Exempt offerings require care

While it may be tempting to offer exotic investments to your high net worth—or even mass affluent—clientele, advisors should think twice before dipping their toes into the exempt market, according to one finance professor.

Exempt market offerings run the gamut on risk, ranging from principal-protected notes and certain types of commercial paper, to private placements in public or private companies and flow-through limited partnerships.

It’s a massive market. In 2010, there was $16.2 billion raised in British Columbia alone through exempt-market offerings, roughly seven times more than what was raised via prospectus. Of that $16.2 billion, non-reporting issuers raised 55%.

“The fact that there is such a massive amount of this stuff being issued means we have to talk about it,” said Robert Ironside, professor at Kwantlen Polytechnic University in B.C., faculty member at The Knowledge Bureau and speaker at the 2011 Distinguished Advisor Conference in Palm Springs.

While the exempt market typically conjures up images of high-net-worth clients investing in speculative ventures, the offering memorandum exemption (available in all provinces except Ontario) has allowed exempt market-products to be sold to “almost anybody,” he said.

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“In many cases, it’s ending up in totally the wrong places,” he said. “Even with accredited investors, just because they have a great deal of money, doesn’t mean they are financially very astute.”

Too often investors overlook the value of liquidity. Much of the OM market is highly illiquid, and even high-net-worth investors may need to access their capital. Because there is no secondary market for these offerings, they may be stuck holding the investment for a very long time.

“If your clientele is a group that wants relatively low-risk product, then this in general is not right for you,” he explained. “Even principal-protected notes are not, in my mind, a very good product for most people, especially in today’s market.”

Conversely, the advisor whose clientele includes high-net-worth individuals who have high risk tolerance might find it worthwhile dealing in exempt market offerings. It also helps if the clients are younger, Ironside said, due to the illiquidity.

“For those people who are able to bear the risk, and who are able to differentiate what they think is a reasonable risk-return prospect, I think it can be useful,” Ironside said.

Prior to September 28, 2010, there was no regulation covering who could deal in these types of offerings. Since the implementation of the Client Relationship Model, dealers and advisors must be registered to sell exempt-market offerings.

“In the past, the people selling this stuff weren’t properly educated,” he said. “[Now] there’s a huge onus on people selling this stuff to get a better understanding of who it is really appropriate for.”

He admits that even as a finance professor, he knew virtually nothing about the market until he was asked to teach a course for the licensing exam. His research into the market alarmed him, and he wants investors to understand the risks involved.

“This is venture capital—it’s not being called venture capital, but that’s what it is,” said Ironside. “The exempt market is Canada’s answer to providing more VC; we all know that VC is extremely risky and not suitable for many people.”

The Canadian venture-capital market is rather poorly formed, and the exempt market provides a path of least resistance for entrepreneurs developing their businesses.

“Venture capital is important for the growth of Canada, so from a macro perspective, the more that we can facilitate the growth of the small firm, the better we are as a country. But—huge caveat—this is risky stuff. It’s only appropriate for a segment of your clientele.”