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Rule changes create opportunities, but they may not be available or suitable

By: Dwarka Lakhan

The new offering memorandum (OM) prospectus exemption provides retail clients with the opportunity to invest in myriad private-market investments that previously were available only to high net-worth, institutional and pension investors.

However, availability does not necessarily mean accessibility and suitability, which can limit the options for your clients.

The exemption took effect on Jan. 13 in Ontario and is expected to become effective on April 30 in Alberta, New Brunswick, Nova Scotia, Quebec and Saskatchewan. (See story below for details of the changes.)

“The OM rule change brings more choice to retail investors,” says Radovan Danilovsky, equities analyst with Accilent Capital Management Inc. in Toronto. Specifically, they now have access to private investment products in a range of categories, such as real estate development, mortgages, energy, oil and gas, receivables factoring, short-term lending, royalty funds, venture capital, lease financing and agriculture.

OM investments also can offer unique, non-traditional investment opportunities. For example, an investment portfolio of fine wines offered through an OM is too small and specialized to be considered seriously by large institutions, but may appeal to individuals, Danilovsky says: “Without the OM exemption such opportunity would be exclusive only to a select group of wealthy individuals.”

Among the more popular products in the current low interest rate environment are higher-yielding investments, such as mortgage investment corporations and receivables factoring, which can meet your clients’ demand for higher yields, says Vipool Desai, president of Ara Compliance Support in Toronto.

Adds Brian Koscak, president and general counsel with Pinnacle Wealth Brokers Inc. in Calgary and vice chairman of the Private Capital Markets Association of Canada: “With interest rates at historic lows, bond yields have dropped significantly, leaving investors searching for investment options that can generate higher yields in their portfolios.”

Typically, OM-based products are non-correlated to traditional public-market investments, such as mutual funds, bonds and equities, and have the potential to provide higher returns, says Koscak. And by adding a non-correlated OM product to a client’s portfolios, you can enhance diversification and reduce risk for that client, says Danilovsky.

For example, he says, “Investors with a passion for micro-capitalization stocks in, say, mining exploration, technology or biotech, may opt to invest in a professionally managed OM-based small-cap or venture-capital fund, as opposed to investing in individual stocks through a brokerage account.”

However, OM investments can be much riskier and are less liquid, depending on the type of investment and the size and reputation of the issuer. Says Koscak: “There are different risk/reward profiles for private companies, and investors in the private market generally accept the higher degree of risk [in exchange] for potentially higher returns.”

But Danilovsky argues that not all OM-based investments are risky or speculative. For example, he says, “An investor may buy shares [offered by OM] of a closed-end hedge fund focusing on a basket of mature, blue-chip companies with a specialized mandate of income preservation and dividend-income maximization.”

This would indicate lower risk, he adds, albeit in a hedge fund structure.

Michael Banwell, certified financial planner and president and CEO of Banwell Financial Inc. in Toronto, looks at investor risk from a different perspective. He contends that by investing in non-publicly traded vs publicly traded securities, investors “are substituting market risk for the skills and the risk profile of the underlying manager of the OM product.” From a compliance standpoint, Banwell ranks all OM investments as high-risk.

Although OM investments offer new opportunities, they are not necessarily readily accessible to all retail clients because OM investments can only be distributed through broker-dealers and exempt-market dealers. “Not everyone can sell exempt-market securities, including mutual fund and life insurance advisors,” says Koscak.

In addition, many of the eligible distributors do not support OM investments. “Firms want to keep their lives simple and stick to traditional products on their shelves,” says Desai.

By doing this, distributors reduce their regulatory hurdle, he adds, because OM investments require a great deal more compliance scrutiny. As well, firms take into consideration whether these investments will compete with other products on their shelves.

Furthermore, some financial advisors are reluctant to be certified to invest OM investments, even if their firms support these investments. Although Banwell’s firm carries OM products, he says, “As advisors, we take a step back and think of the added work required to scrutinize OMs, the added risk they bring when they are supposed to lower risk in certain instances and decide that they are just not worth the effort.”

Banwell is particularly concerned about small issuers: “Quite frankly, venturing into the OM world with small issuers makes me nervous. From a portfolio-construction perspective, OM products make total sense. However, from a practical standpoint, many of these alternative strategies fail to work out as expected.”

Another potential problem is that the average retail advisor is not familiar with many OM products, says Desai.

Adds Banwell: “I would say most average advisors do not understand the space, strategies and different types of risk [of OM investments], and I believe many [advisors] are not interested in understanding or playing in this space.”

Koscak contends that education is key to understanding OM investments. His firm focuses on providing education for advisors on the products it distributes.

Further limiting accessibility to OM investments is that not all make it to the product shelves of distributors that choose to carry OMs. These investments are subject to comprehensive due diligence that involves reviewing the firm’s business, and its financial and non-financial information. This entails, among other things, reviewing the OM documents, financial statements and marketing materials, and examining the business operations of the issuer.

“Our role is that of gatekeeper or detective. We look for red and yellow flags as part of the due-diligence process,” says Koscak. The due-diligence report is presented to the firm’s product review committee, which either approves or rejects the OM.

“The due-diligence process is about knowing your product [KYP],” says Desai. “Some of the considerations that typically go into the process are how long the issuer has been in business, the assets it has under administration and its track record.”

The KYP process varies among dealers. However, KYP comes down to whether an investment is suitable for an investor. “The change to the OM exemption rule does not change the fundamental rule for dealing representatives to ensure they only make recommendations that are suitable for investors,” says Koscak. “[Advisors] should pay particular attention to documenting the case for suitability.”

In the April issue: The risks inherent in exempt-market investing.

The second of three articles in a series on exempt-market investing


Under Ontario’s new offering memorandum (OM) prospectus exemption, the total cost of OM-based securities that an eligible investor can acquire within a 12-month period cannot exceed $30,000.

However, eligible investors who have received advice from a portfolio manager, investment dealer or exempt-market dealer on the suitability of such investments can invest up to $100,000 a year.

An eligible investor is someone whose net income before taxes exceeds $75,000 – or $125,000 combined, in the case of an investor and spouse – in each of the two most recent calendar years and who reasonably expects to exceed that income threshold in the current calendar year; or an investor whose net assets exceed $400,000. (An ineligible investor – whose income and assets lie below those thresholds [a.k.a. an “average” retail investor] – can invest up to $10,000 a year.)

The existing rule that allows accredited investors (individuals who meet criteria for being designated an accredited investor, or a family member, friend or business associate) to invest in OM securities remains in effect.

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