This is the single-most asked question posed by syndicators to their investors, because it is required by law in the United States. Syndicators have to follow certain regulations set forth by the SEC in order to operate legally. There are 2 main categories of private placements, 506(b) and 506(c). Within these are certain restrictions affecting the kind of investors they can accept. This article will help explain the difference between an accredited versus sophisticated investor.
Operating under Regulation D, Rule 506(b) and Rule 506(c) regulations (actually exemptions) are the most common syndication methods used by multifamily syndicators. Sponsors using 506(b) can accept both sophisticated and accredited investors, while 506(c) can only accept accredited investors. Sponsors usually have a preference for one or the other going forward into future projects, and must list the number of each type of investor with their SEC filings.
Although 95% of syndicators operate under 506(b), they tend to focus their attention on attracting accredited investors rather than sophisticated investors.
What is an Accredited Investor?
Certain securities offerings that are exempt from registration may only be offered to, or purchased by, persons who are accredited investors. An accredited investor is:
- A bank, savings and loan association, insurance company, registered investment company, business development company, or small business investment company or rural business investment company
- An SEC-registered broker-dealer, SEC- or state-registered investment adviser, or exempt reporting adviser
- A plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5 million
- An employee benefit plan (within the meaning of the Employee Retirement Income Security Act) if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million
- A tax-exempt charitable organization, corporation, limited liability corporation, or partnership with assets in excess of $5 million
- A director, executive officer, or general partner of the company selling the securities, or any director, executive officer, or general partner of a general partner of that company
- An enterprise in which all the equity owners are accredited investors
- An individual with a net worth or joint net worth with a spouse or spousal equivalent of at least $1 million, not including the value of his or her primary residence
- An individual with income exceeding $200,000 in each of the two most recent calendar years or joint income with a spouse or spousal equivalent exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year or
- A trust with assets exceeding $5 million, not formed only to acquire the securities offered, and whose purchases are directed by a person who meets the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment
- An entity of a type not otherwise qualifying as accredited that own investments in excess of $5 million
- An individual holding in good standing any of the general securities representative license (Series 7), the investment adviser representative license (Series 65), or the private securities offerings representative license (Series 82)
- A knowledgeable employee, as defined in rule 3c-5(a)(4) under the Investment Company Act, of the issuer of securities where that issuer is a 3(c)(1) or 3(c)(7) private fund or
- A family office and its family clients if the family office has assets under management in excess of $5 million and whose prospective investments are directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment
What is a Sophisticated Investor?
Also known as a non-accredited investor, a sophisticated investor must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment. These non-accredited investors must either possess sufficient financial knowledge on their own or be advised by a purchaser representative who has the necessary sophistication, and should be able to make an informed investment decision without the full disclosure provided in a public offering. A sophisticated investor does not need to meet the financial thresholds in the accredited investor definition to invest in certain offerings, but can only participate in offerings under Rule 506(b).
In August of 2020, the SEC adopted amendments to the “accredited investor” definition, which affects sophisticated investors. “The amendments allow investors to qualify as accredited investors based on defined measures of professional knowledge, experience or certifications in addition to the existing tests for income or net worth. The amendments also expand the list of entities that may qualify as accredited investors, including by allowing any entity that meets an investments test to qualify.” At this writing, however, “defined measures of professional knowledge” has not yet been outlined.
Why Does it Matter?
Under 506(c), syndicators are allowed to advertise their deals widely, but they can only accept accredited investors. 506(b) does not allow advertising. Instead, all syndicators must have a pre-existing, substantive relationship with their investors. Further, the syndicator under 506(b) is required to keep track of emails, conversations, and other methods of communication with you in case they are audited by the SEC, especially if you are not an accredited investor.
A syndication organized under 506(b) can only have 35 sophisticated investors participating in any given project, though the number of accredited investors is unlimited.
Ideally, when a sponsor interviews a sophisticated investor (yes, it goes both ways), they must be very careful about onboarding them as an investor. The syndicator should exercise good judgement and only accept money from these non-accredited investors if they can afford to lose their whole investment and not suffer a financial hardship.