Can I Invest in a Hedge Fund?

Investments like hedge funds and venture capital funds can be exciting and have high potential for returns. They are also riskier and more complex than most other types of investments, and for this reason, they are not open to the general public.

In order to invest in a hedge fund, venture capital fund, or most private equity deals, you'll need to be an accredited investor, which means you need to have a certain level of income or assets. And in some cases, you may need to meet even higher standards if the fund charges performance-based fees or doesn't wish to register as an investment company.

What is an accredited investor?

Under U.S. law, securities cannot be offered unless they are either registered with the Securities and Exchange Commission (SEC) or if an exemption from registration applies. This is where the concept of an "accredited investor" comes in.

For individual investors, there are two potential ways someone can qualify as an accredited investor, which is also commonly referred to as a qualified investor. They must either:

  • Have earned income of $200,000 or more ($300,000 together with a spouse) for each of the previous two years, as well as a reasonable expectation of the same this year. The same method (single or joint) must be used for all three years, and the income must be earned -- that is, from a job, self-employment, or from a business in which the investor plays an active role.
  • Alternatively, they must have a net worth greater than $1 million, excluding their primary residence. A net worth calculator can give you an idea if you'd qualify.

In addition, trusts, corporations, and other entities can be considered accredited investors if certain criteria are met.

What can accredited investors do that the general public can't?

Accredited investors can invest in hedge funds or venture capital funds. Accredited investor status also allows you to invest in so-called "private placements," which is a general term for investments that are sold to a group of select investors and aren't available on the open market to the public.

Angel investing is an example of a private placement that is generally available only to accredited investors. The JOBS act allows private companies to raise capital from non-accredited investors under some circumstances (known as equity crowdfunding), but the companies must register with the SEC and provide certain information to utilize this option.

The general idea is that accredited investors have a certain level of financial sophistication, and therefore should be better equipped to handle riskier endeavors such as start-up investing, and can better afford to absorb losses should things turn sour.

Two other classifications that could be important to you

In addition to requiring investors to qualify as accredited investors, there are two other definitions that may apply to some unregistered investment opportunities.

If a private investment fund, such as a hedge fund, plans to charge performance-based fees, they can only do so to individuals who are qualified clients. To be a qualified client, an investor must meet one of these four criteria:

  • At least $1 million in assets under management with the advisor right after the investment advisory contract begins.
  • A net worth of at least $2.1 million, excluding their primary residence.
  • A "qualified purchaser" (more on this shortly).
  • An executive officer, director, trustee, general partner, or employee of the advisor.

For example, if a certain hedge fund plans to charge investors 20% of the fund's gains, they would need to find qualified clients to invest in their fund. Qualified clients generally also meet the criteria for accredited investors -- the only potential exception is someone who qualifies based on the last criteria in the list. However, not all accredited investors meet the criteria for a qualified client, as it is a generally stricter standard.

Finally, if a private fund doesn't wish to register as an investment company, it must be owned by 100 or fewer qualified purchasers. Qualified purchasers are also informally known as super-accredited investors, because of the higher net worth standards.

For an individual to be a qualified purchaser, he or she must own $5 million or more in investments. Trusts can also be qualified purchasers, provided that they weren't set up for the specific purpose of investing in the fund. And professional investment managers and corporations can be qualified purchasers if they control at least $25 million in investments.

Verifying your status

To be clear, the accredited investor and other distinctions are in place to protect investors from getting into situations they don't fully understand, and from taking risks they can't afford to take. They are not for the protection of investment companies and hedge funds.

For this reason, the burden of verification is on the party selling the investment. Hedge funds, venture capital funds, and other private placements are legally required to take steps to verify your eligibility to invest in any opportunity.

So, if you decide to invest in, say, a hedge fund, you should expect a thorough verification process before you're actually allowed to invest. To expedite this process, it's a smart idea to gather documents that can prove your net worth, investment value, and/or income. Just to name a few possibilities, you may need:

  • W-2s and 1099s
  • Copies of your last few tax returns
  • Pay stubs
  • Bank account and brokerage account statements
  • Verification of other investments held outside thee accounts (ex. deeds to investment properties you own)
  • Personal balance sheet

Unfortunately, there's no "one-and-done" way to become an accredited investor (or qualified purchaser or client), so you should expect a verification process for every opportunity you pursue that requires such a status. In other words, you can't simply tell a private company raising capital that you're invested in XYZ hedge fund, so therefore you must be an accredited investor.

The bottom line is that before you decide to invest in any restricted investment offering, be sure you meet the criteria, as it will likely be thoroughly verified before you are allowed to put your money to work.

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