Part of the appeal of investing in hedge and other private funds is their inherent exclusivity.
If you've got money with one, it's shorthand for being rich and, in the eyes of the government, sophisticated enough to understand the added risks. In other words, private funds seem sexier to some than pedestrian investments like stocks and mutual funds.
But access to those funds may get much more exclusive.
The Securities and Exchange Commission is considering changing how a so-called accredited investor is defined. In doing so, it's facing pressure from outside groups to dramatically increase the minimum savings and income requirements to invest and adding other measures of financial sophistication, like being a chartered financial analyst or having an advanced business degree. If approved, the changes would slash the number of people who the government deems wealthy and sophisticated enough to invest in hedge, private equity, venture capital and other private funds and investments.
"The new rules could significantly reduce the number of accredited investors. That would narrow the amount of eligible U.S. investors for hedge funds and others," said Steve Nadel, a private funds-focused partner at the law firm Seward & Kissel.
For decades, the SEC has used money as a proxy for being smart enough to understand the risks of private funds, which aren't required to disclose much about their investments. A person with a net worth of more than $1 million or an income of at least $200,000 over the last two years ($300,000 with a spouse) has been "accredited."
The Dodd-Frank Act of 2010 set up potential changes.
The financial reform law mandated that the SEC review the definition of accredited investor every four years beginning in 2014. That came after a new rule in December 2011 saying that the value of a home could no longer be counted toward the $1 million net worth requirement. And in July 2013 the SEC asked the public for comment on changing the definition of the term.
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Now, the SEC's Investor Advisory Committee—a group of consumer advocates, private funds and others—is discussing potential changes. It has yet to issue a recommendation, and even that would be nonbinding. But there appears to be relative consensus that, at minimum, the wealth levels set in 1982 should be increased.
"We think the thresholds are clearly inadequate," Barbara Roper, director of investor protection for the Consumer Federation of America and a leader on the SEC committee, said, echoing other consumer advocate groups.
Even a hedge fund representative on the committee, Pershing Square Capital Management's chief legal officer, Roy Katzovicz, said "thresholds set many decades ago should be revisited" during a hearing of the SEC's advisory committee meeting in July.
One common suggestion from the North American Securities Administrators Association and other advocacy groups is to raise the minimums by adjusting for inflation. That would mean a new net worth requirement of about $2.5 million and income of $400,000 ($600,000 if married).
A Government Accountability Office analysis in 2013 showed that increasing the wealth minimum for inflation (then to $2.3 million) would decrease the number of households qualifying to invest in private funds by 56 percent, from approximately 8.5 million to 3.7 million.
Hedge funds aren't fighting the potential change, even if it might mean losing a small percentage of clients.
The lead industry trade group, the Managed Funds Association, has publicly said it supports efforts to "increase investor qualification standards over time" to "ensure that only sophisticated investors with the financial wherewithal to understand and evaluate the investments" are able to use the industry.
About 65 percent of capital in hedge funds is from institutional investors like pensions and endowments, according to data tracker Preqin, meaning "high net worth" individuals aren't the dominant industry client base. Most hedge funds also require at least $1 million in investments from individuals, weeding out most people with wealth of under several million dollars (Smaller hedge funds and funds of hedge funds would be hurt more as they often have lower minimum investments).
Even fewer investors in private equity funds—about 11 percent of funds closed in 2011-2013—come from wealthy individuals, according to Preqin. The Private Equity Growth Capital Council didn't respond to a request for comment on the issue.
The changes would hit venture capital and others who invest in start-up businesses the most.
"The current definition works well for angel investors and the high growth startups they invest in, creating all of the net new jobs in the country, and without fraud," a spokesman for the Angel Capital Association said in an email statement. "An increase in the financial thresholds would reduce capital available for these startups and hurt the economy." (ACA estimates that nearly one-third of its current members wouldn't meet the new thresholds.)
There are a slew of other proposals to refine the definition of an accredited investor.
Some, including U.S. Reps. Patrick McHenry and Scott Garrett, recommend adding people with certifications like CFAs, certified public accountants and other existing financial certifications to accredited investor status, regardless of savings and income levels. Others have suggested developing a test to show financial sophistication even for those with the required wealth levels.
There are also calls for further defining wealth levels, such as excluding retirement accounts or a small business, from counting toward the savings threshold. There could also be percentage limits on the amount of income invested in private offerings, especially at levels just above the minimums.
"While there's some correlation between wealth and some financial sophistication, the levels of financial literacy in this country are so low it's no guarantee whatsoever that you'll have the particular expertise necessary to understand the risks and rewards of these offerings," Roper said.
Adding complexity to the definition doesn't appeal to all, including Katzovicz of Pershing Square.
"I'm all for simplicity," he said in the July public meeting, noting that many of the proposals would be too difficult to put into practice. "I don't think very dynamic rules are a good idea in this space," he added.
Consumer advocate Roper remains confident there will be more than a money-minimum increase.
"I don't think there's a snowball's chance in hell," she said of whether the SEC would simply raise the thresholds without another measure of financial sophistication.
While the advisory committee could make a recommendation this fall, there's no clear sense of when the SEC will decide on the issue. But some change appears likely, and various groups will continue to jostle on the issue.
—By CNBC's Lawrence Delevingne