Not everybody is allowed to make all types of investments. More exotic investments, like hedge funds and early-stage startups, are exempt from a whole range of rules and regulations that aim to protect regular investors from the high levels of risk involved. These big risks, however, can also yield exceptional returns.
Accredited investors have the money or the know-how to handle all of the risks involved. But what is an accredited investor, exactly?
Accredited Investor Definition
The Securities and Exchange Commission (SEC) defines an accredited investor as someone who meets one of following three requirements:
- Income: Has an annual income of at least $200,000, or $300,000 if combined with a spouse’s income and the expectation of maintaining the same level of income this year.
- Professional (new as of August 2020): Is a “knowledgeable employee” of certain investment funds or holds a valid Series 7, 65 or 82 license.
- Net Worth: Has a net worth of $1 million or more, either individually or together with a spouse, but excluding the value of a primary residence.
The stringent criteria on net worth, professional experience and income are designed to protect investors who might not have the cash reserves to weather significant losses. In the eyes of the SEC, less experienced investors could get in over their heads, especially since these offerings can have significant minimum investments.
That’s not to imply that every early-stage startup or hedge fund will lose money. Rather, unregistered investments of this kind are inherently riskier because they’re only required to disclose basic information to their investors.
What Types of Investments Can Accredited Investors Make?
Accredited investors may invest in:
- Venture capital.
- Angel investments.
- Real estate investment funds.
- Private equity funds.
- Hedge funds.
- Specialty investment funds, like those focusing on cryptocurrency.
These entities sell investors securities that are called private placements, or Regulation D (Reg D) offerings. Unlike the Federal Reserve’s Regulation D, which has implications for savings accounts, the SEC’s Reg D guidelines exempt certain securities from SEC guidelines.
When a company registers a Reg D offering, it’s only required to submit basic information about the company’s location, officers and the offering itself. Any additional information an investor may receive is left entirely up to the company issuing the private placement.
By comparison, a company issuing public stock must go through a lengthy application process with the SEC and withstand intense due diligence to verify that the company has been truthful and has made all legally necessary disclosures.
How Do Companies Verify You Are an Accredited Investor?
While the criteria to become an accredited investor are rigid, there’s no federal verification process for accredited investors. Instead, it’s up to each company to verify the accredited investor status of prospective partners before allowing them to invest.
It’s common for accredited investments to request income and net worth verification, such as bank and investment statements, proof of securities licensing or employment, and tax returns. Keep in mind that the value of your primary residence can’t be counted toward net worth requirements.
How Can You Invest in Startups?
Getting in on the ground floor of a new company may sound exciting. Who can forget the rumors of secretaries at Microsoft who ended up as millionaires? Unfortunately, outside of employee stock options, most people cannot invest in pre-IPO startups. (Startup crowdfunding is changing this slightly, which we’ll discuss below.)
Accredited investors, however, have several options to invest in startups. Most commonly, accredited investors accomplish this via a venture capital (VC) firm or by using an online marketplace to source private placement offerings.
With venture capital firms, accredited investors become an investor in a VC fund, and then the firm invests money from the fund in a range of startups. There is always limited liquidity in a VC fund, meaning you probably won’t be able to get your money back whenever you wish. Accredited investors should always be clear about a VC fund’s investment horizon and be mindful of the risks involved.
Online marketplaces such as Yieldstreet, Peerstreet and Cadence connect accredited investors with investment opportunities. Liquidity varies across these platforms, and due diligence is a must before choosing any investments.
Even if you’re not an accredited investor, relatively new crowdfunding platforms can enable you invest in start-ups. StartEngine, WeFunder and NextSeed welcome investors of any income level to support startup businesses as equity investors. Just be aware that these investments are far riskier and much less liquid than shares of public companies.
How Can You Invest in Hedge Funds?
A hedge fund is an investing vehicle where fund managers put money to work in an array of different investments in order to “chase alpha,” or generate positive returns. The goal of a hedge fund is to deliver positive returns, regardless of market conditions.
Investing in a hedge fund can be an ordeal. You can’t just call up a hedge fund or invest through an online brokerage. You typically need to know someone at the fund, and the vetting process can be demanding. Like venture capital investments, there’s very low liquidity in a hedge fund, and the investment minimums can be very high.
Management fees for hedge funds can be significant as well. In addition to an expense ratio, fund managers typically earn 20% of the fund’s returns, cutting further into an investor’s gains.
It’s worth noting that accredited investors can also invest in funds that are built to mimic the diversification of mutual funds, called funds of funds. Funds of funds tend to invest in multiple other mutual funds or hedge funds. Fees for funds of funds are similar to those for hedge funds, and their performance can be tracked and benchmarked using the Barclays Fund of Funds Index.
As of mid-September 2020, the annual rate of return for funds of funds in 2020 is 2.79% compared to the S&P 500’s 7.48%.
Do I Need to Be an Accredited Investor to Get Good Returns?
There are countless investment opportunities for people with high net worths. However, you don’t need to be an accredited investor to earn a reasonable return on your investment.
Since inception, the S&P 500 has returned an average of about 10% per year. In bull markets, hedge funds struggle to beat that number, although they excel during bear markets.
For most investors, a diverse selection of ETFs and mutual funds—or even a carefully curated basket of individual stocks—can help generate the returns that will help you fund both your retirement and a legacy.
Regardless of your net worth, be vigilant about investment opportunities. Do you own due diligence, know how liquid your investment will be and ask the tough questions when faced with making a substantial or risky investment. Can you afford to lose that money or wait out for a potential recovery?
While all investments carry risk, accredited investors must be hypervigilant as the offerings that open up to them have less oversight and require a larger financial commitment upfront. If you want to explore the options available to you as an accredited investor, reach out to a financial advisor to start a conversation.