You are at a party, hanging with friends, or simply eavesdropping on a nearby conversation and you hear about someone investing in an exclusive fund that is not available to just anyone. Impressed by the returns, you ask yourself “How do I get a piece of that action?”
The investment could be a private equity fund that invests in pre-publicly traded start-ups or a hedge fund that boasts eye-popping historical returns. Whatever the opportunity, your curiosity is piqued.
Going Beyond the Ordinary
Most investors buy easily accessible investment vehicles – mutual funds, stocks, bonds, ETFs, and maybe even some options. However, some investors want to invest in “private funds” that are more exclusive such as hedge funds, private equity funds, or private real estate funds.
Private investment vehicles such as these are not open to just anyone. An investor must qualify as either an “accredited investor” or a “qualified purchaser”. So how does one qualify, and what does that mean?
It is easier to qualify as an “accredited investor”. To do so, you must meet one of two criteria, i.e. income or net worth.
For income, you must have earned income greater than $200,000 ($300,000 for joint filers) in each of the last two years. You must also reasonably expect that your income will be the same in the current year. Note that “earned” income represents the figure you put on line 7 of your 1040 tax form: wages, salaries, tips, etc. It does not include investment income, IRA distributions, pensions, social security benefits, or other “unearned” income.
To qualify based on net worth, it must exceed $1 million excluding the value of your primary residence.
As defined by the Securities and Exchange Commission (SEC), a “qualified purchaser” is an individual or family-owned business with $5 million or more in investments. Note that this is different from the accredited investor requirement. This criterion relies solely on the value of investments, rather than net worth.
What do the Categorizations Mean?
Both categorizations allow investors to access private investment funds. The biggest difference is that “accredited investors” can only invest in funds owned by 100 individuals or fewer. If a private fund wants to have more than 100 investors, they all must be “qualified purchasers”.
Note of Caution: Fewer legal protections! The SEC does not require private funds to register as investment companies, so investors receive fewer legal protections (see: Madoff, Bernie).
Investors who meet either criteria are deemed less likely to need regulator oversight and are therefore free to invest in high-risk, potentially high-reward investments. These investors are (in theory) more sophisticated and better able to withstand potential losses from such investments.
If I Qualify, Should I Invest in a Private Fund?
Answer: “It depends.”
Private funds characteristics:
Before you invest, consider whether your personal situation can allow you to lose the funds without jeopardizing your financial future. While financial impact is a primary factor, also consider your tolerance for holding an investment that is not performing at the level of expectation. Investment anxiety can have a devastating impact on life in general.
Those who qualify as “accredited investors” or “qualified purchasers” gain access to investments not available to the general public. Whether or not to take advantage of this access is a question each investor must answer for her/himself.
David Crossman, CFA, is a Senior Portfolio Manager with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email David at [email protected].
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