Published in Finance

SEC considers modernizing accredited investor definition

BY Sunday, February 02, 2020 04:25pm

If federal regulators want to increase the flow of capital to startups across the U.S., Tim Parker suggests they consider creating a new class of investor.

The president of Grand Rapids-based Grand Angels, Parker envisions creating a form of “junior investor” who could get involved in an investment group, invest in companies at smaller amounts, and learn alongside seasoned investors. Grand Angels is structured “to be able to help people like that who want to come into this space” and can essentially train new accredited investors in the private capital markets, he said.

Top left to bottom right: Tim Parker, Justin Crawford, Michael Gross, John Cassady, Lucas Mansberger COURTESY PHOTOS

Parker offered the idea in comments he submitted to the U.S. Securities and Exchange Commission, which has proposed altering the decades-old federal definition of an accredited investor to broaden the pool of people who can participate in private capital markets.

“I’m a fan of changing those requirements and making this class of investing more accessible to more people,” Parker told MiBiz. “I would like to add to (the proposed new definition) and have an ability for people to participate at a lower level of investment, as long as they’re working with a group that could educate them and mentor them so that they’ll aspire as their career and as their net worth grows to go deeper into early-stage investing.”

In the proposal, the SEC wants to go beyond the long-held definition that uses financial thresholds to qualify accredited investors. The SEC’s proposed language would enable people to meet the definition if they have the knowledge, expertise and sophistication, but not necessarily the income or accumulated wealth required currently. 

For example, by allowing individuals with certain professional certifications to become accredited investors, federal regulators hope to create more investors who can participate in private capital placements, either by investing directly or as part of an investment fund.

Parker, who also serves on the board for the Center for American Entrepreneurism in Washington, D.C., considers the proposal a “step in the right direction” that can expand and diversify the investor pool.

“It brings more capital to the table, (and) it brings more expertise to make decisions and to mentor and support the scaling of these companies,” he said.

Grand Angels manages three venture capital funds, plus angel investing groups in Grand Rapids, Kalamazoo, Detroit and Flint that have 105 members combined.

Expanding categories

Under present SEC regulations, individuals who want to become an accredited investor must have a net worth of at least $1 million, minus their primary residence, or an annual income of at least $200,000 in each of the two prior years, or $300,000 combined if married.

The regulations are designed to protect investors by ensuring they have the financial sophistication to analyze investment opportunities and understand the inherent risks of investing in private capital markets, and that they can handle any resulting losses.

The SEC proposal leaves the existing financial thresholds intact and would modernize the rule by adding new categories under which an individual could become an accredited investor, such as holding “certain professional certifications and designations” or “other credentials issued by an accredited educational institution.”

The SEC also would add a new category for a person who is a “knowledgeable employee” at a private investment fund, as well categories for family offices with at least $5 million in assets under management and Native American tribes owning investments of $5 million or more.

The proposal is an approach that attorney Justin Crawford, a partner at the Kalamazoo office of Honigman Miller Schwartz and Cohn LLP, endorses for the potential to broaden the investor pool.

The present accredited investor definition was adopted in the 1980s, well before the emergence of the information age and the internet, said Crawford, who works with companies raising capital.

“If you consider the increased availability of information and technology advances that have occurred since then, it makes sense to expand the definition in certain ways,” he said. “I view the rule as a positive development and update. It primarily updates the current accredited investor definition to reflect current societal and market reality when you look at it.”

‘Highly desirable’

The SEC did not propose raising the financial thresholds for an accredited investor. That could have defeated the SEC’s intent and decreased the pool of eligible investors, Crawford said.

As written, “I think it will increase the pool of qualified investors and allow companies and startups and funds more flexibility in terms of who they can take on,” Crawford said. “While there’s some risks with that, there’s also the potential upside with the high technology and venture-backed companies. This expanded group of people can share, possibly, in that expanded upside.

“In Michigan, it’s harder to raise money than it is in Silicon Valley or Boston, so if we can expand that pool of qualifying investors yet still provide a level of protection (for investors) that’s appropriate, I’m all for it and I think the rule as proposed would appear to accomplish that. From my clients’ perspective, a broadened pool of qualifying and accredited investors is highly desirable.”

Michael Gross, managing director at venture capital firm Beringea in Farmington Hills and chairman of the Michigan Venture Capital Association, believes the present accredited investor definition that’s based on an individual’s wealth and income is “too narrow.”

Gross likes that the SEC proposed keeping those thresholds and would add provisions that allow people who can show a sophistication through a professional certification, experience and skills to become an accredited investor.

“The carve outs that are proposed are very well done and accurate to open up the private capital markets to another set of very sophisticated individuals who do have the knowledge to appropriately analyze those investments that put their capital at risk,” he said. “At the end of the day, it will open up the access to capital for emerging private companies which are so critical to our entrepreneurial ecosystem in the state.”

The SEC proposal comes as venture capital firms and angel groups see more interest from prospective investors who want to get involved in either field as part of their investment portfolio, Gross said, “and this will be a pathway for the right ones to be able to invest.”

Parker said he looks at the SEC proposal as a way for organizations such as Grand Angels to bring aboard the “next generation” of younger investors who are “just as capable as others” but are early in their careers and do not meet the present financial thresholds.

“We want to be able to bring in more people because it makes us make better decisions,” he said.

Ensuring protection

The SEC issued the proposed rule change Dec. 18. Publication of the proposal Jan. 20 in the Federal Register triggered a 60-day public comment period.

Many of the public comments submitted as of last week supported the rule change, although some did mention the need to ensure investor protections.

One of the comments submitted to the SEC noted that “financial scams, elder fraud, and Ponzi schemes are all too common” in private offerings made under federal Regulation D. Some of the comments urged the SEC to look at putting more investor protections in place if it wants to broaden the definition of accredited investors.

John Cassady, chief investment officer at Red Cedar Investment Management LLC in Grand Rapids, sees the need to update and modernize the existing federal definition and expand the investor base, although concerns about the level of investor protections remain.

“By its very nature, there’s not as much disclosure in the private markets. That’s one thing to keep in mind if you’re going to open this to investors from all walks of life,” Cassady said. “That could cause some issues. We’ll see how this all works out. Hopefully, there’s not any issues down the road.”

Lucas Mansberger, senior manager selection analyst and investment strategist at Greenleaf Trust in Kalamazoo, notes the “very strong” divergence in public comments to the SEC between the investment industry and investor advocates and protection organizations.

When people are moving from public to private capital markets that have less oversight, “we view that it’s much more likely that abuses will occur,” Mansberger said.

“Our stance is that we believe investor protections are there for a reason and that in general, the idea of significantly expanding investor access to private alternatives without providing any additional disclosure requirements for private offerings or changing other investor protections in a way that benefits and protects investors is not necessarily a prudent idea,” he said.

Mansberger does agree that an asset or income test “is no guarantee” of an investor’s financial sophistication.

More analysis needed?

While the SEC proposes significant changes to the accredited investor definition and speculates on the possible effects for capital formation, it does not “talk at all about whether or not private market investing, as a whole, has not been favorable for investors in this class,” Mansberger said.

From that perspective, “there’s a dearth of analysis, generally, from the SEC,” he said.

“This goes to the point that even among sophisticated, professional investors with experience in private alternatives, there’s a divergence of opinion as to which strategies, which areas of the market are actually beneficial for investors to invest in, and in a situation like that where there is this huge divergence of opinion and there is a dearth of regulatory oversight, one should tread warily,” Mansberger said.

Read 1178 times Last modified on Wednesday, 05 February 2020 11:29
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