Hedge funds and “sophisticated investors”

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A hedge fund is a limited partnership that is open only to sophisticated investors. Sophisticated investors include financial institutions, pension fund managers, some charities and trusts, and a few individuals. Hedge funds are not required to register with the SEC.

Individuals who qualify as sophisticated investors must meet one of two criteria:

6. “a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or …”[1]

It’s possible to be very wealthy and not understand anything about financial instruments, hedge funds, or anything related to financial markets. To a certain degree, hedge funds are designed to transfer wealth from those individuals to the fund managers.

[1] Source: http://www.sec.gov/answers/accred.htm.

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About Tony Lima

Retired after teaching economics at California State Univ., East Bay (Hayward, CA). Ph.D., economics, Stanford. Also taught MBA finance at the California University of Management and Technology. Occasionally take on a consulting project if it's interesting. Other interests include wine and technology.

2 Replies to “Hedge funds and “sophisticated investors””

  1. Touc

    Greetings Professor,

    An interesting article on the topic of who is considered a sophisticated investor is titled “The Birth of Rule 144A Equity Offerings” by William K. Sjostrom Jr. In the article, Mr. Sjostrom speaks glowingly about the emergence of private IPOs whereby a company can issues shares only to Qualified Institutional Buyers and Sophisticated Investors. Too bad Mr. Sjostrom couldn’t see, or was unwilling to acknowledge, institutions are very unsophisticated when they’ve got their hands on other people’s money (OPM).

    In the article, the only examples of private IPOs were all done at or near the stock market top in 2007 proving that the institutions buying the private IPOs were soon parted with their money.

    In private IPOs, the issuing company is not required to provide a prospectus or any financial information to the “qualified institutional buyer” or the “sophisticated investor” (p.425). Amazingly, there are/were willing buyers of these private IPOs even though there is no ability to exercise any form of due diligence at the time of issuance and at any point in the future.

    It is worth noting that if we exclude the concept of individuals participating in private IPOs, the very fact that institutions get involved in these transactions is alarming. Considering the fact that WAMU, Wachovia, AIG, Lehman, Fannie, Freddie, hedge funds, and various mutual funds have failed or routinely under perform despite the constant inflow of funds. It seems that when OPM is involved, the “prudent man rule” does not apply.

    Another note about the article above. There are specific references to how a flash crash occurs (p.427).

    Another matter of concern is the fact that while an institution can participate in a private IPO, the rules allow for the redistribution of the shares to other institutions that can acquire the shares using money from individuals who participate through the purchase of mutual funds.

    As noted in your posting, the fact that you have a lot of money or control an innumerable amount of money does not mean that there is any level of understanding of how investing works.

    Thanks for a great topic.