Drew Adams, President, Privest Wealth Management Inc.
Stance: Exempt products insulate you from the vagaries of public markets
Acquired credibility
Prior to National Instrument 31-103, the private securities market in Canada was largely unregulated — not just the products, but also the people. There were no proper checks on the suitability of investments or risk tolerance of investors. Now every exempt market dealer (EMD) must adhere to rules regarding proficiency, conduct, capital, compliance, know-your-client and suitability.
These checks and balances have forced alternative markets to mature. They’re now a respected domain for investment professionals, not a haven for quacks. As a result, many financial planners have begun embracing exempt markets, and reaping the rewards of higher risk.
It’s not just about retaining clients and keeping them happy. An exempt market licence offers an edge if you’re trying to lure clients away from another advisor.Alternative advantage
Exempt securities don’t trade publicly. So the real advantage of incorporating exempt securities is that a certain percentage of the client’s portfolio becomes tied to private markets that don’t fluctuate daily.
The historical approach has been to park most of the client’s portfolio in publicly traded securities, whether bonds or mutual funds. We don’t discount the value of public securities, but we believe in reducing the client’s connection to the vagaries of public markets — attach at least 10% to 20% of the portfolio, depending on the client’s situation, to the private side of the investment world. As a general rule, an investor’s tolerance for increased risk increases when financial capacity (net worth and/or income) and sophistication are higher.
By disconnecting from public markets, you insulate the portfolio from global vicissitudes that can freeze markets — sovereign debt issues in Europe, political turmoil in the Middle East, nuclear reactors in Japan, or a fiscal cliff in the United States.
Flip side
Like everything else, these investments come with fine print: limited liquidity. Exempt markets have
different terms.
You’ll find certain investments with a 12-month cycle, but those are rare. Most investment opportunities from the private side have three-to-six-year terms.
It’s also tricky to pick products. Every company will assure you it’s offering the best investment.
The onus is on you to sift through the chaff and pick out the winners.
Pick winners
To vet these investments, start with the people associated with the offering. Check their resumés; study their track records; conduct comprehensive back searches. If someone has been in this business 30 years, we’d want to know how she’s done with other investments.
Next, dissect the opportunity. All propositions are based on a set of assumptions — the market will go up; it will stay flat; the product will grow faster than the rest of the products in the market, etc. We start by doing third-party analysis to verify if the assumptions are reasonable.
For instance, if the investment opportunity is based on demographic growth in the city of Kelowna, B.C., we’d start by researching historical data.
Even in the absence of a prospectus, almost all exempt securities have some corporate structure — limited partnership, or trust and disclosure documentation — often as part of the offering memorandum itself.
Dissecting this documentation isn’t the domain of the average guy. We bring in third-party securities specialists and lawyers to validate the veracity of each document.
Not all exempt securities are appropriate for everyone. But there are certain ones that fit well with an average portfolio. For example, you can quite easily find a mortgage investment corporation with a 50% loan-to-value ratio.
It provides a nice income stream, and there are plenty of assets to back up the investment.
Due diligence
The starting point for advisors eyeing an alternative investment is to carefully study the dealer’s due-diligence files. There’s often confidential information in the file regarding the issuer, or the company in question. Dealers typically don’t allow those files to leave their offices. But most dealers will allow advisors to come in and have a look.
Ask the issuer if you can spend a couple of hours in their boardroom, review their documents and ask them questions. Issuers active in the exempt market are also quite willing to take interested advisors on a behind-the-scenes tour.
David Di Paolo, partner and regional chair of the Securities Litigation Group, Borden Ladner Gervais, Toronto
Stance: You’ll have to brave higher risks, regulations and obligations
Advisors shouldn’t necessarily shy away from this vibrant market. But if you get into this space, know the unique risks, rigorous scrutiny and enhanced obligations that come with these products.
People think regulations have made these products safer. But the exempt-market provisions under NI 31-103 haven’t really impacted the risk profile of exempt market investments. That wasn’t even the intended purpose. These regulations were more about streamlining the registration process than they were about dealing with risk and viability.
Although there’s more scrutiny in the exempt market now, it still isn’t as high as for those registered under IIROC or MFDA. The lower level of scrutiny may have led to abuses of the available exemptions, especially the accredited investor exception. There have been quite a few instances where regulators have found advisors playing fast and loose with AI criteria.
As a result, securities regulators across the country are taking a harder look at exempt markets and you can expect a further tightening of rules.
Regulators are also considering third-party verification of investor status. That will be an added cost. I’m skeptical about how that would work in practice: Who will pay for that service — clients or dealers? Who will perform the verification? Will the third-party verifier need to be registered as well?
Cover your bases
If you wish to dabble in exempt products, any effort at due diligence must commence with getting to know your product inside and out. CSA staff notice 33-315 — suitability obligation and know your product — is always a good starting point.
Gauging the people behind these products is equally important. Start with management’s power point presentations; they can give you fair guidance about the nature of the product and the market assumptions it is based on.
Have conversations with the management and board, and if possible, visit them in person. Review the operations firsthand, take a look at the issuer’s business plans and financials.
If available, look through the SEDAR filings (electronic files for documents by public companies and investment funds across Canada), and examine the offering memorandum. Also, ask to speak with the issuer’s legal, accounting and tax advisory teams. If the offering involves natural resources, have conversations with the geologic or technical experts as well.
Due diligence doesn’t end here. Document each of these steps: make note of who you talked to, when you talked to them, and what they told you.
If the product implodes and you’re asked to prove your KYP due diligence, you’ll need proof that you fulfilled your KYP obligations. I can’t tell you how many regulatory interviews I’m involved in with clients who’ve done thorough due diligence, but have no evidence to prove it.
That raises a huge problem in court. Oral evidence is not as valuable as documented proof. This issue often comes up when advisors are questioned about the due diligence they did to satisfy themselves that their clients met the AI criteria.
Oftentimes, advisors claim: “I manage only $100,000 of this client’s account, but he told me he has another account worth half a million elsewhere.” That isn’t sufficient to establish the client as an accredited investor.
Sometimes clients might say, “What I have with another dealer or where my other assets are is none of your business. Just focus on the assets you manage.” At that point you have to be blunt and tell the client: “If I can’t see documentation to prove you’re an accredited investor, I simply can’t sell you
the product.”
If you do otherwise, then you are exposing yourself to regulatory scrutiny.
Clean up
A product could blow up despite best efforts at due diligence. If that happens, involve your compliance department in dealing with client complaints.
But your first effort must be not to reach that stage. For starters, don’t make lofty promises. Products like Portus and Norshield came into the market with a lot of fanfare. Amid the euphoria, many advisors made tall claims about guaranteed recovery.
It came back to bite them. There are risks inherent in every product; make sure you fully explain them to clients.
Secondly, consolidate a file of any client correspondence, discussions and KYC information. Your compliance department will rely heavily on that material if things go wrong.
Kanupriya Vashisht is a Toronto-based financial writer.