By: Michael Loo
At the Practicing Law Institute “SEC Speaks in 2016” conference, acting SEC chairman Michael Piwowar shared his thoughts on how SEC should remove the distinction between accredited investors and non-accredited investors.
An accredited investor can currently invest in securities that are not registered with the financial authorities. Under SEC Rule 401 of Regulation D, some of the requirements to be an accredited investor include an income of $200,000 or $1 million net worth (excluding primary residence). This naturally targets the alternative investment space, such as hedge funds and private equity funds, and could potentially increase the pool of investors these alternative investment mangers can tap in to.
Piwowar argues that by making the distinction, “(the) world of private offering investors (is divided) into two categories: those persons accorded the privileged status of ‘accredited investor‘ and those who are not.” Investors who meet the requirements have a lot of investment opportunities available to them while the non-accredited investors are severely limited.
Piwowar applies two concepts from financial economics to back up his claim. The first concept is the risk-return tradeoff. Investors are risk averse, so riskier securities should offer higher returns than the less risky ones. By generally prohibiting non-accredited investors from participating in these high-risk securities, the SEC is essentially blocking these investors from earning high expected returns.
Another concept he applies is the modern portfolio theory - the risk of the portfolio as a whole is lower than the risk of any individual assets that portfolio holds. Even if investors add high-risk securities to their portfolio (through portfolio diversification), that risk decreases. As long as these high-risk securities have low correlation to the portfolio, the investor can increase his or her expected return with little to no change in the portfolio risk profile and, in some instances, decrease the risk profile.
By preventing certain investors from investing in private securities, the SEC may be inadvertently limiting the tools available to diversify portfolios. Alternative investments managers should watch how this develops over the coming months. With the current administration’s stance on deregulation, if the SEC does remove the restrictions on investors who invest in private securities, there may be a whole new group of investors that managers can reach out to.
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