Private Equity Investments and Your Registered Savings and Income Accounts

The art and science of building your financial plan depend on facts, advice and having the conviction to make hard decisions. You also need the benefit of insight to perceive market and economic change and courage to make hard decisions light of these conditions. Given all you have heard at how illiquid private investments are – should you hold them only in non-registered form or could they be included in your RRSP and or RRIF?

The Answer Is Complex

Accepting that readers of this column may currently hold or are considering private equity investments, the question remains: what have you done up until now and have you considered your needs for income and exit if you have chosen to include them in a registered plan?

Your Investment Plan

Basic investing tenets suggest investors and their advisors build portfolios that hold a diversified collection of different asset classes. Cash and near-term liquid investments will ensure safety and available capital to take advantage of buying opportunities. Intermediate and long-term fixed income bonds provide income and possible capital gains as interest rates decline. Equities are included to provide dividends and total return growth. Your specific asset mix or allocation should reflect your age, investment goals and personal tolerance for risk.

Many investors today have grown wary of being concentrated only in these conventional market securities and now look to private equity (or exempt) markets seeking better returns and an alternative to the status quo. Loading up on these private and exempt market securities without the same standards of diversification and care in their selection – particularly inside RRSPs and RRIFs – invites potential disaster.

Liquidity

Strong performance history and the allure of tax-deferred growth provide the motivation to hold private equity and fixed income investments inside RRSP accounts. The fit seems obvious but you must take care to use sound portfolio management techniques – even though these are non-traditional securities.

In a conventional registered account – you can buy or sell investments to meet demands for income and or take advantage of changing market conditions. This may not be the case with exempt or private equities. While many private equity issuers are offering more enhanced liquidity options than ever before, they still have no formal secondary market and any liquidity provisions may be limited or subject to cost. This requires you take extra care to select only those investments you are willing to hold until maturity, realizing the risk that the results are by no means certain.

Structure:

The structure of your portfolio must also consider the need for income in retirement. This means ensuring a pre-determined amount of cash is available to meet the government-mandated minimum withdrawal amount. One possible technique would be to build a portfolio of investments with expected completion dates that mature according to a set schedule.

Bond ladders are portfolios in which equally allocated dollar amounts are held in either 5 or 10-year schedules. For example – a bond ladder with a 5-year schedule would see 20% of the allocated amount invested into a 1, 2, 3, 4 and 5-year security. Every year, one bond matures and the strategy requires the purchase of an additional bond at the end of the schedule, in effect a new 5-year holding.

This structure removes the guesswork behind what an investor should buy and removes much of the market’s interest rate risk, exposing you to market volatility for only a 20% position. Extending the strategy to 10 years allocates only 10% portions in a similar structure.

Such a laddered structure can be applied to your holdings of private equities where equal amounts (or as close as possible) are invested in projects maturing each year over a 5 or 10-year horizon. This structure is far from perfect as delays happen. Your strategy must recognize that even the best of plans may be challenged if projects fail to meet their exit dates.

If this happens, investors must take care to hold back enough cash to meet their annual income distribution requirements before reinvesting any remaining capital.

Risk:

Private equity investments are not risk-free. Monies contributed to registered savings accounts are subject to risk – perhaps greater risk of loss than many other conventional securities and are not for the faint-of-heart. Investors must remember that catastrophic loss in registered accounts offer no financial buffers such as capital loss tax treatment and can only be made up by depositing new funds – which may or may not be available depending on their available contribution room, financial situation and time horizons.

It might not make sense for investors nearing the common conversion age from RRSP to RRIF to hold too large a position in long-dated private equities. If possible, investors should shorten the duration profile of their holdings to provide the required income according to a liquid schedule.

Plan Ahead. Be Flexible, And Expect Challenges.

Finally, it might make sense to incorporate traditional investment securities (stocks, bonds, ETFs and mutual funds) with private equities in the same account in order to provide an additional buffer, income source and liquidity to meet your diversification and income requirements.

The allure of potentially higher private equity returns in registered savings and income accounts is unmistakable. Investors need to take care to structure these accounts with the end in mind and not simply “load up” on too much of a good thing.

Bob Carter, BA, GBA, CIM, is currently Regional Vice President of Sales with one of Canada’s leading life insurance companies. bob@canadianaccreditedinvestor.ca.

The opinions expressed are those of the author and not necessarily those of Canadian MoneySaver (CMS), The National Exempt Market Dealers Association (NEMA), any Exempt Market Dealers or Issuers.