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Get Rid of the Accreditation Requirement

As anyone who has tried to raise angel capital knows, there are strict restrictions on taking money from individual investors. Unless, of course, those individuals are Accredited Investors as defined by federal securities law. That is, unless they are rich enough. If you don't have more than $1 million in assets or income over $200,000 per year, the law reasons, you aren't sophisticated enough to understand private equity and should thus be banned from making those investments. But this goes way beyond startup fundraising. In fact, securities law as it is currently written represents one of the largest transfers of wealth in human history from the middle class to the upper class and is against the principles of our society.

First, some (simplified) background. There are two types of equity (stock) investment: public and private.

Public equity is stock in companies that are "publicly traded" -- typically, on stock exchanges. Most of the big companies the average American knows (Google, Apple, Coca-Cola, Boeing, et cetera) are public companies, and their stock is public equity. Mutual funds, options, futures and most other derivatives contracts are forms of public equity. Anyone can buy public equity.

Private equity is stock in companies that are not publicly traded. Facebook, for instance, is a private company, and there are major restrictions on who can invest in such companies. While there are exchanges for this equity -- such as SecondMarket -- purchases must be tightly controlled to comply with securities law. "Private Equity" also includes the funds that invest in private companies, including venture funds, buyout funds, growth and distressed capital funds and a menagerie of other stuff. With a few exceptions, only accredited investors can invest in private equity.

Yet private equity, as a broad-based asset class, has traditionally outperformed public equity. Data around this is difficult to capture, since private equity is a complex field and there are no requirements for firms to report returns. However, State Street's Private Equity Index is a good place to start, and they have regularly reported private equity markets outperforming public.

And how were those returns generated? Often, at the expense of publicly traded securities -- whether it's a venture fund selling its interest in a private company to a public entity via an acquisition or a hedge fund creating outsized returns by shorting the market or making algorithmic trades. These abnormally large returns must -- by federal law -- accrue to wealthier individuals.

The argument for the accreditation requirement goes back to the inherent riskiness of private equity. But given the catastrophic losses individuals have repeatedly taken in public markets, there is simply no longer any logical reason behind the distinction. From John Maudlin's testimony to Congress in 2007:

"Why should 95% of Americans, simply because they have less than $1,000,000, be precluded from the same choices available to the rich? Why do we assume those with less than $1,000,000 to be sophisticated enough to understand the risks in stocks (which have lost trillions of investor dollars), stock options (the vast majority of which expire worthless), futures (where 95% of retail investors lose money), mutual funds (80% of which underperform the market), and a whole host of very high-risk investments, yet deem them to be incapable of understanding the risks in hedge funds"

I couldn't have said it better myself. But at least both public and private equity asset classes have positive internal rates of return -- the government actively sanctions lotteries, casinos and other means of fiscal speculation with a negative IRR. In fact, the government actively targets lower and middle class individuals with these schemes -- just see all the ads for the New York lottery in the subway. Federal and state governments are telling the lower and middle classes "You aren't smart enough to understand private equity. Why don't you put your money in the lottery instead?" This exacerbates the gap between rich and poor, further eroding the middle class.

Not only is this a massive transfer of wealth from the middle to upper classes, but it is fundamentally at odds with a mobile and meritocratic society. Why should the government restrict access to a certain class of investments by wealth? Lots of things are financially risky, like quitting your job and starting a company. Should the government save us from ourselves by requiring everyone to meet certain asset requirements before we can form an LLC, or even quit our day jobs? To take an example from outside of finance, driving a car is extremely risky. The government manages that risk by making all prospective drivers take a test to verify their driving skills. Perhaps those wishing to take part in high-risk investments should take an SEC certification exam such as the Series 7, which is required for those selling securities.

But that is still an imperfect analogy. If a clueless driver is on the road, they put everyone else at risk. If a clueless investor is buying and selling equity, they risk only themselves -- especially if they are a smaller player. But at least an exam is meritocratic in nature, whereas an asset requirement is simply oligarchical.

Yet not only will the accreditation requirement be kept, but it is likely to be raised to a minimum requirement of $2.5 million in assets, stripping access to private equity from even the upper middle class. This is clearly a bad piece of legislation, and there are a lot of people betting it will change. Given our leadership's tendency to respond to specific problems with ham-handed reform, I'm not holding my breath.