Knowledge-based accreditation, a boon to small hedge funds

The SEC announced on Wednesday that they are modernizing the accredited investor definition. They’ve added an exception to the income/net-worth rule for investors with professional knowledge and experience. This is good news!

Traditional hedge fund offerings

Hedge funds typically raise money through Reg D, 506(b), which directs offers to invest only to accredited investors. Accredited investors include individuals with a net worth of at least $1 million, not including the value of their primary residence. Also included are individuals with an annual income of at least $200k ($300k if combined with spouse) for the prior two years and with a reasonable expectation of the same or greater income in the current year. Hedge funds marketing to such individuals might ask for past tax forms, or have a third party (CPA or attorney) represent that the investor is accredited.

Now with this change, the scope of accreditation is being expanded to sophisticated individual investors who understand the law and the investment risks involved. Concretely, now included are holders in good standing of the Series 7, Series 65, and Series 82 licenses. Additional certifications, designations, or credentials may be added in the future.

This may help small hedge funds

This change will not make a difference for large hedge funds. They are not marketing to people with low net worth, regardless of sophistication. In fact, to the extent they target individuals at all, most hedge funds actually raise money only from qualified purchasers, who have at least $5 million in investments. And the minimum investment amount can be very high. Here are some examples from hedge fund offerings reported on SEC Form D for 2020 Q2:

Fund offeringMinimum investment
Newport Patriot LLC$325,000,000
Winton Rio Grande Fund LP$200,000,000
Atlas Institutional Equity Fund, L.P.$150,000,000
ERS Launchpad, LLC$150,000,000
Morris Island Partners, L.P.$100,000,000
CMAP SRPA Fund Ltd$50,000,000
CC ARB West, LLC$50,000,000
Blue Isles Futures Fund Ltd.$40,000,000
ABRAMS BISON PARTNERS, LP$25,000,000
Darsana Fund LP$20,000,000
Four Pines Onshore Fund LP$10,000,000
Squarepoint Core International Feeder Ltd$10,000,000
Verdad Opportunity Fund I, LP$10,000,000
Think India Opportunities Fund LP$10,000,000
Orion Commodities Delaware Fund LP$10,000,000

So, as far as hedge funds are concerned, this change is only interesting to low-capacity funds that would consider taking small investments.

Series 7

The Series 7 exam is for broker-dealers. It has a prerequisite – the Securities Industry Essentials exam. Also, you must be sponsored by a member firm to take the exam. Here is an example question:

Convertible bonds have all of the following features except:
A. an ability to protect a short position on the stock into which they are convertible
B. permissibility for use as collateral
C. a normally higher yield than non-convertible bonds of the same issuer
D. fluctuations influenced by changes in the price of the underlying common stock

Series 82

The Series 82 exam is for conducting private securities offerings. It has the same Securities Industry Essentials exam prerequisite and sponsoring requirement. Here is an example question:

When must checks to purchase securities in a contingency offering be delivered to the escrow agent?
A. By noon the next business day
B. Immediately
C. Within 2 business days
D. Within 3 business days

Series 65

The Series 65 exam is for becoming an investment advisor. One does not need to be sponsored to take this exam. Here is an example question:

XYA a manufacturer of computer circuit boards has $50,000,000 worth of subordinated debentures outstanding. Each debenture carries an interest rate of 6.5% and has warrants attached to the debenture to purchase 5 shares of XYA at $25 per share. XYA’s stock is trading in the market place at $28 per share and the warrants are about to expire. How many new shares can XYA reasonably expect to issue?
A. 50,000
B. 250,000
C. 500,000
D. 25,000

Conclusion

As my intention is to start a small hedge fund, this change to the definition of accreditation can only help. Also, since I intend to take the Series 65 exam anyway, this will give me the added benefit of (myself) being an accredited investor no matter what income fluctuations come in the next few years without a job.