New Criteria for US Accredited Investors: Looming Pain for Alt Funds?

The Securities and Exchange Commission might think it is protecting Americans from risky investments as it considers changing the criteria for defining accredited investors, but middle and back-office executives at hedge fund management shops are worried their livelihoods and client service levels are at risk.

The Dodd-Frank Wall Street Reform Act requires the SEC to review the definition of “accredited investor” — that is, individual investors with sufficient income or assets and presumably sufficient investing savvy to handle higher risk investments — every four years. The current income and net worth standards have not been updated since 1982. If  those thresholds were to be adjusted for inflation — one of several options the SEC is now considering — the annual income criteria today could be US$500,000 or US$740,000 for a married couple. The net worth requirement could be US$2.5 million. Currently, an accredited investor is required to have an income of more than US$200,000 annually or US$300,000 if married or a financial net worth of more than US$1 million.

The definition of accredited investor has also taken on heightened importance because of the Jumpstart Our Business Startups (JOBS) Act, through which the SEC lifted the ban on general solicitation, allowing fund managers to more easily market private placements as long as they can independently prove investors are accredited. By some industry estimates about 8.5 million investors meet that definition, which the SEC is reviewing based on recommendations made by an Investor Advisory Committee (IAC) on October 9.

Hedge fund professionals are concerned about the broader trickle-down effect on their employment and compensations. “Any material modification to the definition of accredited investor which shrinks the field of investors will undoubtedly harm the hedge fund industry without clearly benefitting investors,” cautions Ron Geffner, partner at Sadis & Goldberg and vice president of the Miami-headquartered Hedge Fund Association (HFA), which has been among the most vocal critics of the SEC’s proposals.

Fund professionals have reason to be worried. Should the SEC tighten the financial criteria for retail investment in privately-held funds — often alternative investment funds — the number of potential investors will shrink. Fewer investors, in turn, make it harder for fledgling hedge funds to raise funds and may prompt some to shut down or not open for business. Those that manage to stay afloat could end up having to cut salaries or reduce the number of employees, says Geffner.

Hedge funds will be hesitant to limit compensation or reduce the number of star portfolio managers and traders, so middle and back-office specialists will have to bear the brunt of the new budgetary constraints. Or so some tell FinOps Report. “We are always the first in line to suffer when budget cuts have to be made,” says one operations manager at a New York-based hedge fund. His views were shared by five other operations managers at US hedge fund shops. “We think that we will either face a pay reduction or staff reduction. That leaves fewer people to do more work.”

Another group of professionals potentially affected by any SEC decision: some hedge fund administrators, especially those catering to smaller funds. “Given that large fund administrators generally deal with mega funds whose investors primarily consist of qualified purchasers or investors with net worth of more than US$5 million, the SEC’s proposal to change the definition of accredited investor would have a greater impact on mid-sized or boutique service providers,” explains Ian Asvakovith, chief executive of hedge fund administrator Piedmont Fund Services in Herndon, Virginia.

The reason: with less capital available from accredited investors, there could be far fewer small to mid-sized hedge funds in business, leaving surviving funds to compete for fewer accredited investors and institutional investors who will demand higher service levels. Such a scenario, says Asvakovith, will force boutique fund administrators to upgrade their technology to compete with far larger providers — such as brand name banks with deeper pockets– or exit the business.

Just how will investors be affected? No one is willing to publicly say. However, it stands to reason that with fewer or less qualified staff available to handle the same workload, “doing more with less” could increase error rates or mistakes in valuations, client reporting, risk metrics and even clearance and settlement.  Granted, hedge fund management shops do rely on some automation and even outsource their middle and back-office operations to fund administrators and other third-party shops. However, that doesn’t absolve them from the legal liability of ensuring the work is done correctly. Hence, they still need to maintain a skeleton crew of operational experts who may be increasingly overworked in this new scenario — a potential Catch-22 situation with no good outcome.

Power Through Knowledge

Although hedge fund professionals agree that the SEC needs to consider updating the criteria for accredited investor, they argue that the SEC should avoid changing the financial requirements and focus on access to information or understanding of the investment risks instead. “Its a far better way of ensuring investor protection while allowing for an increase in the pool of capital available for hedge fund managers,” says Asvakovith. “Many accredited investors, particularly high net worth individuals, still don’t have a full understanding of a hedge fund’s risk profile.”

Such a possibility is one of several presented by the IAC to the SEC on October 9. Of course, this option would require investors to undergo online or in-person classes and it is unclear just who would take on the potential legal liability of creating and offering such a program, how much it would cost, and how it could be proven that investors understood what was taught. Likely, they would have to pass a qualifying exam before they could invest in certain classes of assets. Asvakovith suggests that educational programs offered by the HFA and Washington DC lobbying group Managed Fund Association could go a long way to helping investors understand the risks and rewards of buying into hedge funds.

Regardless of what the SEC ultimately decides, one set of players in the alternative funds market could end up making a lot more money — attorneys, broker-dealers, accountants or other third parties who could “independently” verify that the investors are indeed accredited. So far, the alternative fund managers must do so based on information provided by investors themselves. Not all rely on external verification.

One such independent third party firm, Verinvest in Philadelphia, uses tax records, credit information and other external data sources in a behind-the-scenes process to certify investor accreditation for funds and issuers, without sharing private investor information. Benefits to fund managers, according to Verinvest’s chief executive David Benway:  eliminating potential conflicts associated with internally managed or broker-administered verifications, as well as reduced administrative costs and errors.

Such qualifying services may ease some of the chaos for alternative funds and for investors too if the SEC decides to make qualifications more restrictive. Verinvest’s certifications are actually portable for investors subscribing to their service, so the process doesn’t have to be repeated each time an investor looks at a new investment.