What Is An Accredited Investor? Friday Q&A Series
What Is an Accredited Investor?
The short answer is that an accredited investor is a rich guy who should know better than to invest in anything that requires you to be an accredited investor in order to invest in it. Let’s look at the long answer.
Physicians are often targeted by people running private investment funds or hedge funds because they qualify (barely) as accredited investors by virtue of their income. The requirements to be an accredited investor come from rule 501 of Regulation D of the Securities and Exchange Commission (SEC). People running mutual funds and similar investments have to do certain things to protect their investors like diversify the fund and disclose certain fees. People running “Reg D funds” don’t have to do this. In short, they can take on more risk (obviously with the hope of more returns, at least for the guy running the fund and hopefully for his investors too.)
You must meet one of these requirements in order to be an accredited investor:
- Income over $200K ($300K together with spouse) in both of the last 2 years and a reasonable expectation of the same income this year
- Net worth (with spouse) excluding primary residence of $1 Million
- A bank, insurance company, registered investment company etc
- Charity, corporation, or partnership with more than $5 Million in assets
- An employee benefit plan with more than $5 Million in assets where a registered investment adviser makes the investment decisions
- A trust with more than $5 Million in assets where a “sophisticated person” makes the investment decisions.
- A business entirely owned by accredited investors
- A director, executive officer, or partner of the firm selling the securities
Doctors usually only qualify under the income qualification (and even then many don’t), although later in your career you may qualify under the net worth qualification. The SEC doesn’t specify if the “income over $200K” refers to gross income, adjusted gross income, or taxable income. If you have to ask, perhaps you shouldn’t even be considering these investments.
Why It Matters
The SEC was formed to protect investors. They assume (perhaps wrongly) that people who make a lot of money don’t need that protection. They’re supposed to be smart enough to properly evaluate investments on their own. They also can supposedly afford big losses…like their entire investment. You can go your entire life and have great success investing and never purchase an investment that requires you to be an accredited investor.
However, if you decide to go ahead and invest in one of these unregulated investments, you should realize a few things:
You Will Need to Do Your Own Due Diligence
There are very few regulations protecting you. At a minimum, you should do a background check on all of those involved (expect to pay between $3000-4000 per person for background checks.) You should also review the offering with an appropriately specialized attorney. Unless you are investing a large sum of money, the costs of doing this may eat up any additional returns (if they materialize at all.)
You May Not Get High Returns
The track record on the average hedge fund is very poor. The track record on private equity funds is highly variable and seems to get better the longer a fund has been in business.
Liquidity Can Be Severely Limited
Limited liquidity is not necessarily a bad thing, but keep in mind you can liquidate most public investments on any day the markets are open. It might take years to liquidate some investments. You SHOULD be paid for that lack of liquidity. There’s no point in investing in an illiquid investment when you can get the same risk-adjusted return from a liquid one.
Limit Your Investment
Even though these funds may not be very diversified, your portfolio still should be. That means you need to limit the amount of money you put into one of these to say 5-10% of your portfolio. You only need to get rich once. If you’re an accredited investor, you don’t need to take on gargantuan risks like putting half of your portfolio into a risky, speculative investment. If the investment requires a minimum $100K investment, and your entire portfolio is only $400K, it’s not for you.
Before purchasing any investment requiring you to be an accredited investor you should ask yourself, “Do I really qualify to be an accredited investor? Am I capable of doing due diligence on an unregulated investment? Can I really afford to lose this entire investment?” If the answer is yes, go ahead and take a look. If the answer is no, like most physicians and similar professionals, don’t feel bad. There are many roads to Dublin, and the one involving only publicly-traded securities still works just fine.