An article on the Abolition of the Sophisticated
Somewhere, a Leninist is rubbing their hands with glee.
About a month ago, I mentioned a clear delineation in finance between ‘Sophisticated’ investors and the rest of us. And, like hapless peasants refusing to admit the emperor has no clothes, not one of you thought to question what this term means.
Well, I’ll be the first to admit I was ‘tackle out’ and, due to absolutely zero demand, I am going to try and explain the difference in more detail.
Depending on where you live, there’s a lot of different terms for these investors: Sophisticated and Unsophisticated. Accredited and Unaccredited. Wholesale and Retail. High Net Worth Individuals and the chattering classes…
I’m sure tax lawyers are having an aneurysm over my not mentioning the nuanced differences between the terms, but what have tax lawyers done for me lately? Tax lawyers can stay in their lane, thank you very much.
I know that these terms can be a bit loaded for people, as there is certainly some that would prefer less politically charged language, so for this article, if you feel uncomfortable with sophisticated and unsophisticated, just imagine Bourgeois and Proletariat. Much less controversial.
In Australia you can be classified as sophisticated if you make more than 250,000 dollarydoos a year or own more than $2.5 million in assets. With this classification, you can invest in companies without the protections of the Corporations Act 2001, meaning that in our current system, only the rich can go in unprotected. Primarily, this means that companies don’t have to provide a disclosure document before you invest.
Disclosure documents are incredibly useful, because the company has to admit every problem they might have in explicit detail to pass regulators. This means that, as a retail investor, you have access to as much information as you need before putting your money in, assuming you bothered to do your research, which I have no doubt you haven’t.
A good example of this was in 2019 when Uber went public. In its disclosure document, the company had to admit that there was a good chance they would never be profitable, as the number of ride-sharing apps on the market had exploded and they had no means of maintaining market dominance. They also showed how, even at their heights, Uber was losing more money than it made.
That’s the kind of information I’d want to have before I invest, and exactly the kind of information Uber didn’t have to publicly admit to while they remained a private company.
As a retail investor, I can be assured of these safety nets, which lowers the chance of losing all my money.
Some people want to remove the classification, so let’s look at some argument why, and why not, we should remove the sophisticated/unsophisticated divide.
The obvious one is that it is unfair to have a two-tier system. Sure, there is much more risk investing in private companies, but that is where all the real money is made. Going back to Uber as an example, if you had bought as soon as the company became public, you would have spent roughly $42 per share. Since the current price is $37, that would be considered a bad investment. However, if you had invested as little as two years earlier, when the company was still private, you would have paid $30 a share.
This means that, had a retail investor known and wanted to buy shares, they would not have had the chance to buy at the cheaper price and wouldn’t have profited in the same way, if at all. This just seems like giving rich people a chance to get richer first.
First was a reason to scrap the delineation, here’s a reason to keep it: Liquidity.
Liquidity is just how fast you can sell an investment. Shares in Amazon or Bitcoin are highly liquid as there is always someone willing to buy them off you at moment’s notice.
A truck full of used sex toys are highly illiquid because it’s going to take you a long while to find someone depraved enough to actually buy it.
Private company shares are the used sex toys of investments. Most people aren’t in the market to buy, most of those who are, haven’t even heard of your specific truck full of sex toys and even of the few that are willing to buy... they have 6 other trucks full of sex toys trying to hock them their wares. Worse, often you can only choose to sell all your shares, or none. After all, the kind of person that is willing to buy a truck full of used sex toys is very unlikely to only want half a truck full of used sex toys… I think this analogy has run its course.All this is to say when you do decide to sell private shares, it might take you a long time to get a buyer. If you’re rich and can wait out any problem on your luxury super yacht while sipping a coke and covid cure cosmopolitan, concocted by Pfizer, it’s probably not a big deal to you if it takes so time, but if you’re poor, chances are you are selling because you need the money for something now and don’t have years to wait.
Private markets are one of those risks that gets bigger the poorer you are, like contracting malaria or liking marvel movies.
Another argument for the downfall of the sophisticated moniker is that, as it currently stands, most of these investors are white, male, and particularly grumpy that I just brought up that they are white and male. Theoretically this doesn’t matter. A good investment is a good investment, and I am sure most of these people would love to invest in any company provided it was a good deal. But the fact is that most people hang out with other people like them, so non-white, non-males often struggle to simply get access to these investors. In America, 30% of entrepreneurs are Hispanic, but only 3% of companies that receive private funding are Hispanic.
I would hate to call it systemic racism, but I know that if I do, Ben Shapiro will mention me on his show and let’s face it… I need the signal boost.If we removed these requirements, people of colour and women might have more opportunities for funding, simply because they would have more access to prospective investors.
Another reason to smash the bourgeoise, because maintaining a consistent pattern of pros and cons is for cowards… the delightfully arbitrary definition of who is and isn’t sophisticated is completely arbitrary. You don’t need a nuanced understanding of finance. The requirement is simply that you make a certain amount of money per year or have a certain amount of wealth. But if I won the lottery tomorrow and could qualify as sophisticated, I wouldn’t magically develop financial acumen… I’d just develop a substance abuse problem.
Likewise, imagine I had paid attention at Uni and actually knew what was and wasn’t a good investment, but didn’t have much cash. I wouldn’t be wealthy enough to use said theoretical knowledge. If there was to remain a difference between sophisticated and unsophisticated investors, maybe it should be based on provable knowledge. Maybe you can only become accredited if you can recommend an investment without using the words ‘paradigm-changing’ or ‘blockchain’.The last big issue is that, like Metallica says, in the end none of this matters all that much. That’s totally what they sung, right? You see, private companies have one other rule that makes them different to public: they are only allowed a small number of shareholders at any one time. In America, the maximum number of shareholders is 2000 but for Australia it is only 50, so there is no chance I would want to sell off shares of the company to a retail investor that can only offer me a few hundred dollars at a time. It just makes sense for me to go find the richest group of people I can find and pitch my company to them. The only reason I would ever bother with poor, retail investors would be if my company was so bad that sophisticated investors refuse to touch it. And remember, these sophisticated investors fell for FTX, Theranos, Enron, Twitter, WeWork, WorldCom, WireCard, and even a cleaning company made by a 15-year-old called ZZZZ Best… so if they refuse to touch something, you know it must be dodgy. Changing the rules won’t remove the preference of companies seeking rich investors as their first choice, but it will give scammers easier, less regulated access to investors who can’t afford to be scammed.
The U.S. House Committee on Financial Services has been listening to arguments like these over the last few months, but since we all know that won’t diddly squat, do you think the financial system should keep this system? Write your responses in the comments and I promise not to read them or steal your points for a follow up article.