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Tertiary Market

A Paradigm Shift-A Guest Post from Llenrock Group

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Ray Cirz
Ray Cirz

This post from Eric Hawthorn is part of our Llenrock guest post series and originally appeared on the Llenrock Group blog.

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Last year, I did a post exploring what constitutes an “accredited investor,” a term denoting someone with the financial wherewithal to invest in sometimes-risky private investments, which aren’t required to maintain the same level of transparency as publicly offered securities. As I mentioned, the implementation of the Dodd-Frank Act changed the criteria by which private-fund investors were accredited, ensuring that only (relatively) high net worth investors could participate in private offerings.

Private placements, exclusive investment opportunities not offered to the general public, are a significant part of the economy–and a major reason the world of investment and finance can’t be simplified to a few numbers from the stock market. The SEC’s way of “accrediting” investors for private placements consists of measuring investors’ income and net worth. If a person makes over $200k per year, they’re deemed competent for such private, high-risk investment.

To the SEC, then, a high income is tantamount to investment savvy. Intelligence and experience don’t come into the equation–just the level of income necessary to buffer the investor from a major financial setback. The Dodd-Frank Act alters this rule by removing an investor’s home equity from assessments of his or her net worth (a liability like one’s mortgage exceeding one’s home value is also included in this assessment). Thus, the field of potential investors in private offerings has been narrowed, though by how much remains a little unclear.

However, another piece of legislation, the JOBS Act, seeks to encourage private investment, especially for smaller enterprises, by loosening an eight-decade-old restriction on how private offerings are discussed.

Bloomberg’s Dave Michaels reports,

Hedge funds and other companies seeking private investments will be allowed to advertise publicly for funding under a rule approved today by the U.S. Securities and Exchange Commission.

The rule, which passed by a 4-1 vote, is the first one mandated by last year’s Jumpstart Our Business Startups Act to be completed by the SEC.

Loosening a Depression-era financial regulation is news in itself, but this is especially relevant to investors and fundraisers whose activities have long been restricted by what amounts to a gag order when it comes to discussing certain investment opportunities. The loosening of this restriction may be a paradigm shift for the alternative investment field, of which real estate is a major part, since this increases the freedom of smaller funds to compete in a playing field dominated by large private equity groups and public REITs. According to the Bloomberg article, companies raised $899 billion through private offerings last year, roughly triple the amount raised through more regulated stock offerings.

If fundraisers are able to publicize or openly announce new opportunities, will this create a surge of private capital in the commercial real estate market? Will the public’s increased interest in CRE translate into greater liquidity for investment companies whopromote their funds rather than hope the news makes its way through the grapevine to interested investors?

Not necessarily. Here’s Bloomberg again:

The limit to sell only to accredited investors explains why many hedge funds probably won’t respond by taking out print and television ads seeking new investors… Instead, the rule may free up hedge-fund managers to communicate more freely at conferences and to offer more information about fund performance on their websites.

The SEC’s decision to loosen this very old restriction is clearly aimed toward increasing transparency, but some are skeptical that freer communication may exceed accountability. Consumer advocates have been critical of this move, and the SEC’s lone dissenter, Commissioner Luis A. Aguilar (D), quickly expressed his disappointment with the decision:

Without common-sense protections, general solicitation will prove a great boon to the fraudster… Experience tells us that this will lead to economic disaster for many investors. (qtd in Bloomberg)

Luis A. Aguilar official portrait A Paradigm Shift for Private Capital?

Luis A. Aguilar, wary of fraudsters

Is this true? The SEC has announced efforts to create greater oversight of companies raising capital through private offerings to prevent the sort of fraud Aguilar fears.

For the commercial real estate industry, the opportunity to communicate information about offerings more freely seems like a great thing, especially for lower-tier markets that don’t attract investment from large public companies. Many funds acquiring properties or portfolios in second- and third-tier markets rely on private, high net worth investors with a little appetite for risk. Will people lose their shirts as a result of the SEC’s decision? Maybe, but sometimes people make bad investments. Provided the SEC exercises greater oversight of the claims private funds make, investors may be as well protected as ever.

As always, the government isn’t responsible for an individual’s own due diligence. If somebody wants to invest in a class C office building in Antarctica, they can. As I said, “accredited” investors are simply people with money; know-how is a separate issue.

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