Keeping the American Dream Alive: Is It Time to Close the Private Equity Divide?

Photo by Markus Winkler on Unsplash

Background

Young Americans are becoming increasingly skeptical of the American Dream. A 2024 study by the Pew Research Center found that only 42% of adults under fifty years old believe it is still possible to achieve the American Dream. Investopedia estimated the cost of the American Dream to be at $4.4 million in October 2024. Notably, this number is over a million dollars more expensive than its 2023 estimate. It is also over a million dollars higher than what the average American with a bachelor’s degree makes in a lifetime. Additionally, Forbes pointed out that these estimates do not account for essential costs such as food, healthcare, and other necessities. 

The logical inference is that wages are insufficient for Americans to fulfill the cornerstones of the American Dream, so Americans must turn to investments. However, not all investments are created equal. There is a big divide between investments available to the average American through the stock market and private equity investments available to sophisticated “accredited investors.” First, private equity tends to outperform public markets. Second, there are widespread concerns that the U.S. stock market may be overvalued, leading to even more limited growth opportunities for retail investors. Third, historically, only the wealthiest have qualified as accredited investors, leading former SEC commissioner Elad L. Roisman to issue a statement calling the system “fundamentally unfair, unequal, and unjustified.”

Accredited Investors and the Current Regulatory Framework

An accredited investor as defined by Section 5 of the Securities Act–as applied to natural persons–is an individual who: a) has a net worth of over a million dollars (excluding their primary residence); b) has an individual yearly income of over $200,000 ($300,000 joint with spouse or partner) for the last two years–and reasonably expects the same for the current year; or, as of 2020, c) qualifies due to professional criteria such as expertise in the specific fund or enterprise, or being an investment professional in good standing with the Securities and Exchange commission. These individuals can invest in unregistered securities–such as unregistered stock shares issued by private companies–which is otherwise forbidden under 15 U.S. Code § 77e.

This framework is intended to protect non-accredited investors from placing risky bets in private companies that do not have the same kind of disclosure requirements as public companies. However, more and more companies are choosing to remain private for as long as possible. As of 2021, Private equity firms managed approximately 20% of the U.S. Corporate Equity. Private markets now raise approximately four times more money than public markets. This means that the majority of the population is excluded from the largest and most profitable set of new investment opportunities. 

Notably, this bar applies even in relation to retirement accounts as ERISA places strong limitations on private equity investments in 401(k) plans. Similarly, Social Security trust funds are invested entirely in U.S. Treasury securities. Thus, retail investors have virtually no way to access the benefits of private equity investments.

Proposed Changes: Expanding the Accredited Investor Definition & Additional Safeguards

One idea is to expand the definition of “accredited investor” to allow retail investors to qualify through special certification exams, effectively allowing education as a channel for accreditation. The SEC briefly discussed this idea in a 2015 report. In the report, the SEC focused on the difficulty of identifying an existing certification examination that would effectively eliminate the need to protect the certified individuals. Some examples of already existing certifications include FINRA’s Series 7, Series 65, and Series 82 certifications, which respectively qualify individuals to become a general securities representative; a uniform investment adviser; or a private securities offering representative. The SEC could also design its own certification exam. This idea was suggested to the SEC in 2019 as it considered the expansion to the definition of “accredited investor” that took place in 2020.

Additionally, the SEC has the choice to place additional guardrails on the admission of less wealthy investors. The Marketplace Lending Association has suggested implementing a sliding scale placing limits on the investments of retail investors who do not meet the current accredited investor standards. This would allow the SEC to increase market participation while maintaining sensible protective measures for less wealthy retail investors.

Why Change Is Needed – Addressing Counter Arguments and Concerns

Bridging the private equity divide and increasing access to investing draws criticism from those particularly concerned with safeguarding against fraud and ensuring investor protection. Skeptics push the view that expanding participation will lead to an uptick in fraudulent activity. However, as evidenced by its decision to expand the definition of “accredited investor” to include intra-industry experts in 2020, the SEC shows that subject matter expertise makes investors arguably better versed in fraud prevention. We argue that adequate education should have a similar effect.

We must also distinguish between protecting investors from fraud and shielding them from potential financial losses. Private equity investments are risky and less liquid overall compared to other securities. The SEC has stated that the accredited investor standard is there to protect investors with fewer resources from such risk. Concerns persist surrounding the accessibility of private equity investments to retail investors, given how complex and covert they are versus public markets. Under the accredited investor standard, it is assumed that investors able to fulfill the wealth or income requirements have correlating financial literacy skills needed to make mindful investment decisions. A study by the National Bureau of Economic Research suggests this correlation to be true. Yet the same study suggests investment sophistication is also derived–albeit to a lesser extent–from education and experience. The main upside of the current regulations in place is that they shield less experienced investors from risks by making it more likely that accredited investors have the resources to obtain the information needed to fend for themselves. Having access to the kind of information that would be otherwise available in the form of a registration statement is pivotal according to SEC v. Ralston Purina Co. However, this comes with the cost of creating division. This division may not be necessary because wealth alone is enough to become an accredited investor, but it does not guarantee access to information.

Another key argument against providing greater access to private equity investment is the disparity in bargaining power between retail investors and private equity sponsors. Due to the structure of private equity funds as LPs with controlling general partners setting stringent terms, investors are given minimal input. Less experienced investors could be subject to unfair terms outside of their control. Through the solution of investment limits, overexposure could be avoided without cutting off market participation entirely. Investors’ autonomy must be taken into account as well, but while striking a balance with safeguarding measures. Mirroring the EU’s regulatory approach, investor transparency should be prioritized over restriction, bridging the gap between protecting investors and allowing broader participation in private equity markets.

Conclusion

Current private equity regulations, specifically the accredited investor standard, have led to a divide within investment opportunities, heightening wealth inequality. This regulatory framework reinforces a system where wealthy investors benefit from high returns inaccessible to typical investors. By implementing solutions like tiered investment access based on financial knowledge, enhanced risk disclosure requirements, and regulatory frameworks tailored for retail investors, policymakers can expand private equity participation while maintaining necessary safeguards. Opening private equity markets to a wider range of investors could promote fairness, capital formation, and further benefits for all parties. Pointed regulatory adjustments can aid in ensuring relative wealth does not equate to one’s ability to make informed investment decisions, disparately impacting retail investors. Making these investments more accessible should serve as a wealth-creation catalyst that allows retail investors to share the benefit from private markets.    Worries around investor protection, illiquidity, and information asymmetry can be managed through financial education, proper oversight, and diversified access mechanisms like regulated funds and capped retirement plan allocations. The current state of private equity must be reevaluated by policymakers to balance investor safeguards with more accessibility. By making conscious changes to PEI regulations, a more equitable investment landscape can be paved in support of accessible financial opportunities. After all, accessible wealth-creating opportunities are the foundation of the American Dream.

*The views expressed in this article do not represent the views of Santa Clara University.