The financial and investment world is rife with terminology and regulations. For an investor who wants to grow, battling against vocabulary is frustrating enough – let alone understanding the investment strategies that will help you reach your goals.
Differentiating between a qualified investor vs accredited investor might appear simple on paper. But in reality, the tangible distinction is huge.
In this article, we’re going to take a look at the difference between two classifications of pro investors – accredited and qualified investors – and examine exactly what it takes to get there too.
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So hold on a minute… What do today’s investment decisions have to do with future opportunities? The answer lies in investor classification tiers. Let’s take a look at why.
Why Do We Classify Investors?
Following the economic crash of the Great Depression of the late ’20s, a regulatory framework emerged in the United States to protect individual investors, entities, and the markets from similar events occurring in the future.
Investor classifications like “accredited investor” and “qualified purchaser,” as well as government regulatory bodies such as the Securities and Exchange Commission (SEC), were a result of these frameworks.
The Securities and Exchange Commission
The Securities and Exchange Commission is designed to regulate the buying and selling of publicly traded securities in such a way that protects investors against associated financial risks. The purpose is to shield everyday investors from a potential lack of understanding or experience in the big markets and deceitful market operators.
SEC regulations preclude the general public from potentially grave financial outcomes by limiting participation in the riskiest investment categories to only a certain group of qualified individuals with the investment experience and financial muscle to absorb failures.
This inhibits the general public from the lucrative financial prospects offered by unregistered securities. However, the pitfalls of failure are also exclusively designated to those with the financial sophistication and means to manage the significant loss.
The Securities Act of 1933
Following the Great Depression, the Securities Act was enacted to encourage greater transparency in the financial markets. It requires that all investments made available to the general public are registered with federal government bodies (such as the SEC) to accomplish two main objectives:
Investors can have access to financial information regarding securities being offered for public trade
Prohibit deception, misrepresentation, and other fraudulent activity in the sale of securities
As a result of the Securities Act of 1933, investors are better informed about the financial vehicles they engage with, and the risk of another major economic crash is accordingly reduced.
The Investment Company Act of 1940
Under the directives of The Investment Company Act of 1940 (ICA), privately held capital firms are required to register as investment companies when they make (or propose to make) public offerings of outstanding securities that are not solely held by qualified investors.
When firms choose to work exclusively with qualified investors rather than opening their proposals to the general public, they are exempt from fixed SEC registration and regulatory requirements under the ICA.
By gaining exemption status, funds can skip tedious registration obligations mandated by the SEC, and they do not have to publicly disclose related investment theses or positions. Instead, they can access investors with high-risk tolerance while retaining flexibility in their corporate strategy and investment approach.
What is an Accredited Investor
In a nutshell, an accredited investor is an individual or an entity that can invest in securities that are not registered with financial authorities, such as the Securities and Exchange Commission (SEC). There are specific net worth benchmarks that the person or entity must reach to be considered an accredited investor.
Companies and private funds can skip the registration of particular investment opportunities, provided the firms sell the assets to accredited investors. If individuals or entities meet the SEC’s net worth requirements, they can directly invest in highly profitable projects that are not available to non-accredited investors. These could be private equity, private placements, venture capital, and equity crowdfunding.
Because unregistered securities can be high risk and come with a high potential for failure, though may also be highly rewarding, an individual qualified for accredited investor status is considered better able to foot the financial risk of these ventures.
How do I Become an Accredited Investor?
To qualify as an accredited investor, you must meet designated financial benchmarks related to your income, asset portfolio, net worth, governance status, and overall financial sophistication.
Proving that you are an accredited investor is the task of whichever investment vehicle or fund you choose to invest in. You would usually have to provide documentation such as financial statements, credit reports, and tax returns and fill out a questionnaire provided by the fund.
Let’s take a closer look at the thresholds for qualification:
To be an accredited investor, you must have an annual income above $200,000. If you invest with your spouse, your combined annual income must be over $300,000. You must have made this amount for the past two consecutive years, and you are required to expect to have the same or greater income in the upcoming year.
This is a condition, and there is no leniency for those who are only able to provide one year of income proof.
Either as an individual or with your spouse, you must have a joint net worth of at least $1 million. This prerequisite is additional to your income proof requirement. Notably, the value of your primary place of residence is not counted in your overall net worth.
Professional and Educational Experience
An accredited investor could be a general partner, executive officer, or director of any company that issues unregistered securities. Furthermore, individuals who can exemplify a level of educational or professional experience can also qualify as accredited investors.
As of 2016, registered brokers and investment advisors were also able to qualify as accredited investors.
More recently, in 2020, the SEC made amendments to the definition of an accredited investor to encompass a threshold of professional experience, certifications, and knowledge to drive engagement in the private markets regardless of income level.
Private companies and businesses with organizational assets above $5 million also qualify as accredited investor entities. If all equity owners in a commercial entity are accredited investors, the entity itself can also be granted accredited status. However, entities are not allowed to be formed for the sole purpose of purchasing unregistered securities.
What are the Advantages of Accredited Investor Status?
Some say that wealth begets wealth, and accredited investors are high net-worth individuals who can expose themselves to lucrative unregistered financial ventures. Because regular investors are considered unable to support the high-risk factor of these ventures, most people do not have access to take part.
Accredited investors can contribute to funds with strict caps on the investor pool. This number usually sits at around 100 investors total. Although for certain funds not exceeding $10 million, the number of accredited investors can increase to 250.
What are the Disadvantages of Accredited Investor Status?
While an accredited investor has full agency over the investments he or she chooses to partake in, there are some disadvantages to the opportunities themselves.
Most unregistered securities are high-risk ventures. Accredited investors are considered capable of handling this financial risk if they lose their money, which does happen in some cases. Further to that, there are usually high minimum investment amounts. It’s not possible to invest only a few hundred or a few thousand dollars into accredited investor projects – it’s usually a few hundred thousand or a few million at the point of entry. This means that accredited investors stand to lose significantly more money than a regular investor participating in a registered investment may.
The fees associated with investments are high, some even ranging between 15% and 20%. These are usually performance fees, and accredited investors are happy to foot this bill for the opportunity for lucrative returns that may await.
Accredited investments tend to have high illiquidity, meaning invested capital is locked up for a long period of time. Take hedge funds, for example, where your money can be inaccessible from anywhere between a year to more than five years.
What is a Qualified Investor?
A qualified purchaser is an individual or a business entity that owns over $5 million in investment assets. These assets exclude any primary place of residence or any property used for business.
Private funds, such as hedge funds and private equity funds, do not have to register as investment companies, provided they meet the criteria:
They are not offering securities to the public, and either
It must be owned by 100 individuals or less, or
It must be owned exclusively by “qualified investors”
Above, we mentioned that accredited investors can partake in private funds investments provided there are no more than 100 investors. However, in the case that a private equity fund offers non-public securities to more than 100 individuals, all investors are required to be “qualified investors” rather than accredited. These may be private funds, hedge funds, and venture capitalist funds.
It is much harder to become a qualified investor. A person or entity’s eligibility is based on their investment portfolio rather than net worth and financial credentials, which is a benchmark used for accredited investors.
Qualified investors seek to expand their investment assets under management. The term investment is broadly applied in this context and refers to stocks, bonds, commodity futures contracts, cash equivalents, cash, real estate, financial contracts, and other assets.
How do I Become a Qualified Investor?
Qualified investors must have at least $5 million invested in assets under management. But other factors could be taken into account to be eligible for a qualified purchaser status.
Any individual, entity, or investment manager, that has invested a minimum of $25 million in private capital from either its own account or on behalf of qualified investors can count as a qualified purchaser. The same primary residence property exclusions outlined for accredited investors apply in this case.
A trust that is managed or sponsored solely by qualified investors is considered a qualified purchaser. Alternatively, a trust can be gain qualified investor status if it has a portfolio worth over $5 million and is owned by at least two close members of a familial unit. Owners may be spouses, siblings, or children of the primary investor and their spouses.
Notably, the trust must not be formed for the sole purpose of participating in the investment in question.
Any entity owned entirely by qualified purchasers also qualifies for qualified purchaser status.
How is Qualified Investor Status Determined?
The issuer of unregistered securities is the one who determines whether an investor meets the criteria for a qualified investor or not. For example, when there is a start-up involving a venture capital fund, the private equity firm would be considered the General Partner (GP), and the qualified investors are considered Limited Partners (LP).
While the actual process varies depending on the nature of the investment, typically GPs require documentation from LPs such as W-2s, bank statements, tax returns, and brokerage statements for asset-based accreditation. Proof of accreditation can be obtained through various ways and must be provided to the GP too.
Here are some of the investments that a qualified investor may hold:
Securities such as stocks, bonds, and notes. This excludes any help by a third party under common control while the entity seeks qualified purchaser status.
Real estate assets that are exclusively held for investment. Any primary residence or places of normal business operation are excluded from the real estate category.
Commodities futures contracts, or options on commodities futures or physical commodities that are traded on a contract market or board of trade, and are held specifically for the purpose of investment.
Collections of commodities – for example, precious metals – that are held for investment, provided the commodity’s futures contracts are traded on a contract market or board of trade.
Swaps and other negotiated financial instruments – with the exclusion of securities – held for the purpose of investment.
Any binding capital commitment of an investment company or commodity pool
Liquid assets that are held solely for investment purposes. The working capital of a company is excluded from this category, as is day-to-day cash used by the investor.
What are the Advantages of Qualified Investor Status?
Qualified purchasers have the opportunity to invest in a wider range of projects than what is accessible to accredited investors or the general public. This is because the benchmark for qualified investor status is held beyond that of the accredited investor.
A private fund with no upper limit on the investor pool can be owned by qualified investors only. These ventures tend to be significantly higher risk and are therefore only allocated to those who can absorb the potential failures.
What are the Disadvantages of Qualified Investor Status?
Qualified investors can choose to participate in severely profitable projects. The major disadvantage of being a qualified buyer is that they can lose a substantial amount of their invested capital when things go wrong.
While qualified purchasers must prove they have the funds, investment experience, and financial sophistication to foot potential losses, the projects they invest in are generally at higher risk and they have less financial protection when things go wrong.
Furthermore, minimum investment amounts tend to be high, and funds are commonly illiquid, meaning that invested capital will be held up for a long time.
What is the Difference Between a Qualified Investor and a Qualified Institutional Buyer?
Similar to accredited investors and qualified purchasers, a qualified institutional buyer (QIB) is deemed to have the experience and financial muscle to participate in the trade of unregistered securities.
An institution must manage above $100 million in securities from issuers that are not affiliated with the institution to qualify as a QIB. If the institution is a bank or a savings and loans providence, they are required to have a minimum net worth of 10 million dollars. If the institution is instead acting in an individual capacity, it must electively own and invest at least $10 million of non-affiliated securities.
As such, QIBs are typically found in the financial management spheres as an insurance company, a bank, a 401k plan, a business development company, or even a trust fund.
Why is Investor Qualification Important?
The reasons investor qualification is important should be pretty clear by now. They prohibit small investors from undertaking financial risks that they do not have the financial experience or sophistication to shoulder.
Qualifications provide a tiered classification of investment experience and portfolio designation that allows only high-risk-tolerance individuals or entities to participate in high-risk financial ventures.
Due diligence is where this comes into practical application in the investment world.
Due diligence is a necessary process for buyers and sellers to ensure their envisioned transactions get executed quickly and effectively. On a large and small scale, it protects the financial markets and all of its constituents from dire straits.
Private funds need to ensure they are trading with individuals and entities who can undertake the risk involved. On the other hand, individuals and entities must ensure they have the correct information to assess their risk tolerance according to their desired projects.
This is why publicly traded securities issuers are required to provide comprehensive investment information to all investors so they can make informed choices about the risk they shoulder. Equally, private issuers of securities are required to ascertain that any given investor is qualified to undertake the investment risk associated with a venture. Both of these are an imperative part of the due diligence process.
The difference between a qualified investor vs accredited investor is substantial when you consider the investment opportunities available to each and the reasons these barriers exist.
Any individual or entity that has sufficient investment experience and financial muscle can qualify as an accredited investor or qualified buyer, and partake in more lucrative high-risk opportunities. That said, it may feel like a few rungs up the ladder for many investors who are still growing their portfolio and experience.
One of the best ways to use your wealth to grow your wealth and work towards becoming an accredited or qualified investor is to participate in high-return professionally managed real estate syndicates. You benefit from a range of low-risk investments in the world’s most profitable asset class, plus you have an expert team to manage your portfolio for you.
If you want to grow your real estate portfolio, speak to the experts at People’s Capital Group today and accumulate the financial backing and experience you need to become an accredited investor!