another is that survivorship bias is more severe in hedge fund and startup data, meaning failed investments are often not included in calculations.
But on the whole, the argument that private investments truly do outperform public ones appears convincing.
You must be 'accredited' to buy most private investments
If you're raising money in the US, you generally need to register the offering as a security with the SEC (Securities and Exchange Commission).
Registration is expensive and comes with a slew of onerous requirements, including regular publication of audited financial statements, and disclosure of information that companies may not want to share with the world.
Obviously, companies would prefer not to register if they don’t have to. So the SEC offers ten exceptions to avoid many of the requirements (including Regulation D Rule 506, which our ALTS 1 Fund falls under).
There are lots of rules we'll skip over. But what it boils down to is that most private investments are only available to accredited investors.
But what makes someone accredited, anyway?
Accreditation is (unfortunately) all about money
In the eyes of the SEC, "accredited" is just a euphemism for sophisticated, or trusted. The idea is that accredited investors are trusted enough to fend for themselves,
In other words, since accredited investors don’t need the SEC’s protection, their investments don’t need to be held to the same standards. So the SEC lets them invest in opportunities regular investors can’t.
Now, there's no doubt that private investing is riskier than public investing – which is why education is vital. After all, without training (like what our friends at QAI have created), it’s hard to differentiate legitimate investment opportunities from garbage and outright fraud.
But here's the thing: To test whether an investor is able to look out for themselves, the SEC doesn’t really rely on knowledge or expertise. Instead, it’s mostly about money.
In the US, to qualify as an accredited investor based on financial criteria, you need either:
*Note: This rule is especially bizarre. I'll explain why below.
Introducing Altea 🌱
Our new private community for accredited investors.
Private markets have evolved over the years, and so have communities.
But one thing has remained constant: You need connections to invest in the best deals, many of which have $50k+ minimums.
Altea is a supportive community we've created for accredited investors.
It gives you access to better alternative investment deals, a robust network of compelling individuals, and once-in-a-lifetime travel experiences.
We are looking for founding members to join our first cohort.
You'll get:
We're looking for people to help build and nurture the community. Contribute to discussions, join events, chime in with due diligence, and invite other exceptional folks to join us.
And if you're accredited, apply as a Founding Member
Why do accreditation rules exist?
Well, let's just say it's rooted in good intentions.
Part of the SEC’s mission is to "protect investors."
Traditionally, it has done this by ensuring people have access to truthful, comprehensive information to make their own investment decisions — an approach known as the disclosure philosophy.
But lately the SEC has occasionally strayed from this philosophy, and some recent decisions seem to have nothing to do with disclosure.
The SEC's new philosophy of risk
The SEC has started to police not just disclosure, but also risk.
Usually, it’s up to investors to decide the risks they want to take after considering all the information.
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But in a few cases, the SEC has decided what risks investors can take!
Ultimately, a court forced the SEC to approve the Bitcoin ETF, stating that the agency was being "arbitrary and capricious" in its refusal. Last week, those ETFs finally went live.
It’s hard to rationalize these decisions based on disclosure.
Instead, it seems like the SEC is trying to "protect" investors from losing money by limiting access to investments or strategies it deems too risky – an approach we can call the risk philosophy.
Officially, the SEC has stated that the term accredited investor is:
...Intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.
So, according to the SEC, accredited investors don’t need protection because:
The accredited investor rules exist at the intersection of both approaches. And this right here is why the SEC uses money as the delineator.
Are people with a higher net worth or income more financially sophisticated, and better able to handle losses in private markets?
Probably.
But this reasoning is still incredibly weak when you consider the inconsistencies and hypocrisy in the current system.
Accredited investor rules don’t make sense
To illustrate why, let me tell you a quick story about how I became an accredited investor.
In 2013 my wife and I bought our first house — a modest starter home in California. We lived in this house for six years, during which time the value of California residential real estate appreciated significantly.
In 2019, we moved to Australia and rented an apartment in Melbourne, meaning our California starter home was no longer our primary residence.
Boom. Suddenly, just like that, in the eyes of the SEC, I was now an accredited investor — a person capable of making wise decisions and investing in the lucrative world of private markets. Hooray!
This is just one absurd example of (unintentionally) gaming the system to reach accreditation status. Any startup founder who raises millions or gets a 409A valuation immediately becomes accredited too.
Keep in mind that startup founders are some of the least risk-averse people in the world. Despite risking their careers, relationships, and investors' capital, the SEC says they are well-suited for accreditation.
The arbitrariness of this whole thing boggles the mind.
But the larger point is this: As a matter of policy, I would argue the SEC shouldn’t have a risk philosophy to begin with.
Why? Because there’s no way for the SEC to consistently determine what constitutes acceptable risk!
Think about it:
The fact is that money is a poor measure of an investor’s need for disclosure protection.
There’s just no reason to think that a dentist making $500k a year is automatically more qualified to make investment decisions than an accountant making $100k.
Plus, wealth compounds throughout life, so plenty of people nearing retirement gradually eclipse the investor accreditation requirements without any necessary increase in their financial sophistication.
So, if the SEC’s risk philosophy is illogical and inconsistent, it’s just left with the disclosure aspect.
I would argue the need for disclosure depends on each investor’s financial sophistication, and that this sophistication should be based on not money, but education and training.
How should investor sophistication be determined?
A better approach to accreditation is a widely available financial sophistication test.
Private investing is like driving a car:
Beyond fraud and misrepresentation, non-investable companies are rampant in the private markets, which is why being financially sophisticated is so important. Being able to leave one's own biases at the door and objectively analyze investment opportunities are key in private ventures.
The SEC has the authority to approve a general accreditation test today, but they’ve shown some hesitancy to do so.
One bill passed by the US House of Representatives (H.R. 2797), would require the SEC to do this. But the bill is still some way from being enacted.
By law, the SEC needs to review its accredited investor definition every four years, and the agency is currently in the process of doing so. So the time could be ripe for a change.
One possibility is that the SEC could authorize certain investment certifications to verify accreditation status — including the Qualified Accredited Investor certificate from a company called Doriot (today's sponsor).
The SEC is currently in the process of reviewing Doriot’s application.
This might be particularly true given the SEC is signaling that the accreditation wealth thresholds could increase to account for inflation.
Since doing so would make the system even more exclusionary, it could create greater pressure for the SEC to implement a general accreditation test.
Now, if you’re itching to make private investments today, there are a few workarounds to the existing accreditation system — some of which are SEC-approved.
How to get around accreditation restrictions
Another big secret about accreditation
Many private investment offerings are off-limits to non-accredited investors.
But how do those offerings determine if you’re accredited anyway?
Self-verification isn’t enough for some offerings, including Reg D Rule 506(c) exemptions.
But in certain cases, you may just be able to basically "check a box" that says you’re accredited and, well, nobody will really check...
(Note: Popular platforms such as AngelList, Republic, and StartEngine all require a letter from an accountant stating you meet the definition of an accredited investor).
NOTE: I am absolutely not recommending you do this!
I am merely pointing out that there is a ton of regulatory structure in place for something that isn’t even always enforced — and whose value, in my opinion, is increasingly dubious to begin with.
But in the meantime, we need to live with the rules we have.
If you want to level up your financial knowledge and take a step towards accreditation, consider QAI's exam.
And if you're accredited and looking for a trusted, vetted community to share the world's best alternative investment deals, apply to become a founding member of Altea.
What do you think?
Accreditation is a fascinating, contentious topic. Let us know your thoughts. We read everything.
See you next time, Stefan
Disclosures
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3mole début est toujours difficile