Exempt market a dragons' den

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If you've got the wealth and the knowledge of a Dragon's Den investor, the exempt market can be a winning investment tool. (PAT ROQUE / THE ASSOCIATED PRESS)

Want to check out an exempt-offering deal?

Hatch Alternative Securities is holding an information seminar this Monday at 7 p.m. at Canad Inns Fort Garry. Mosaic Capital, a publicly listed investment firm, is providing an update on its exempt-market investments. Before going public, it was an exempt-market firm offering exempt-market securities to retail investors. Today, it invests in venture energy and technology firms and real estate deals. Also presenting is Optimus US Real Estate Fund, a Canadian firm that invests in depressed U.S. real estate. Call 975-6616 for more information.

RRSP- and TFSA-eligible?

Many exempt-market offerings are RRSP- and TFSA-eligible, but finance professor Robert Ironside wouldn't recommend using these investments for these purposes. Exempt-market products tend to be risky, and many do not turn out to be profitable. Any losses inside RRSPs and TFSAs cannot be mitigated by claiming them on your tax return to reduce taxes paid on capital gains realized on investment outside RRSPs and TFSAs. "It (an exempt-market security) should be held outside an RRSP or TFSA," he says.

How to evaluate a deal

If you're considering the exempt market, here are some points to consider:

1. Don't invest money you can't afford to lose. Ironside says a prudent investor who has considerable assets could invest five to 10 per cent of his or her total portfolio in the exempt market.

2. Do your research. If you're a disillusioned mutual-fund investor, that doesn't mean the exempt market is for you. Most mutual-fund investors want to invest with little thought or effort and then forget about their investment. The opposite approach is needed for the exempt space. Read the entire offering memorandum. Get a second opinion. Don't just invest based on the argument provided by the dealer recommending the investment. Ask your accountant, your financial planner or a lawyer for advice.

3. Talent is everything. A good idea can be poorly executed. The individuals putting together an exempt-market offering often mean the difference between profit and loss. Don't just research the deal's economics. Ask questions about the dealer's background or the experience of the people running the company in which you're going to invest. You want to see a history of competence. You want to know the estimated return, how it will be achieved, what the risks are and how you will get your money back if the deal doesn't go as planned. Don't get clear answers? Not a good sign.

The term "exempt market" might not ring a bell for most investors, but they likely have more familiarity with it than they realize.

Deals brokered on the popular TV program Dragons' Den take place in the exempt market. You also might have had relatives or friends ask you to invest in their business startup. Or you've seen ads for real estate investment opportunities in Alberta or overseas. Maybe you've even attended a seminar dubiously promising the "investment opportunity of a lifetime."

All these likely fall under Canada's exempt market. Such deals collectively account for tens of billions of dollars changing hands every year.

In the United States, the exempt market is called the alternative market.

Although the Canadian and U.S. markets share similarities, such as funding startup firms, they are markedly different.

The American alternative market is the domain of institutional investors -- banks, pension funds and hedge funds. They seek investments not listed on stock exchanges or other public markets. They suss out those deals that will pay the high returns and endure those that utterly fail. It's big money, too -- think Facebook, Twitter or LinkedIn. All originated in the U.S. alternative market.

"Venture capital accounts for 21 per cent of GDP in the U.S.," says Sheldon Stier, president of Winnipeg-based Hatch Alternative Investments. Canada's market for venture capital and private equity is a more diminutive creature.

"Canada's a small-scale version of the U.S. model. We just simply don't have the capital that the U.S. does."

Institutional investors are active here, too. In Manitoba, Investors Group and Great-West Life are the leading exempt-market investors, says Ainsley Cunningham of the Manitoba Securities Commission.

Overall, investment in the exempt market in the province was $16 billion for 2010, the most recent figures from the provincial regulator.

Yet unlike the United States, Canada's exempt market is built for the little guy to invest.

Regulations provide an exemption for the eligible investor that allows the average Joe or Jane to become part of the venture game. In provinces other than Ontario, Canadians can invest up to $10,000 regardless of income as long as they receive an offering memorandum.

The OM, as it's often called, is a mini-prospectus. All companies providing mutual funds, stocks and bonds must file a prospectus with the provincial regulator and make it available to the investing public. The OM is much the same, only with less detail.

The exempt market in Canada has evolved for the better in the last few years for the retail investor. Salespeople and dealers offering these deals used to be exempt from licensing.

"All that changed a couple of years ago," says Dr. Robert Ironside, a professor of finance at Kwantlen Polytechnic University in Surrey, B.C.

"You have to be registered to sell the stuff."

Stier says regulation is a good step forward for the industry, which has had its share of fly-by-night players in the past.

"There's a much greater likelihood that those investments will be more reputable, because the dealers will have vetted them because they have some liability."

He says added regulation should create a more diversified market, as in the United States.

The alternative market has always been more vigorous in the U.S. simply because that's where the big money is. In contrast, Canada's alternative or exempt market has typically seen a lot of land deals or resource exploration plays originating in B.C. or Alberta.

"It's not frothy, where you've got a lot of different opportunities in the hands of lots of different firms raising capital," Stier says.

But that, too, is changing, and not just because of better regulation. The exempt market is attracting more investors, too. They've lost faith in their mutual funds or the stock market, certified financial planner and exempt-market saleswoman Tesia Brooks says.

"I've been in the financial industry for 20 years and sold a lot of mutual-fund and segregated funds for clients, and I'm just finding so many people are disillusioned," says the adviser with Brooks Financial in Winnipeg.

A sales representative for Alberta-based Pinnacle Wealth Brokers, Brooks says a new generation of exempt-market products can offer better returns than the bond and stock markets and, in her opinion, carry less risk.

Pinnacle's chief investment officer, with 14 years' experience in public markets, says the firm is just following the lead of large investors who find better returns in the exempt market because it's less correlated to economic conditions, such as the euro crisis, that play havoc with the stock market.

"If you look at the last three years, respected institutional investors like the Yale Endowment Fund and Harvard (Management Co.) have shifted their focus to private equity," says William McNarland, CIO with Pinnacle.

Pinnacle offers a variety of investment choices, from distressed U.S. real estate to small-business lending. He says these investments are expected to pay a better return than the stock markets.

"In private fixed income on the shelf that we have, the lowest yields are between eight and 13 per cent," McNarland says. "We wouldn't look at anything in the equities space that would have an expected return of less than 10 per cent."

Typically, higher yields result in increased risk, but McNarland says public markets arguably have more risk amid current economic conditions.

The biggest risk for investors is these investments are illiquid, Brooks says. You can't sell them quickly to get your money back.

But Ironside says exempt-market investments are risky by nature, more so than the stock market.

"With any high-risk investment, it's like anything else," Ironside says. "You certainly have to sort out the wheat from the chaff."

To do that, you need experience behind you, and Ironside says some dealers and salespeople in the sector might not be as savvy as you think.

The finance professor recently taught a prep course in B.C. for salespeople taking the licensing exam.

"Very few of the people selling these products had any background in finance," he says.

What he found even more troubling is they were all making a lot of money brokering these deals -- even though he suspects most exempt-market deals offered to small investors will not be profitable.

"I had a friend who sells this stuff in Alberta, and he said he expects 90 per cent of these things to fail."

Ironside says the exempt market requires a great deal of investment acumen -- and money you can afford to lose. Just think of the Dragons. They are knowledgeable investors and, as importantly, wealthy enough to risk money on startup companies.

"The typical investor doesn't have that knowledge," he says. "For most average investors, they should give it a pass."

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Are you accredited, eligible or neither?

To invest in the exempt market -- investments not traded on exchanges or sold as mutual funds -- you need to qualify as one of the following:

Accredited: This applies to pension funds, banks, governments, hedge funds and investment firms that can invest as much as they want in a company or financial instrument. Individuals of high net worth can also invest. Accredited investors need at least $1 million in investable assets, or $5 million in assets, or a net income before tax of at least $200,000, or a family income of $300,000 for two years. An accredited investor can invest as much or as little as desired. They also do not need to invest through a licensed dealer.

Eligible: This type of investor (may be with a spouse) has $400,000 or more in net assets, or an annual net income before taxes of $75,000 for at least two years, or a combined net income before taxes of $125,000 for both spouses, or has obtained advice on suitability from an eligible adviser. These investors can invest as much as they want.

Neither? Other exemptions allow people to invest regardless of their income or net worth. Anyone can invest $150,000 or more in a one-time-only investment. Family, friends and business associates can invest as much as they want. Anyone who receives an offering memorandum can invest up to $10,000.

-- Dr. Robert Ironside, Kwantlen Polytechnic

Republished from the Winnipeg Free Press print edition March 17, 2012 B10