Exempt markets deliver results

The newly created exempt-market-dealer category in NI 31-103 creates a safer investment environment for exempt-market securities, because the rules provide greater oversight and proficiency requirements.

There are benefits to greater scrutiny. A safer market depends on better risk analysis by dealers, and better management of investors’ expectations.

As such, the Canadian Securities Administrators have proposed amendments to the “Accredited Investor Definition and Minimum Purchase” exemptions. These exemptions were established in the 1970s and allowed for the sale of securities without a prospectus, provided the purchaser satisfied a minimum annual income or purchased more than $97,000 of said securities.

At the time, there were very few ways to raise capital privately beyond your friends, family or business associates. The minimum purchase amount was raised to $150,000 in 2003 when CSA introduced NI 45-106, which provided broader capital-raising exemptions. It is the basis for what has become the exempt market today.

Integrating these securities

We limit exempt-market securities to 10%-to-20% of the asset mix, and diversify that portion among 10-to-15 securities. Since exempt-market securities often lack liquidity and have poor transparency, they should not be packaged and promoted like a retail mutual fund. Instead, approach the exempt market like venture capital.

The most prevalent risk in both venture capital and the exempt market is business risk. Clients who can afford to lose their entire investments (or not receive a return for several years) are suitable investors.

When assessing deals, the venture capital industry applies the 2-6-2 rule: In 10 given deals, you will lose your money on two, break even on six, and win big on the remaining two. Knowing which deals to consider increases the likelihood that those two winners will be in your basket — making the process worth pursuing.

Many firms hire or contract out this risk analysis or rely upon research created by others. Also, many firms in the exempt market invest alongside their clients.

The big picture

Interest in the exempt market is buoyed by the storm brewing south of the border. As the Economist reported in February, Wall Street is reeling from massive drops in fixed-income, currencies and commodities trading, which have traditionally been responsible for almost 50% of investment banking revenues. Net outflows from traditional stocks are no longer headed to the bond market.

Instead, the home of choice for unhappy capital is becoming alternative assets. In 2012, Towers Watson expects one in every four dollars will be allocated to alternative assets in the U.S.

Yet in America, access to alternative assets is reserved to institutional and accredited investors only. Not so in Canada.

With the Facebook IPO, early-stage investors are expected to earn 1,000 times their initial investments. Had Facebook been a Canadian company, your plumber or butcher could have been an early-stage investor.

And, Facebook founder Mark Zuckerberg could have bought flow-through shares to save some of that newfound wealth before the IRS lays claim.

The exempt market in Canada represents a huge opportunity for investors, issuers, and dealers. The challenge will be to make exempt-market investing safer by offering more consistent results.

Delivering on the promise made by the exempt market will require better risk assessments and better education for investors — they should know to expect some losses if they are to find the big winners.

Sheldon Stier is the founder of Hatch Alternative Investments Inc., an exempt-market dealer registered with the Manitoba and B.C. Securities Commissions.