- Private investments such as private equity, hedge funds, venture capital and equity in start-up companies usually require investors to be “accredited”.
- In the early 1980s, the top 1% to 2% of households were accredited. In 2019, the share was 13%, according to the SEC.
- Private investments can offer higher returns than publicly available ones, such as mutual funds, but come with more risks, experts said.
Fg trade | E+ | Getty Images
More investors are gaining access to investments that were previously reserved for the wealthiest members of society, but it may be risky for some to participate, experts said.
Private investments – such as private equity funds, hedge funds, venture capital funds and shares in early-stage companies – usually require investors to be “accredited”.
Generally, this means that investors must have a certain income or household wealth to participate. Criteria include earned income of at least $200,000 per year for a single person or at least $300,000 with a spouse, or a net worth of $1 million, single or with a spouse.
These rules are intended to protect against the “unique risks” of private investment associated with public stocks and mutual funds, according to the Securities and Exchange Commission. For example, private equity may have fewer disclosures to investors. Accredited investors are considered more financially sophisticated and able to bear the risk of loss, the SEC said.
More from Personal Finance:
How to use ETFs in your portfolio
More part-time workers to access company pension plans
You May Pay 0% Cryptocurrency Capital Gains Tax in 2023
But there’s a problem, according to investor advocates: The financial thresholds to become an accredited investor aren’t indexed to inflation; they haven’t changed in decades. As a result, the protective bar of “accredited” status has been diluted as wealth and income have naturally increased over time.
In 1983, “accredited” status was reserved for the wealthiest households — roughly the top 1% to 2%, according to the SEC. However, 13% – a total of about 16 million households – are eligible in 2019.
That expansion allows some middle- and upper-middle-class households to get in — but many may not have the risk capacity or financial savvy to invest in private markets, said Micah Hauptmann, director of investor protection at the Consumer Federation of America, a consumer protection group.
If indexed to inflation since 1983, the threshold for an accredited investor would be $629,000 in earned income for individuals, or a total net worth of $3.1 million today.
“A net worth of $1 million doesn’t mean that much these days,” said Charles Faila, a certified financial planner and founder of Sovereign Financial Group. “You don’t have to be that sophisticated an investor to be 70 years old and have $1 million.”
Private equity investments are, as their name suggests, different from their publicly offered counterparts.
Generally, anyone can buy shares of public companies on a stock exchange or buy pools of stocks or bonds through publicly available mutual funds and exchange-traded funds. In comparison, private equity allows people to invest in companies that are not listed on a public exchange.
Even investing in or potentially lending to a private startup to a friend or family member may require accreditation, said Cassandra Borchers, a partner at the law firm Thompson Hine.
Non-accredited investors can invest in private startups through crowdfunding campaigns. However, there are limits on how much they can invest – usually up to 5% or 10% of their net worth – unlike accredited investors.
A net worth of $1 million doesn’t mean that much these days. You don’t have to be such a sophisticated investor to be 70 years old and have $1 million.
Charles Faila
founder of Sovereign Financial Group
The appeal of private equity investments is that they often “simply have better returns” than their public counterparts, Borchers said. That’s why she thinks it’s generally good that more people have gained access.
Private equity returns, for example, have outperformed the S&P 500 by 1% to 5% annually since 2009, according to a 2021 report by Michael Chembalest, chairman of market and investment strategy for JP Morgan Asset & Wealth Management .
Mike Curtis, 58, an accredited investor based in Honolulu, Hawaii, has invested in more than a dozen private companies over the past 15 years. One he’s particularly fond of: an investment in Shaka Tea that netted him at least a 400% return, he said.
Julio Estela, 41, who lives in Wantagh, New York, made his largest private investment in 2021 in Green Coffee Company. Estella, an accountant and people director at insurer Lemonade, estimates he’s made a 60% to 70% return on his money since then.
Curtis and Estella declined to disclose the value of their respective investments.
But Curtis and Estella have also had losers.
For example, one of Curtis’ failed ventures aimed to recycle wooden shipping pallets that arrived in Hawaii, rehabilitating them and putting them back into circulation.
“It was a good idea,” said Curtis, managing director of finance at Elemental Excelerator, a nonprofit that invests in climate-focused startups. “We probably didn’t study it as thoroughly as we should have, and it ended up going south.”
Hxyume | E+ | Getty Images
Some of America’s biggest investors, such as pension funds, often have some exposure to private equity, supporters say. For example, 89 percent of public pension plans have private equity investments that represent 11 percent of their total assets, according to a 2022 survey of 176 plans by the American Investment Council, a trade group. Public stocks represent 46% of the plans’ assets.
Private markets, however, are “two-tiered,” said Hauptman of the Consumer Federation of America.
Mom-and-pop investors don’t have access to the best deals often reserved for institutional investors, such as pensions, Hauptmann said. Pensions also typically have teams of advisers who specialize in evaluating the merits of private companies and funds — something most average investors can’t do easily, he added.
“I really think … people should start with their 401(k), invest in them [mutual] funds, learn the basics,” said Curtis, the accredited investor. “Investing in private companies is more of a college course. You don’t start without the premise.”
Private equity also has a wider “dispersion” of returns than public markets. This means that the range of investment results, from high to low, is wider.
For example, from 2005-2019, private equity funds had a 21% average variance measured from the 5th percentile to the average fund return; by contrast, publicly traded stock pools have dispersion of 3% or less, according to a 2021 SEC report that cited data from Cambridge Associates.
As with public stocks, betting on a single private investment rather than pooling risk in a fund of many private companies is an even riskier strategy, experts said.
“If we’re talking about startups, they have great rates of return when they’re working, but pretty terrible rates of return when they’re not,” Faila said. “It’s inherently a much higher risk potential and a much higher return potential, probably,” he added.
What this all means: Only invest the amount of money you’re willing to lose in private companies, Hauptmann said.
Only invest in industries you are familiar with, he said. Investors should ask themselves: Do I have access to information—such as the company’s financials, its business plan, and its position in the competitive market—to determine whether this is a viable business and likely to succeed?
Often, mutual funds and ETFs are a better long-term approach for most people, Hauptman added.
“I know there are a lot of shiny objects. Sometimes it’s private equity, sometimes it’s crypto,” he said. “[But] slow and steady wins the race.”
