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Mar 1, 2016

Non-Traditional Investments

by Bob Carter

Bob CarterThe recent proliferation of “Private Equity” and non-traditional investment firms seems to be in response to a growing uneasy feeling amongst Canadian investors who have grown tired with their advisors’ recommendations of the “same old-same old”. Perhaps the investing public have grown wise to the fact you cannot expect different results by taking the same actions taken time and again or that today’s service models that fail to meet expectations that have driven this migration to supposed greener pastures. The fact of the matter remains – several funds and stock recommendations have missed their mark and investors are wary of the advice they are receiving.

The question then becomes, are these non-traditional investments good for me, and what am I risking?

In the broadest possible sense, you might include private pre-IPO equity deals, real estate and limited partnerships as all being “non-traditional” – or – different from stocks, bonds, fund and ETFs. They are often sold by licensed Exempt Market Dealers (EMDs) and their representatives, but may also be promoted by referral agents – who have little or no financial training or qualification.

EMDs are firms that are licensed to offer investment products exempt from having to provide a detailed product prospectus – although often do provide detailed offering memoranda that should always be read thoroughly before any decision is made to commit funds. Representatives of these firms are required to complete minimum proficiency standards and maintain know-your-client (KYC) profiles for every investor they serve.

The strength of “conventional” investment offerings largely rests on the wide availability of information and liquidity of markets that can provide a ready exit if need be (albeit with costs and possibly losses if your investment of choice has performed poorly or you’ve been caught in a market trend against your favor). The downside to these more popular choices is costs, uncertain performance and possible advisor bias.

Likewise, non-traditional investing has its own pro and con list.

Private equity deals are more often longer term or at least term-specific in nature – with no or few liquidity options. That means funds earmarked for these vehicles must be held to term – with no absolute guarantees of performance. Costs may be greater or less than those available through open markets and the question of suitability is always left to the investor – which pre-supposes the investor is capable of making such determinations.

So why have these non-traditional investments become so popular?

In short – they have captured the attention of investors who seek higher rates of return – or at least returns that do not behave like the rest of the market. The promise of higher returns does not come however, without their unique margins of risk.

This additional risk is why these investment products have up until now have been limited for sale to Accredited Investors (AI), only who meet a variety of eligibility requirements to be accepted by EMDs to take part in the project or offering. These requirements have been set by securities regulators to provide proof that the investor has the wherewithal to survive financial loss that may be as much as 100% of their committed capital. There are a number of eligibility requirements, specified in the Offering Memorandum. They may be income-based ($300,000 minimum annual earned income per married couple or $200,000 minimum annual earned income per single), asset based ($1.0 Million in liquid investible or $5.0 Million in fixed assets) or be granted to current or previously licensed securities investment professionals. Investors are required to complete a disclosure statement providing proof of the exempt status criteria they meet. Investors need only meet one of the requirements listed.

Should the investor complete the required forms and meet all conditions – they are eligible to invest in these projects for as little as $25,000. Investors who fail to meet these criteria are not precluded from investing – but must commit a much larger sum ($150,000) in order to “gain entry” into the project or meet eligibility requirements for the product. Some private pre-IPO deals require minimum investments of $500,000 and more. The larger sum acts as a measure of sober-second-thought to perhaps dissuade anyone from allocating such a large sum to any one vehicle unless they can handle the loss.

New rules that just became effective on Jan 13, 2016 have made these investments (subject to the issuer’s approval for their respective offerings) more widely available to individuals who previously would not have qualified.

A new class of private investor has been created; the Offering Memorandum Exempt Investor (OME). These are investors who would not have qualified as an AI but still represent a potentially “appropriate” new audience. Income requirements have fallen for these people to $75,000 per individual or $125,000 per couple. OMEs may also qualify if they hold $400,000 in net fixed assets (including a principal residence). A third class of “Non-Exempt Investor” (NEI) would qualify everyone else.

In order to create balance between the AI rules and these new investor classes – regulations have been installed limiting the amounts these individuals can invest in any given year. OMEs can invest up to $100,000 in any 12 months – provided they work with a licensed Exempt Market Dealer – or $30,000 if they deal directly with the issuer. NEIs would be limited to taking positions of no more than $10,000 in any 12 month period.

There also new investor protection rules, including a 2-day cooling off period and a new standard holding directors of issuing firms responsible should their offering memoranda be found to include misrepresentations. These are protections not currently afforded today’s AI.

But is this all a “good thing”?  Perhaps.

The opportunities are now more available and if the investor understands that these vehicles are potentially unlike anything they have ever held – then this may be a breakthrough for investor, issuer and advisor alike. It is of course up to the issuer to decide who should be a part of the pool. One concern would be previously “unqualified” investors may end up being lured into markets they do not understand – simply in the pursuit of “better returns”. But that doesn’t happen – does it?

Fortune may still favor the brave. That coupled with the discipline that comes from a lack of liquidity and the resulting elimination of possible panic-selling often yields great returns (as previously detailed in this column) although there are never any guarantees.

If investors meet AI, OME or NEI qualifications and can accept the tight and controlling requirements in order to participate in these offerings and accept the risks – then these private equity securities and limited partnerships may be a sound choice. If your investment profile requires liquidity and your psyche can only find peace by looking up a price quote or net asset value every day in the paper or online – then steer clear. These products are not mean for you.

Fortune favors the brave, the patient and in this case the aware.


Bob Carter, BA, GBA, CIM