By Steven Cinelli, Founder | CEO PRIMARQ/REMARQ,
Certainly over the last two years, with the introduction of the JOBS Act, the discussion of “accredited investor” has never been so fashionable. A concept precipitated in the aftermath of the Crash of 1929, within the construct of the Securities Act of 1933, the objective was to enable small companies an efficient avenue to raise capital without the laborious and costly effort of filing a full registration statement. Simply, as long as such companies sold their securities to those of financial means, there were limited disclosure requirements. The logic was that such investors of means had the financial wherewithal to conduct their own review of the opportunity as well as absorb any loss that may result from such investment. In 1982, after a series of iterations, the Securities and Exchange Commission finally established specific financial thresholds as to what “means” actually meant, thereby placing minimums of income and net worth on defining “accredited investors” in the context of a natural person. Of course, other types of accredited investors include institutional investors of certain asset size, which similarly had the means and the alleged acumen to make informed investing decisions.
The goal was logical and, yes, admirable. Capital formation being important, could be conducted in a much more efficient and less costly way, avoiding the filing of registration tomes and being subjected to an increasing labyrinth of reporting, whether under the ’34 Act, Sarbanes Oxley, or even Dodd Frank as long as such firms sold their respective issues to those of means. As the phraseology depicts, those that can ‘fend for themselves’ can invest in such “high risk” investments. Broadly, small companies created jobs, needed capital, and let’s support their efforts.
But seriously, let’s review the landscape, and the investing opportunity:
• Less than 1% of the 27 million businesses in the USA are publicly traded, and approximately 5.7 million of said businesses have employees. In fact, over 86% of businesses with over 500 employees are privately held. A scant of 5000 companies actually issue securities, registered for public consumption. Might there not be some fairly interesting companies, that are both risk averse and value creators, that would welcome broader participation by the non-accredited John Q. Public, while such John Q’s may be interested in deploying a bit of their savings in such? Unfortunately, way too much of the accredited debate centers on the next Google or Facebook, with the risk associated on pre-revenue companies seeking to become “unicorns” in rapid pace. (Unicorn, a piece of VC vernacular, representing companies achieving billion dollar valuations). Even the JOBS Act was really premised on generic private company financing, not specific to early stage technology initiatives.
• As publicly-traded companies in the spotlight are required, maybe demanded, to perform for quarterly numbers, rather than long term growth and value creation. Might this suggest that private companies may be a more prudent play? Certainly a more available play.
• With the advent of computerized trading, the average share of stock trades every five days now, no longer the eight-year hold of the 1960’s. Query whether there may be more “trading risk” than “investing risk” in the public markets? Let’s not even comment on OTC companies, vagrant of SEC reporting, yet available to John Q.
Think about our investing environment at the present time. Thanks to the Fed’s monetary policy of low interest rates, ostensibly to promote borrowing, i.e., if you can borrow from the risk averse banking market, while the flip side of the equation are pools of investors starving for returns. As with the institutional investment community in a quest to achieve certain “hurdle” rates to, say, cover pension obligations, there has been a marked shift toward alternative assets, whether yield driven real estate, or alpha-targeted private equity or venture capital. Living in a low-slung fixed income environment, the quest for return should not be the province of only the players that can “fend for themselves”, but should be commonly available and applied. It’s not only about protection, but also opportunity costs, to capture a better return. The “accredited investor” discussion has delved into the retirement space, that private-company investments are characterized by risk and fraud, and we should protect those that “can’t protect themselves”. With lower saving rates and lower returns, more households are deferring retirement, working into their ‘70’s to pay off debt and live comfortably (possibly). The investment thesis of higher risk-higher return has been diligently applied to the institutions that have to make good on their own retirees, and as those that can “fend for themselves”, they are allocating larger sums to non-core asset classes. Why not afford the same opportunity broadly? This is not about just protection, but about opportunity and equality, and certainly required to be wisely conceived and applied. That should be the mission of those governing – how more can participate in private company growth creation, not why not.
One key buzzword in the world of unregistered securities is that of illiquidity, i.e., that an investor cannot “convert to cash” his investment position, and thereby there exists a significant risk that if one attempts to monetize it, it would be at a significant discount, eroding the principal amount, becoming devastating to the investor. Let’s look at this subject from a couple of perspectives. Certainly, protecting the unlettered from investing in such suspect securities is commendable, but that same individual has full discretion to, say, pursue other means for high returns on capital, such as lotteries and gambling. This “substitute offering” theme suggests that regulatory oversight in securities investing is a bit hollow. Cavalierly, one other classification of accredited investor that few bring up are those that are either “a director, executive office or general partner of the company selling securities” are in fact “accredited”, with no financial means requirement. The implication here is that there is a relevant knowledge level that allows of proper access and assessment for being an insider. In fact, most wealth creation in the USA is achieved by owning a stake in one’s business, and yes, the vast majority (98%) are owned in an unregistered manner, i.e., reflecting ownership in securities never available on the public exchanges. Should there be limitations on investment in such SMEs (Small to Medium Enterprise) by their owners in their quest to build a valuable business? And should they be held to a different standard and universe of investors to access capital than those that file a registration statement? And if the insiders, non-accredited most of them, can invest in their own “private” companies, based on inherent knowledge, shouldn’t the debate, or rather I submit a polemic approach, to educate others to invest in this broad universe of companies, rather than simply exclude them?
One area near and dear to this author is the subject of housing, particularly in light of this “accredited investor” conversation. Recall the concern with private investments about the ability to absorb risk of loss, be able to assess the risk and opportunity, and the concern of illiquidity. Introduce the American Dream, more specifically the dream of homeownership. Since the 1930s, with the establishment of the Federal Home Bank, Fannie Mae and other housing related agencies, home ownership has been a mantra for many reasons – wealth creation, community development, political participation, and so many other socio-economic benefits. Uniquely, even as a capitalist economy, our housing finance system is highly “socialist”, in that the government virtually controls the market and its management of such effectively determines the financial health of so many households. While many aspire to own a home, given its price, homes are not purchased, they are financed. With debt, and large amounts. Not only do US government agencies own about 90% of the underlying mortgages, but the US is one of only four countries that still allow for the mortgage interest deduction, thereby incentivized households to leverage up in many ways to acquire and hopefully benefit. In this space, we inspire financial risk, not mitigate it. Further indication of government’s role is the interest rate controls, highlighted with quantitative easing, benefiting the government itself with its federal debt overhang, and also the housing finance market. Compare rates globally, and we have a subsidized housing system. We promote the wrong behavior – borrow not save.
I bring this up in the context of the two “values” ascribed to housing: utility value (i.e., a place to rest your head) and financial value (i.e., participate in its appreciation). As we have clearly learned, housing, as an asset class, is not one that moves in only one direction, namely up. It is a volatile asset, and yes, quite illiquid. But to expend what typically is one’s life savings on a down payment, and then indebting oneself, for possibly 90% of the value of the home, which commands not a single payment but monthly checks for 30 years, and oh yea, if you don’t pay the bill, you lose the asset, is this a protocol for financial oversight and responsibility? Given this scenario, to buy a home, one doesn’t need to be accredited, having no insights as to the “risk associated” with price movement, and in typically exhausting most if not all liquid resources for the Dream, might not the powers to be endorse “risk”? And this asset, the home, is an “investment”, which you acquire on “margin”, with the government’s blessing and incentives. We even provide federal programs (FHA) allowing for very nominal down payments (3.5%), which if you sell the home which doesn’t appreciate you lose your equity in mere friction costs (selling commissions). From 2007 through 2011, it is estimated that nearly $8 trillion of wealth evaporated with the housing “correction”, where retirement and education “set-asides” vanished. Where was Reg D when we needed her? We might talk about the needed avoidance of private financings for the elderly and those that cannot fend for themselves, but we see the complete antithesis of government sponsored financial risk, with advocacy of excessive borrowings to acquire volatile and illiquid assets. I question whether one finds empirical evidence of such a loss of wealth in private financings, and the incremental liability overhang due to “margin lending” in these financings. I assert we have to look at the acquisition of investment assets thru the same lens and with the same objective. The role of the SEC and other regulatory agencies are set up to enable yet protect, venerable in their pursuits, but please, show consistency. Just because one is dedicated to one application, doesn’t relieve responsibility in other areas. Compare your primary physician with a government agency – if he’s great in assessing a common cold, but oblivious in noticing cancer, maybe it’s time for a different conversation, and a different doctor.
To wit, we need consistency in regulatory oversight with respect to investing in general, and first and foremost we need to insure an understanding of an opportunity, the risk and return scenarios and the desired results of invested capital, be it for those of means or those that are shy. In small private business, we seek to enable capital formation. We seek to enable positive investment returns which meet stated or unstated objectives. And we seek to protect those that cannot seemingly protect themselves. Focusing on the private securities market and the participation of a dedicated class, i.e., accredited investors as defined, without perspective on other available and allowable “investment” paths seems nonsensical, inconsistent, and actually detrimental to capital flows into areas that may in fact not be the most prudent avenue.
In both private financing and housing, we still live under that shadows of legislative and regulatory anachronism, evolving from the 1930s, rather than taking a step back and recognizing that a fresh and honest perspective need be applied. As the internet, combating the world of phone and facsimile, changed the world of communication, financial markets, risk assessment, availability of capital, investment opportunities, and the simple premise of freedom of choice need to prevail purely and rationally. Trying to build upon a 1930 Model T in the 21st century, rather than recognizing that Tesla is the new standard, is shortsighted, and actually undermines the longer term health of the American investing public and our overall economy.
The current Accredited Investor banter should not be about ‘exclusion’, but rather about one of ‘inclusion’, and in a manner that promotes best, or at least better practices. The SEC has suggested a level of financial literacy or acumen as a relevant proxy for participating in private investing, rather than just the financial thresholds currently in existence. That is a bit of improved thinking. Build up an understanding to assess, which is the premise of Reg D, nee Rule 215, nee Rule 146.
I implore the SEC to create a framework for private investing, allowing the John Q’s to participate in private value creation, rather than watching successful companies enrich only the currently defined “accredited”, until such time the public is allowed in. There is no need to reference the now average valuation of IPO companies, the point where John Q can play, or that the mass transfer of wealth of institutional purchasers of residential real estate capturing the lows from foreclosed homes to flip to John Q at the highs. This should not be a discussion of risk aversion, but rather opportunity creation and enablement. In the most banal descript, the concept of “accredited investor” as promulgated has lived its life, and now, it’s time to move on. Figure ways for broader participation. Establish ways of knowledge collection and dissemination, informed decision making, efficient disclosure, parity and fairness. Convert exclusion to inclusion. We can do this.
For the definition of “accredited investor”, it is time to say “buona notte”. And with it, capital can flow, value reaped, and the disparity of who can play becomes more democratic. Creating the entrepreneur is an American attribute. Let’s lead the way for entrepreneurial investing too.
About the Author
A career financier, Steven Cinelli has been on the forefront of technology enabled capital formation as founder of OffRoad Capital in 1999, the first online capital market system for unregistered securities, and more recently, PRIMARQ, an effort to revolutionize the housing finance system. Mr. Cinelli is an active speaker, panelist and author on topics of venture capital, housing finance, financial technology, and capital markets.