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New SEC Accredited Investor Definition Amendments Unlikely To Impact Asset Raising To A Great Extent

On August 26th U.S. securities regulator the Securities and Exchange Commission announced that it was amending the definition of an ‘accredited investor’ – those institutions and individuals able to invest in private funds.

The amendments broaden the existing pool of potential investors eligible to invest in private funds; some of the most notable amendments for individuals includes a provision for knowledge, in the sense that the SEC now assumes that individuals with certain professional qualifications understand enough the risks that are involved with allocating to the often complex investment strategies used by private investment funds and their managers; additionally, holders of the Series 7, 65 and 82 licenses are now included in the definition of accredited investor. Furthermore, employees of private fund management companies can now invest in their employer’s own funds.

What seems, on the surface, as a significant opportunity for both private fund managers and investors is not quite as straightforward as it might appear because the United States has differing regulatory regimes which muddy the waters around who can invest in private funds and under what terms. Many hedge and private equity funds are structured as ‘3(c)(1)’ funds – 3(c)(1) referring to an exemption created by the Investment Company Act of 1940 which means that fund managers are exempt from the costly and rigorous registration requirements under the act. Taking advantage of this exemption, however, limits the fund managers to 100 or less investors in each fund. For mid-size and larger managers which claim an alternative exemption under section 3(c)(7) of the Investment Company Act, additional criteria come into play which means that these funds and their managers won’t be busting a gut to raise capital from some of the constituents of the new investor pool.

“Relying on Section 3(c)(7) requires a fund’s investors be “qualified purchasers”, not just “accredited investors” to meet the Securities Act exemption,” said Scott Beal, a Partner at law firm Barnes & Thornburg. “Being a “qualified purchaser” is typically a higher threshold than the “accredited investor” standard. For those funds, I don’t think this change moves the needle that much.”

The individual qualified purchasers to which Beal refers need to have at least $5mn in investments – let alone assets like their home – a significant hurdle for any individual investor wishing to allocate to private funds (and conversely for managers to solicit from these investors). For those smaller fund managers or those just starting out, the 3(c)(1) route may enable them to tap into the broader pool of individual investors that meet the new “accredited investor” definition, but Beal says that managers of these funds have other considerations.

“Those funds relying on the 3(c)(1) exemption are limited to 100 beneficial owners. That puts a cap on fundraising, so each slot has value. You’re going to want to bring in larger investors that can invest more money with you,” he said.

Beal also says that, whilst the change expands the group of employees of the fund management companies who can secure a piece of the action, their commitments likely won’t move the needle much either.

“The expanded definition includes each “knowledgeable employee” of the investment manager. For those employees who wouldn’t otherwise meet the income or net worth tests, it’s a significant benefit and allows the manager to expand access to its funds across more of its employees. But this will likely be a marginal benefit to the fund AUM – if you have an employee who doesn’t meet the income test or has less than a million dollars in net worth they are unlikely to put a large chunk of their money into the fund.”

Jason Meklinsky, Head of USA Business Development for Apex Group, agrees that managers should consider the benefits of sourcing larger investors.

“Larger scale investors are still preferred,” he said. “This [the changes to the definitions] sounds like a great idea at first, but it harkens back to 2006 and 2007 and fund of funds money. The lesson from that time is that hedge funds became an ATM for these investors when they needed liquidity. I think for newer hedge funds their time is better spent looking for a seed investor than aggregating many smaller investors.”

Meklinsky adds that for those smaller and/or newer hedge funds just starting out, outsourcing some of their middle and back office processes can save considerable expense which means that the fund managers don’t have to rely as much on aggregating the capital of many smaller individual investors and can therefore spend more time working the larger investor base he mentioned.

“We have many new and smaller fund managers coming to us looking to outsource their middle office. Areas where a manager could have been spending a million dollars can be outsourced for less than half, especially if they work with a provider across multiple services; it gives them enhanced negotiation power through a larger share of wallet which ultimately means that they can reallocate those funds to hire an analyst who is alpha driving. The impact of that change is immediate and allows smaller managers to operate with less AUM and therefore build a better track record, quicker,” he said.

On the other side of the fence, for those newly qualified accredited investors who are chomping at the bit to allocate to hedge funds and/or private equity funds, James Richman, CEO and Chief Investment Officer at private asset management firm JJ Richman, urges caution.

“Just because the floodgates have been opened a little bit wider does not necessarily mean everyone who can get in should immediately come rushing through the doors. A lot of the risks/rewards involved in sophisticated investments are yet to be fully understood by many accredited investors, let alone retail ones. There’s still a long way to go in terms of achieving a good amount of financial education for many mom-and-pop investors to fully grasp the rewards and equal amount (if not more) of risks involved in investing in often complex investment structures,” he said.

Indeed, Richman says that his firm won’t be seeking out these new investors.

“While cumulatively these new investors may present a good chunk of fresh capital for relatively new fund players as the current appetite from both parties may be high, our team and many other major players are likely to stick to the current structure and offerings. After having successfully completed our Global Market Recovery Fund (GMRF), we won’t be actively seeking out new accredited investors,” he said.

For those American investors who still don’t meet the accredited investor thresholds or who can’t get into private funds for some of the reasons mentioned above, there are other options to get access to hedge funds and/or sophisticated investment strategies. In the U.S., 40’ Act funds can offer hedge fund-style strategies in a mutual fund structure. Some managed futures strategies are available in mutual fund structures as the built-in liquidity in futures contracts trading offers natural synergies with that structure. In the public markets, to cite just one example, British hedge fund manager Brevan Howard has two investment vehicles listed on the London Stock Exchange – BH Macro Limited and BH Global Limited - which have invested assets raised from investors into Brevan Howard strategies. The shares provide synthetic access to the underlying Brevan Howard strategies.

It's not only hedge fund managers which utilise either the retail investor-compliant fund structures or the public markets; there are exchange-listed products which offer investors of all types and sizes access to underlying private equity funds as well. In private equity, the fund sizes raised by even the smaller end of that industry are comparatively large with high minimum investments, further limiting the ability of individual investors to get exposure to these opportunities regardless of whether they meet the accredited investor or qualified purchaser threshold.

“Most retail investors in the US and elsewhere simply don’t have access to the best performing private equity funds partly because the scale of capital needed to participate is too high. Also, they don’t want the illiquidity of cash tied up for a decade or more,” said Deborah Botwood Smith, Chief Executive of U.K.-based trade association Listed Private Capital.

Botwood Smith says that the public markets can solve for these issues.

“Listed private equity offers a solution to this problem. Anybody can easily participate in the upside of private equity by buying shares in listed private equity, while also gaining access to a diversified pool of private equity opportunities.”

Structural changes in the way that private companies raise money means that accessing underlying private equity funds via the public markets means that, for Botwood Smith, getting private equity exposure using this method has never been more appealing.

“Since the shares of the funds are listed, they also provide a liquid way for investors to participate in exciting and high growth sectors. For example, listed private equity provides public access to growing, disruptive and innovative companies. In today’s economic climate, large chunks of high growth sectors such as fin tech, education and life sciences remain off public markets for longer - they can raise the capital they need in the private markets and, as a result, much of the value creation is achieved pre-IPO. And some never need to come to market at all. Private equity doesn’t just bring capital but experience in business-building and improving operations, plus a longer-term perspective – this is attractive to management teams and better suits many types of businesses,” she said.

The changes to the accredited investor definition certainly increase the number and types of U.S. investors who are now able to invest in private funds but the exact impact of the changes in terms of asset flows will be unknown for quite some time. In the hedge fund space specifically, there is a fundamental truism which will determine the extent to which fund managers chase this new pool of potential investors.

“The overarching agreement within the prime broker community is that asset raising success for new hedge funds comes down to pedigree,” said Meklinsky. “Large fund complexes are seeding pedigreed managers, for example. Those folks can get a significant seed capital and don’t need to chase smaller individual investors. But for those which don’t have the backing of a household name, they may well look to aggregate capital from smaller investors. After all, beggars can’t be choosers.”

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