When it comes to private equity investing, which counts more — being rich or smart?

As part of the Dodd-Frank financial reform law, the Securities and Exchange Commission is due this year to review the standards for determining who can invest in private securities offerings — what the industry refers to as an accredited investor. The SEC should use this opportunity to improve the standards, which were set in 1982 and which most observers agree are outdated. The current definition of an accredited investor is a person who has either an income of at least $200,000 a year ($300,000 for couples) or a net worth of at least $1 million, not including a primary residence. Updating the definition is important because a lot is at stake. The SEC estimated the private placement market at about $1.6 trillion two years ago. No doubt it is even larger now. Because they are private offerings, these speculative and often illiquid securities do not have to be registered with the SEC, meaning investors are on their own when it comes to due diligence.

INVESTORS VULNERABLE

History has shown that investors can easily get burned. In recent years, two private placements in particular, Provident Royalties and Medical Capital Holdings, which turned out to be fraudulent, ensnared thousands of investors and resulted in billions of dollars in losses. There is a wide divergence of opinion about what the standards for accredited investors should be — or if there should be standards at all. Some believe the standards should be scrapped and argue that investors should be free to invest in whatever they choose, without regard to their economic circumstances. Another school of thought holds that wealth alone should not be the determining factor in deciding who has the ability to evaluate a private offering sufficiently. Proponents of that concept idea believe that an investor of modest means could, in many cases, be a more sophisticated investor than a wealthy person. The SEC's Investor Advisory Committee, created by Dodd-Frank to represent retail investors, recently debated the accredited investor standard and floated a number of alternative criteria. They include limiting the percentage of an investor's net worth that could be invested in private placements and developing a test to determine an investor's level of sophistication.

GAO RECOMMENDATIONS

In a report last year, the Government Accountability Office recommended that the SEC consider requiring that investors work with a financial adviser as a prerequisite for investing in private placements. All of these ideas are worthy of further investigation by the SEC. Increasing the net-worth threshold to account for inflation would be a minimum step toward bringing the accredited-investor definition up to date. To accomplish that, the SEC would require investors to have a net worth of at least $2.3 million, versus the current $1 million minimum. Though not a perfect gauge, net worth is somewhat of an indicator that a person has the savvy it takes to evaluate investments. Another solid step the SEC should consider is limiting the percentage of net worth that an investor could put into private offerings. Though the idea of somehow testing an investor's level of sophistication in order for that person to become accredited is intriguing, it is hard to imagine a good way of doing that. It also would seem to be a process open to abuse if not policed properly.