As of December 8, 2020, the U.S. Securities and Exchange Commission (SEC) amendments to the long-standing accredited investor definition became effective. The amendments expanded the long-held standards regarding which investors could be expected to have enough knowledge and expertise to participate in private capital markets without risking their financial security.
“It takes money to make money,” as the saying goes. Long ago, regulators concluded that high-net-worth individuals and institutions with millions of dollars in assets are financially sophisticated enough to understand the complexity of unregistered securities, such as private equity, venture capital, and hedge funds. Therefore, they limited these securities to an “accredited investor.” The philosophy is based on a desire to protect smaller investors who would be badly hurt if they took a big hit from an investment gone wrong.
According to the SEC, an accredited investor must have:
According to the Federal Register, in the years before the 2020 SEC amendments, only 13% of American households fell under the accredited investor definition, and even fewer households actually invested in exempt offerings.
This excluded many individuals from valuable investment opportunities and limited new ventures to smaller investor pools. It was a narrow market that assumed that winning the lottery or inheriting a family fortune was enough to be a “sophisticated” investor.
The 2020 definition expansion added the following criteria and categories to the original definition:
The amendments also created new categories for entities to qualify as accredited investors, including investment advisors, rural business investment companies, limited liability companies, family offices, and other entities. The full amendments can be found on the SEC’s website
A 2017 study published in Science Daily and authored by financial planning professors at Texas Tech University and the University of Michigan found that financial awareness scores increase with each year of age up to age 50, then begin a steady decline with age. More worrisome is the finding that financial confidence remained high among respondents 60 and over, even as financial literacy scores and word recall ability dropped. More than half of the wealth in U.S. households is held by this age group.
Many of these individuals also fall into the original accredited investor definition, revealing a flaw in basing financial savvy on income or net worth alone.
A 2019 report titled “The Unsophisticated Sophisticated: Old Age and the Accredited Investors Definition” set out to measure financial “sophistication” across ages. The researchers used financial literacy assessments from two surveys to reach their conclusions: the Consumer Finance Monthly (CFM) and the Health and Retirement Study (HRS).
The researchers wanted to know whether older, accredited households with significant accumulated savings are smarter when it comes to assessing potential investments than younger, non-accredited respondents.
In both data sets, they found that accredited households aged 80 and older are more than 80% less likely than non-accredited investors aged 60-64 to have high financial literacy scores. In fact, respondents with less than a high school degree were more likely to have a high financial literacy score than older, accredited respondents, according to this analysis.
While accredited investors are more financially literate than non-accredited investors within each age group, older accredited investors had significantly lower financial literacy scores than younger, non-accredited investors. And this difference increased consistently with age.
The researchers asked questions such as:
“If your assets increase by $5,000 and your liabilities decrease by $3,000, your net worth would…
“The benefit of owning investments that are diversified is that it …
The disappointing data (for older investors, that is) puts into question the meaning of financial sophistication. Perhaps one’s bank account is insufficient to ensure good investment decisions, but a financial litmus test for accredited investors would be equally hard to create and implement. Plus, opponents think other factors in the equation justify the current restrictions.
Data may show that younger, less sophisticated investors can outperform some accredited investors when it comes to financial literacy scores, but does that mean private offerings are for everyone?
Allowing more investors to participate and increasing how companies can raise funds are two main advantages of the expanded definition. But not everyone agrees. Are you smarter than an accredited investor? Here’s what some proponents and naysayers of accredited investor definition reform have to say.
Because private offerings are not registered or regulated by the SEC, funds get away with more risky investing methods. Some funds invest in derivatives and distressed debt offerings, which are exceptionally risky. Venture capital funds invest in startups, which statistics show are more likely to fail than not. An accredited investor with more money in the bank is better equipped to take on this level of risk and withstand a loss.
With unregistered securities, there is also less public information available to potential investors. Private equity and other unregistered securities require substantially more research to find a skilled fund sponsor or to gauge fund performance. How these funds report their returns is unregulated, and some fund managers have been known to overstate fund performance in the past. Unsophisticated investors can easily be duped into a poor investment or a scam.
Because unregistered securities have the potential for higher returns, skilled fund managers are paid very well. This means higher management fees and, often, a distribution waterfall that favors the fund over the investor.
In addition, unregistered securities tend to have higher contribution minimums than registered securities. Hedge funds, for example, may require more than $5 million upfront from each pooled investor. This creates a barrier for the average investor—and the average American—who must look elsewhere (e.g., crowdfunding investments, mutual funds, etc.).
Private equity investments are not liquid investments, making them disadvantageous for the average retirement plan. While stocks, bonds, and mutual funds can be bought and sold relatively easily, a private equity investment requires several years of fundraising and management to successfully sell the operating company. In the meantime, that investment is on hold.
Some experts caution against using private equity for 401(k) plans, as retirement investors often have reason to count on the daily liquidity of employer-sponsored plans in times of need due to job change, hardship, or other financial needs.
Since the 2020 expansion of the accredited investor definition, a broader pool of investors has become eligible to invest in private capital markets and startups. In 2022, according to Bloomberg Law, the SEC was reportedly considering some revisions to the definition again, this time restricting the pool to boost investor protection.
In addition to the impact on startups, the idea of restricting the definition of an accredited investor also raised concerns about diversity and limiting opportunities from underrepresented communities.
In November 2023, the agenda for the SEC’s Small Business Capital Formation Advisory Committee included discussions of both the accredited investor definition and “Diversity and the Investment Process.” Clearly, this discussion isn’t over. What constitutes an “accredited investor” may continue to evolve and grow.
We think you’ll also like:
[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):
This is an updated version of an article originally published on August 6, 2015, and revised on October 10, 2019.]
©2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Michele has been a director with Financial Poise since 2012. Share this page: