When it comes to retail investors, there are two distinct classes as defined by the Securities and Exchange Commission (SEC): Non-accredited and accredited.
Accredited investors, roughly speaking, represent the proverbial top one percent; they have a net worth, not including their primary residence, of at least $1 million and/or make a minimum of $250,000 per year (or $350,000 per year as a married couple).
Non-accredited investors are everyone else.
Why Does This Matter?
In general, non-accredited investors are not allowed to invest in private securities, such as shares in private equity (i.e. real estate syndications) and hedge funds, while accredited investors are. We’re going to spend a little time discussing what this means and why it’s important.
First off, what is a security? A security is any financial instrument, or asset, whose value is determined by the efforts of others. The most common examples are stocks and bonds.
When an investor buys assets like these, he has no influence over their performance… He’s relying on the management of the company to run a profitable business, which is the securities’ source of value.
Public securities such as shares in Apple, Inc. (NASDAQ: AAPL) are highly regulated by the SEC and can be purchased by anyone as they are freely traded over exchanges. If an owner of a public security wants to sell, he will generally be able to do so at market value almost immediately.
On the other hand, private securities are not traded over an exchange and are in fact restricted from free trade by the SEC. In general, the owner of a private security must hold his position until the the issuer redeems it.
Further, there is an extremely broad range of sophistication in private security issuers – from the most sophisticated hedge funds to the neophyte-managed new business.
Because of the lack of regulation governing private securities, the SEC limits who is able to buy them, ostensibly as a means to protect the public.
While this may be a good thing with respect to uninitiated entrepreneurs using misleading marketing tactics to raise money, it also limits people’s access to well-managed hedge funds that generate better returns at lower risk than what is available in the public markets.
Rule 506 of Regulation D
Such private funds use an SEC registration exemption [Rule 506(b) of Regulation D] that restricts offerings to accredited investors with whom the management has a pre-existing relationship – completely eliminating their ability to advertise – which is why most people have never even heard of some of the most successful hedge funds.
The crowdfunding exemption for private securities [Rule 506(c) of Regulation D, as amended under the JOBS Act] is the arena where the naive play, including many real estate entrepreneurs who simply rely on market cycles.
Secondly, to understand the unique value of hedge funds, we must define risk. Most people are averse to it, but very few have any idea what it actually means.
Risk in finance is the likelihood of an asset’s value to be less than what is expected at the time an owner needs to sell it. Just like projected return, it’s a number that can be calculated.
Even among financial professionals, very few have the skill to make such calculations meaningfully and most of those individuals work for hedge funds.
Good hedge fund managers not only understand how to calculate risk, but also how to structure complex financial products to proactively reduce risk while maximizing returns–regardless of what is happening in the markets at-large.
While most hedge fund managers trade public stock using derivatives, a minority employ similar strategies in real estate. The securities offerings of such hedge funds are in extremely high demand despite the prohibition on advertisement and non-accredited investors as they allow “the rich” to get even richer even as markets (as a whole) contract.
Here’s How the “Little Guy” Can Participate
There’s a little-known solution that affords non-accredited investors the opportunity to participate in the exclusive securities offerings of hedge funds and invest like the top one percent: The investment club.
An investment club is a business entity structured as either a general partnership or LLC in which all members (owners) are also managers who participate by vote in determining the investment decisions of the club.
Because all owners actively participate in the club’s management, ownership interests in investment clubs are not considered securities by the SEC.
While an individual may not meet the standards for an accredited investor, a group of individuals can when organized into such an entity and once the company has a total asset value of $5 million or greater.
Even better still, under Rule 506(b) private funds are allowed to accept up to 35
non-accredited investors, which means the investment club may be admitted by the fund manager while it is still working to reach the $5 million mark.
In other words, investment clubs represent a unique vehicle that allows members to access the exclusive and best performing financial assets in all the capital markets… from hedge funds to the best in real estate private equity.
Further, if an investment club is administratively supported by individuals (i.e. attorneys, accountants, financial advisers, secretaries, etc.) with ties to managers in such firms, the club not only eliminates the regulatory prohibitions on investing, but also serves as a unique conduit of access.
On the flip side, entrepreneurs can make a very profitable business out of educating the investing public (on topics such as risk and private securities) as a means to organize individuals who share the same return, risk and liquidity appetites into investment clubs.
The entrepreneur can profit from the education side of the business (i.e. courses, consulting, etc.) in addition to fees paid by the club members for providing ongoing administrative support.
To learn more about how investment clubs can benefit you, email us at firstname.lastname@example.org.
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