Investors seeking to allocate to hedge funds often find that hedge funds carry significantly higher minimum investment requirements than traditional investments, such as mutual funds. Emerging hedge fund mangers’ minimum investment can be as little as $100,000 to $1,000,000. More established institutional hedge fund managers’ minimums typically start at $1,000,000 but can frequently be $5,000,000 to $10,000,000. One could ask, how is a hedge fund minimum investment decided? Why is there a wide dispersion across hedge fund minimum investments? And importantly, what could a hedge fund’s minimum investment reveal to investors?

A hedge fund is an investment product that generates profits for its investors by employing differentiated strategies that might include short-selling, leverage, derivatives, and alternative asset classes. Hedge funds are less accessible than standard mutual funds that invest in traditional asset classes, but they're also less regulated with regard to their investment strategies, giving them more flexibility than their mutual fund counterparts. Hedge funds, as a result of having fewer restrictions, face certain limitations with regard to how they can operate and market their funds. Due to these limitations, hedge funds typically cater to institutions and high-net-worth individuals and require large sums of money to invest.

One aspect of the Securities Act of 1933 imposes a requirement for securities to be registered with the Securities and Exchange Commission (SEC) of the United States. However, not all securities offerings must be registered with the SEC, such as hedge funds that meet certain requirements. While other conditions must also be met, some possible registration exemptions are available for:

• “private offerings to a limited number of persons or institutions;
• offerings of limited size;
• intrastate offerings; and
• securities of municipal, state, and federal governments.”

Further exemptions from registration are possible under Rules 506 and 504 of Regulation D (Reg D) under the Securities Act of 1933. Yet these exemptions also impose certain conditions on the security, such as limits on the number of total investors, and establish suitability requirements for those investing in the fund. One such suitability requirement is the “accredited investor” threshold, which includes natural persons with a net worth of more than $1 million or yearly individual revenues of at least $200,000 ($300,000 if married), among other requirements. For entities, such as trusts, the net worth requirement is more than $5 million, among other requirements as well.

Recently, the SEC amended their definition of an accredited investor to include measures of professional experience, knowledge, or certifications in order to expand the private markets and allow more engagement regardless of income level. This also includes knowledgeable employees of private funds, as well as SEC- and state-registered investment advisers.

The accredited investor requirement is in place to help ensure that only sophisticated investors are admitted to these funds, which are exempt from the disclosures required by other traditional products because they need to possess the necessary financial means and knowledge to take the risks involved in investing in unregistered securities.

Some private funds, however, may only accept investors that are also considered qualified purchasers in order to maintain a certain exemption status with the SEC. A qualified purchaser is defined in part as an individual or family-owned business that owns $5 million or more in investments. A qualified purchaser can also be an individual or other entity that invests at least $25 million, either for their own accounts or on others' behalf, amongst other criteria. Examples in this category would be a professional investment manager or a corporation.

One of the primary differences between accredited investors and qualified purchasers is that the latter does not include yearly income or net assets, but instead investments, which is broadly defined. Yet much like accredited investors, there are certain funds available only to qualified purchasers, including many private funds, hedge funds, or venture capital funds. Given this regulatory backdrop, investors see higher hedge fund minimum investments compared to traditional financial products, as these managers seek more sophisticated investors.

Sources:
Investopedia - Can You Invest in Hedge Funds? (investopedia.com);
Investor.gov. “The Laws That Govern the Securities Industry.” - The Laws That Govern the Securities Industry | Investor.gov;
Investor.gov. “Rule 504 of Regulation D.” - Rule 504 of Regulation D | Investor.gov;
Investor.gov. “Rule 506 of Regulation D.” - Rule 506 of Regulation D | Investor.gov;
Investor.gov. “Accredited Investors – Updated Investor Bulletin.” - Accredited Investors – Updated Investor Bulletin | Investor.gov;
SEC. “SEC Modernizes the Accredited Investor Definition.”

But why would hedge funds turn away money from the appropriate investors? Hedge funds often use their investor base to highlight their reputation. In reality, many large prospective investors may not care if an unknown accredited investor enters the fund but might be interested to hear that a prestigious pension fund, sovereign wealth fund, or even a university endowment is making a substantial investment into the fund.

The thought being that these large institutions manage large amounts of money and that if this fund is good enough for them and fits their portfolio mandate, then maybe this fund could be a fit for their portfolio too. While this isn’t always the case, investors like knowing that these large institutional players have already given the fund their stamp of approval.

Another reason top-decile hedge funds may require a higher minimum investment is to combat the high demand for their fund. A fund consistently outperforming the broader market will attract the attention of investors, but such attraction might not be in the fund’s best interest. Given the regulations set out by the SEC, such as the limitations on the total number of investors in a private offering, these types of hedge funds may prefer a handful of large institutional investors vs. various accredited investors.

Given the numerous hurdles outlined earlier for prospective allocators, we look to disrupt the hedge fund space and provide more financial advisors with the opportunity to access institutional hedge fund managers at lower minimums for their clients’ portfolios.