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Risky business

But exempt market investing can also offer great returns

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Darren Weeks is an Edmonton-area, self-proclaimed investment educator who wants to spread the gospel of using OPM -- other people's money -- to make your own. Late last month, Weeks, the CEO of Fast Track Capital, brought his investment wisdom road show to Winnipeg, something he says he has done frequently in the past, putting on slick, three-hour presentations over two days in a conference room at the Club Regent Casino.

The key to success, he told the crowd of about 60 people, is to dress the part, know the right people, get the right advice and invest in good businesses.

But a large part of the presentation was also devoted to talking up the advantages of investing with no money down -- or OPM -- in real estate.

So it didn't come as much of a surprise that the free seminar ended with a sales pitch to invest a minimum of $10,000 in a land deal north of Edmonton in a region about to explode economically because of oilsands development, according to Weeks.

The upside, he told the crowd, is the potential to make more than a 162 per cent return on their investment over an eight-year period. And the risk, you might ask?

"What's that saying? The devil is in the details," Weeks said while holding up the investment's offering memorandum, about a 50-page outline of the deal.

"I urge you to read it."

Welcome to the world of exempt market investing, the lightly regulated frontier of market capitalism where the risks are high and, sometimes, the returns are, too. In an investment climate where traditional securities -- stocks, mutual funds, bonds and GICs -- have lost their lustre, investors are increasingly looking for alternatives.

But before jumping into seemingly lucrative investment deals, it no doubt will pay some dividends to understand a little bit about exempt market investing.

The exempt market covers a wide range of investment opportunities, including hedge funds, but it generally applies to any security sold without a prospectus. When a company wants to raise capital by issuing bonds, stock or mutual funds, it must file with the provincial securities commission a prospectus: often a lengthy, legal document outlining detailed business activities of the business and the security it's selling. These publicly traded securities can only be sold by a dealer licensed to sell them.

Often, the process is too costly for smaller businesses and that's where the exempt market comes into play.

"The exempt market stuff is meant for smaller companies trying to raise capital," says Chris Besko, deputy director of legal for the Manitoba Securities Commission (MSC).

More often than not, entrepreneurs can only raise capital in the exempt market from accredited investors -- those deemed to have a high income and net worth, usually making more than $200,000 per year or holding more than $1,000,000 in financial assets.

It's assumed a person with that level of wealth has more knowledge and access to legal, tax and financial advice than the average investor.

But wealth is often the more important layer of protection, says Robert Warren, the I.H. Asper executive director for entrepreneurship at the University of Manitoba's Stu Clark Centre for Entrepreneurship.

"The reason is, if you lose your money, it's not going to be a big financial hit for you," he says.

Exempt market investing involves high levels of risk because many of the companies looking for capital are fledgling businesses, but it can also involve high returns.

"You are probably looking at 10 times cash on cash, so for your $10,000 investment, you'd want a minimum $100,000 back," he says, adding private-equity deals in the U.S. amount to $26 billion annually.

High-net-worth individuals that invest in venture capital deals in the exempt market are often called angel investors. They are the ideal "sophisticated investors," able to carry out the necessary research to determine whether to invest in an up-and-coming business, Besko says.

Because angel investors hold the purse strings, they often can set the terms -- hence, the high rates of return -- but they do so for good reason.

The chances of success are low, even for the experts. For instance, in a portfolio of five private equity deals, one will completely fail, three will break even and one will be successful, says Warren, who is a board member of the Winnipeg Angel Organization.

Yet the exempt market isn't only for the high-net-worth individuals. Average investors can get in on the action, too. Entrepreneurs -- like a small business owner -- can raise money from friends and family to expand their business, regardless of the investors' net worth.

When businesses raise money in the exempt market from members of the general public other than friends and family, an offering memorandum is required.

"It's supposed to provide all the information that you, as an investor, would need to make an important purchase," Besko says.

In Manitoba, anyone can invest up to $10,000 in a deal as long as the business offering the investment provides an offering memorandum. Any amount above that limit is reserved for eligible investors.

"That's either someone who has got some professional advice," Besko says, adding they've consulted a lawyer, accountant or financial adviser that is independent of the company offering the investment.

"Or else they have a certain level of income or net worth that presumes they have a certain amount of sophistication."

Even with amounts less than $10,000, investors need to read over the offering memorandum carefully to understand the risky nature of the investment. But this can be a tall order for the layman investor used to buying mutual funds and GICs.

"These things are very legalese in the way they are drafted," says Tony Demarin, president of BCV Asset Management in Winnipeg. "(Offering memorandums) are a lot like a prospectus, where 99.9 per cent of people don't read them because they can't understand them, or they fall asleep because they are big and long."

But if they don't stay awake and go over the memorandum thoroughly, investors are entering into a deal without knowing the risks, and that's a recipe for losing money.

"Hopefully, by getting the disclosure out there, people will read the offering memorandum and read the risk acknowledgement and give themselves a chance to slow down and think about it," Besko says.

At the Fast Track Capital event, audience members interested in the deal were asked to give their contact information in exchange for the memorandum. Others -- like real estate agent Sharon Yakubicka -- had no intention of investing. They were there for the education, of course.

Yakubicka says while the deal sounded interesting, she'd have a hard time explaining to her spouse why she wanted to invest $10,000 of their retirement savings in a land deal in Alberta. Not to mention, she wasn't particularly overwhelmed by the offer.

"Just because I sat through a three-hour presentation, doesn't mean I'm going to drink the Kool-Aid."

 

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Advice is crucial

 

Lawyer up: For investors thinking about putting money into a private equity or private real estate venture, they're best advised to seek out advice, even if they are investing less than $10,000. Seeing a lawyer specializing in securities law is recommended, though it can be a costly expense for an investment less than $10,000. Still, they are your best source of advice when evaluating an offering memorandum. "You need to have a good lawyer who can look at it and let you know exactly what you are getting into," says Robert Warren, I.H. Asper executive director for entrepreneurship at the University of Manitoba's Stu Clark Centre for Entrepreneurship.

 

Risky business: So what are the risks associated with investing a private equity or land development deal? Before sinking in some dough, it's best to do some homework to answer the following questions:

 

How liquid is your investment? When entering into a private equity transaction, your money will very likely have to remain invested for a long time. "This is not like buying shares in the Bank of Nova Scotia on Monday morning and selling it on Tuesday afternoon," says Tony Demarin, president of BCV Asset Management Inc. "When you have investments in private enterprises, you recognize that you should receive higher expected returns in exchange for turning over liquidity."

 

What's the track record of the management team? The investment idea may be sound, but if the management team is incompetent -- or worse -- it could just as easily fail regardless of its merits. "If they have a long history of success in developing and returning profits to unitholders, then that's certainly one positive in your favour, but if they have a dubious past, that's a huge red flag," Demarin says. Make sure the management team has experience in the region of investment. Just because the team has done successful deals in the U.S., doesn't mean that translates into success in Canada.

 

How's the deal going to be financed? In today's economic climate, access to credit -- particularly for real estate development deals -- can be difficult. While it's common practice for real estate developers to use OPM (other people's money) in deals, Warren says, it's also important for the company to have good access to additional financing beyond that provided by investors like yourself. "The entire world is littered with great real estate projects right now that are a third-built, half-built or are a hole in the ground, but can't get financing to complete it or can't get occupancy to complete it," Demarin says.

 

What is your expected return? Just because someone gives you a sales pitch, citing a big return as a reason to invest, doesn't mean it will turn out that way. Exempt market investing is always risky, experts agree, but the returns can be very rewarding. Do your research. Go over the offering memorandum with help from professionals, and it's also best to read it yourself until you fully understand the deal. You should understand how the investment will make money, and when you can expect to see returns. You should also know the management fees involved. They can be substantial.

 

Giving the salesman his due: Fast Track Capital CEO Darren Weeks bristles at the statement the land deal he presented is risky. In an interview after the presentation, he told the Free Press the level of risk should be lower because of the type of people involved in managing the investment. "I'm not going to say to you we'll make 20 per cent (returns per year). We just show people the memorandum, and we have a pretty good track record," he says. "It's impossible to predict the future and if anybody says they can, they're not telling the truth."

Republished from the Winnipeg Free Press print edition April 5, 2009 C6

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