Investing in a private equity commercial real estate (CRE) deal is risky. Risk and Rewards occurs on a continuum, depending on the property type, holding time, and professional skills of the management. On the one hand, a Class A, single-tenant, net-leased property is often considered low risk, comparable to a corporate bond. A project built from scratch is on the other end of the spectrum, where any factors could cause it to fail and cause investors to lose some or all of their investment money. As a result, the United States Securities and Exchange Commission (“SEC”) restricts the availability of unregistered securities in private offers to persons who are “accredited” or “sophisticated.” In this article, we will look at financial statements and all the factors related to accredited investor framework and sophisticated investors.
Defined Accredited and Sophisticated Investors
To fully grasp what it means to be an accredited or knowledgeable investor, it is crucial first to comprehend the structure of a typical private market equity transaction.
When a private equity company intends to purchase a commercial real estate asset, one of the first things they do is form a Limited Liability Company to serve as the property’s acquisition vehicle. To finance the acquisition, they will arrange debt financing for a part of the purchase price (usually 60% – 80%) and raise the remaining cash via selling business shares to investors. These shares are securitized investments regulated by the Securities and Exchange Commission and must be registered with them.
However, the SEC prohibits these registration requirements if securities are offered to accredited or sophisticated investors as described in Regulation D.
Definition of Accredited Investor
According to Regulation D, an accredited investor is “any individual who falls into any of the following categories, or who the issuer reasonably thinks falls into any of the following categories, at the time of the sale of securities to such person:”
Any bank, savings and loan association, broker or dealer, insurance firm, investment company, Small Business Investment Company registered by the US Small Business Administration, state-created and managed plan, or employee benefit plan having total assets over $5,000,000
Any private business development organization
A group with more than $5,000,000 in assets and tax-exempt status under Section 501(c)(3) of the Internal Revenue Code; Any officer or general partner of the issuing or selling company;
Any natural person with a net worth of $1,000,000 or more, whether that value is the sum of the individual’s net worth or the combined net worth of the individual and their spouse (or spousal equivalent).
Any natural person has a solo yearly income over $200,000 in the two most recent years or combined income with that person’s spouse above $300,000 each of those years and a realistic expectation of attaining the same income level in the current year.
Any trust with total assets above $5,000,000 that was not created specifically to purchase the securities offered and whose acquisition is guided by a knowledgeable person
Any company in which all of the stockholders are accredited, investors and find how to invest in startups India
Most private equity deals seek individual investors from categories 5 or 6 of the above list.
Definition of a Sophisticated Investor
Private equity investments are open to anyone who is not an accredited investor but has the financial knowledge to make sound decisions. Securities may be purchased under Regulation D by up to 35 “sophisticated” non-accredited investors with sufficient knowledge and expertise in economic and business topics to evaluate the proposed investment’s benefits and hazards.
In both cases, the goal of these exempt offerings is to put in place some regulatory safeguards to protect individual investors, such as requiring companies to sell non-registered securities only to individuals who have the financial resources to recover from a loss or the knowledge to assess the risk in a given transaction.
However, not all transactions are created equal. The SEC’s standards allow for two sorts of non-registered transactions, each with its regulations.
What is the significance of this?
For some time, the SEC has been throwing around proposals to “simplify, standardize, and strengthen the exempt offering structure, therefore extending investment possibilities while retaining proper investor safeguards and boosting capital creation,” in its own words. Since June 2019, the SEC has issued proposals/reports outlining possible changes to the current “accredited investor” classification and inviting public opinion. Their efforts culminated in late August with the approval and publication of the final rule, which dramatically modifies Rule 501. In the last version.
506(b) vs. 506(c) The SEC allows two forms of “syndicated” transactions, which are generally referred to as “506(b)” and “506(c).” The primary distinction between the two is that the former allows for sophisticated investors while the latter does not and that the latter is subject to more stringent regulations regarding the advertising of its offering.
A corporation may ensure its exemption under Rule 506(b) by meeting the following requirements:
The corporation cannot offer the securities by general solicitation or advertising.
The corporation can offer its securities to an unlimited number of “accredited investors” and up to 35 sophisticated investors.
Companies must select what information to provide to authorized investors as long as it does not violate federal securities laws’ antifraud provisions.
Prospective buyers must be able to contact the firm and ask questions.
Because of the restrictions on advertising, 506(b) is not usually the favored vehicle for most private equity firms.
Under Rule 506(c), a firm may extensively solicit and generally market the offering while still being regarded to comply with the exemption’s criteria provided the following conditions are met: the investors in the offering are all accredited investors, and
The business takes reasonable measures to verify a person’s qualifying accredited investor status, which may involve checking evidence such as W-2s, tax returns, bank and financial statements, credit reports, etc.
Because advertising is permitted, most private equity companies usually select the 506(c) structure. However, this form of transaction is only available to authorized investors.
The Advantages and Drawbacks of Being an Accredited or Sophisticated Investor
Becoming an authorized investor offers a new universe of investment opportunities beyond typical public markets. This includes opportunities to invest in private funds, hedge funds, venture capital deals, crowdfunding deals, private placements, family offices, or individual deals with private equity real estate firms (like ours) and other alternative investment categories that have a proven track record of outperforming public markets.
Those identical investments, however, go up the risk/return spectrum and sometimes include extended holding periods, increasing costs, illiquidity, and extensive due research before investing.
Who Can Now Be Considered an Accredited Investor?
Individual investors are protected by the standards that regulate accredited investors. They’ve assumed that since private markets are riskier and less transparent than public markets, only high-net-worth investors should be permitted to participate. However, the laws have been criticized for being highly discriminatory and limiting investment options to the richest individuals.
Until, monetary criteria primarily characterized accredited investors: The requirements were a net worth of at least $1 million, minus the value of the principal property, or an annual income of at least $200,000 for the previous two years (or a combined income of $300,000 if married). The new laws broaden the term to include anyone with financial statements and market information, such as licensed brokers or employees of financial institutions.
The latest revisions to the concept of qualified investors further expand the range of businesses that may qualify as accredited investors. Let’s take a look at the most recent additions to the Accredited Investors list:
Anyone with a valid Series 7, Series 65, or Series 82 license (respectively, for broker-dealers and investment advisers) regardless of wealth or income; “Knowledgeable Employees” of private investment funds irrespective of wealth or income (but only for investments in the fund that employs them); Limited Liability Companies with assets of at least $5 million that were not formed for the express purpose of investing;
While the previously mentioned increase in the pool of individual investors is significant, the potential impact of the entity category changes has the potential to be revolutionary. In 2019, over $2.7 trillion in investment money was generated via private securities transactions. Individual investors may now access these private offerings more than ever before.
These modifications have been in the works for a long time and result from years of passionate discussion. While several bills and other laws have been introduced over the years to achieve one or more of the final rule adjustments, they have just been successful. A major expansion of access to private securities markets is imminent. And lastly, this will encourage more people to participate in the private capital markets, strengthening those markets significantly.
The broader definition may result in additional chances for investors to engage in private funds and other investment opportunities previously restricted to those who met the tight criteria of liquid money. Consequently, many sophisticated individuals desiring to participate in “funds” were limited to registered securities offerings (mutual funds). The wealth criteria for accreditation assumed that persons with money were intelligent enough to invest in private offers independently. On the other hand, those who were smart and well-educated on the issue of personal recommendations but needed more net worth were not. The investing universe is becoming more accessible to investors of diverse wealth. With it, alternatives and private offers are becoming more democratized and accessible to investors of various financial statements, and other similar backgrounds.