Accredited Investor vs. Sophisticated Investor - Deceptively Similar Terms with a Huge Difference in Definition

When viewing the words accredited investor and sophisticated investor side-by-side, the average person may think these are the same terms or hold practically the same meaning. Financial professionals often use these terms interchangeably to their detriment. Understanding the difference between an accredited investor and a sophisticated investor is paramount to avoiding serious consequences. Unfortunately, a simple slip up of vocabulary, in this case, can lead to worse situations than a simple misunderstanding. This blog will describe why it is essential to understand the difference between an accredited investor and a sophisticated investor.

The “Accredited Investor”

For our purposes, the most important definition is that of an accredited investor. An accredited investor is an individual or entity that meets precise requirements based on SEC guidelines to participate in Regulation D offerings. The SEC coined the term and created this category with the Title II Jobs Act to promote private offerings while still making them safe and stable. The aim is to allow for less regulation in private investments by the investors taking part in them being able to shoulder the potential loss burden. Hence the focus of accredited investors’ requirements is high net worth, income, or financial knowledge. Understanding an accredited investor’s requirements is also crucial, international accredited investors who also need to meet the same US requirements. Verification of accredited investor status is something to take very seriously and goes beyond classifying types of investors, whether they be accredited or otherwise.

Most importantly of all is the requirement that all investors in Rule 506(c) offerings be accredited investors. Therefore, getting the terms accredited investors and sophisticated investors mixed up could have dire consequences since the SEC is strict in its accredited investor-based offerings. There is no wiggle room for understanding that accredited investors are in their category and have little to do with sophisticated investors, as discussed in the next section.

The “Sophisticated Investor”

Broadly speaking, a sophisticated investor is one who might have an unusually high net worth and/or high income. Additionally, a sophisticated investor usually has a highly developed investment and financial knowledgebase, which commonly leads to great investment intuition. Both of these requirements are loose as the definition of a sophisticated investor varies from one nation to another and may or may not have actual requirements or laws that dictate what it means to be a sophisticated investor. This is more of a blanket term, one that something like an accredited investor would fall under.

Most importantly, a sophisticated investor is expected, but not required, to make sound investment and financial decisions. Since they are knowledgeable about the economy and financial markets, they generally do more research and thoroughly understand the situation before deciding how to invest. Additionally, since they have a lot of money, they can withstand a financial loss if an investment goes south. For this very reason, governing bodies in several countries that handle investment laws restrict specific high-risk investment offerings to sophisticated investors and the more particular classifications that a country might have, such as accredited investors.

It pays to be considered a sophisticated investor or something that falls under that category. It generally opens up access to investment opportunities that are not available to the general retail investor. Most importantly, one should do their research into what their own country classifies as a sophisticated investor. One should also realize that just because someone is a sophisticated investor does not mean that their investment decisions are perfect. Everyone can make mistakes, and the markets that sophisticated investors take part in can be high risk and volatile, just like any other market.

New Definitions Add to the Potential Confusion

            Traditionally in the realm of accredited investors in the United States, having a high net worth and high income was the central pillar of what was required. Knowledge and holding certain licenses was something that many in the private investor community pleaded to the SEC to be added to the accredited investor definitions. Finally, in December of 2020, the SEC added the ability to be considered an accredited investor based on holding specific licenses. Here is the actual definition:

•      The SEC deems “natural persons” with specific certifications, licenses, and other credentials to be “financially sophisticated” enough to qualify as accredited investors. Accepted certifications from accredited educational institutions will initially include the Financial Industry. Regulatory Authority, Inc. (FINRA) Licensed General Securities Representative (Series 7), Licensed Investment Adviser Representative (Series 65), and Licensed Private Securities Offerings Representative (Series 82).

Additionally, the SEC has opened up the possibility of more professional licenses being added in the future.

            The “knowledgeable employee” is another new accredited investor requirement that can also be misconstrued as a sophisticated investor. A “Knowledgeable Employee” of a private fund can invest in said fund if they meet the following criteria:

•      (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the private fund or an affiliated management person of the private fund; or

•      (ii) an employee of the private fund or an affiliated management person of the private fund (other than an employee performing solely clerical, secretarial, or administrative functions with regard to such company or its investments) who, in connection with his or her regular functions or duties, participates in the investment activities of such private fund, other private funds, or investment companies the investment activities of which are managed by such affiliated management person of the private fund, provided that such employee has been performing such functions and duties for or on behalf of the private fund or the affiliated management person of the private fund, or substantially similar functions or duties for or on behalf of another company for at least 12 months.

As you can see, this has more to do with being apart of a financial organization; however, an individual in this type of role would generally possess a degree of financial acumen. Therefore a knowledgeable employee falls under the broad, sophisticated investor category, and one would not be surprised to hear these two terms mixed up on accident.

Future of the “Sophisticated Investor”

For the US, this shows a greater willingness to embrace the financial knowledge side of what it means to be a sophisticated investor. Instead of relying on an investor’s wealth, a more diversified group of investors will join the pool of accredited investors. To find out what this means for real estate investing, check out our previous article.

 If you take anything away from this article, just remember that accredited investors are not the same as sophisticated investors, and the terms should not be mixed up. If you live outside of the US, be sure to research what your regulatory bodies consider a sophisticated investor and if they have ant classifications that have specific requirements. It can almost be stated that all accredited investors are sophisticated investors, but not all sophisticated investors are accredited investors.