A Perfect Storm
By: Cora Pettipas and Craig Skauge
With any challenge comes opportunity and the economic challenges of the last four years are no exception. While Canada has done relatively well during recent economic turmoil, our economies at both provincial and federal levels have not been unscathed. Many people have looked at the combination of low interest rates, tightened credit, and overly volatile markets as a recipe for disaster but for the exempt market we have been presented with an opportunity unlike anything we have ever seen.
While the exempt market’s exposure to retail investors has grown significantly in the past five to ten years, its importance to business and the economy as a whole have come to the forefront since the financial crisis. Many small businesses that were once able to rely on our record profit-making big banks for small business loans are now turned away due to tightened loan policies and a greater risk perception by loan officers.
What is an entrepreneur to do? A smorgasbord of entrepreneurs, from real estate developers, to oil and gas service providers, to restaurateurs, and anything in between have since turned to the exempt market to raise the capital they need to operate their business and investors flocking to the exempt market with the desire for alternative low volatile places to park their cash have created a perfect storm for our industry. “The exempt market plays an important role for many smaller Canadian companies trying to grow” says Dave Baker, President of Newstart Canada. Curtis Potyondi, President of Prestige Capital agrees. “Entrepreneurs have always relied on private equity (such as the Exempt Market) for their capital. Given the current uncertainty in financial markets and lending institutions parameters, the Exempt Market will play an even greater role in project capitalization.”
Poor performing traditional asset classes combined with increasing public market volatility and more aggressive monetary policy have left investors thirsting for something different, especially where the typical asset allocation for a moderate investor has been a 60/40 equity/bond split. “The aftermath of the 2008 financial crisis has created a new era in investing where the old rules no longer apply,” writes Tamsin McMahon in a recent article entitled The Fear Bubble, in Maclean’s Magazine. “The markets themselves seem hopelessly manipulated: by central bankers who print money like it’s going out of style and then use it to buy back their own debt; by automated trading systems whose software glitches have created and destroyed millions of artificial wealth; by Facebook and its disastrous IPO.” McMahon writes that investor fear may not be the most obvious danger to capital markets, but it may be the biggest threat the economy currently faces.
This fear is not surprising, as we are in the midst of the global financial storm. With interest rates at historical lows; bond yields are giving investors minimal returns. Bonds have not been meeting previous means or investor expectations, as we are in a period of historically low interest rates that are facilitating consumer debt accumulation and penalizing savers. The historically high bond yields of the eighties are long behind us. With interest rates set to inevitably rise by the Bank of Canada, holding bonds long is a dangerous strategy as rates are certain to go up, but it is anything but a definite as to when or how fast.
Investors have been just as gun shy of equities as of late. During the 2008 global financial crisis, the drop in equity portfolio values was a shock to investors, with the TSX/S&P composite index dropping by half, leading to emotional selling that peaked in March of 2009. Major stock markets have become increasingly volatile over the periods from June 2008, at about 15,000 points to a trough in March 2009; the TSX/S&P composite index lost half its value. The index peaked again in April at around 14,200 points and has been on an overall bearish trend, as of issue date being at approximately 12,100 points. Global markets have been trending the same way, and are heavily reliant in the past few years on government quantitative easing measures. Experts do not agree on why (technology, globalization and policy have been named) but almost everyone agrees the volatility is here to stay.
In a 2012 Quantitative Analysis of Investor Behavior published by Dalbar Inc., actual historical investment returns for investors using mutual funds have been even less than the benchmarks we measure them by in most reports. The tables from this report shows equity and income returns for the past 20 years.
Based on this experience, investors are shying away from traditional exposures in equities and bond funds, and are tempted to retreat and hold all their money in cash and cash equivalents. While parking money in savings is a good short term strategy if the investor’s timeline for the money is uncertain, it can be more detrimental long term than investing. A modest return of 1 to 2 % may be better than nothing, but it is a negative return when factoring in inflation (and taxes if the money is not in a tax preferred plan such as an RRSP or TFSA).
If bonds have depressed yields and the stock market is volatile and heavily dependent on policy, cash value loses money. Where can investors seek a sustainable portfolio return while hedging the risk? A 2011 survey by Jefferson National of 500 American fee based advisors revealed that half of them have increased their > use of alternative investments. In another survey, Morningstar Inc. found that 79% of Advisors stated that “addressing portfolio diversification with a low correlating asset” is their greatest concern. In addition, 44% of advisors polled are addressing this issue with investments in the alternative asset class.
What is the alternative asset class? There is more consensus about what it does than what it actually is. Alternative investments are used to compliment core asset holdings, to increase diversification and decrease asset correlation which increases alpha and helps manage risk. It is widely debated what is in the alternative asset class; hedge funds, private equity, and hybrid securities featuring commodity exposure, venture capital, as well as derivative based products are all included by most experts. Real estate, tangible assets and collectables are sometimes grouped into the alternative investment category, but may be better left to other investment categories.
Classified as alternative investments, the Exempt Market is private equity, or private placements which are privately negotiated equity contracts between investors and entrepreneurs. This form of financing has a more extensive market in the US and Europe, but is in a growth stage in Canada. In fact, in recent years both Harvard and Princeton University’s endowment funds have increased their exposure to ‘alternative investments’ from zero to 16% in alternative investments and 23% in ‘private equity’ respectively, according to their recent annual reports.
In a recent Financial Post article by David Pett, “The new Portfolio Pie” he challenges that risk adjusted returns are for the traditional portfolio. “Fortunately, retail investors can now buy into a range of alternative strategies and exchange-traded funds that allow them to access many of the same investments that institutional and high net worth clients have long been privy to, including hedge funds and real assets such as agricultural land. Perhaps the only exception is private equity, an asset class that continues to grow in importance institutionally, but is still largely unavailable to the average person.” David Pett compared the traditional and modern weightings for asset classes, as seen in the chart below. However, private equity is available to average investors in most provinces under certain regulatory rules, known as prospectus exemptions. (Private equity is available from Exempt Market Dealers who sell the product, from Issuers through Dealing Representatives).
Although the alternative investment category and the Canadian Exempt Market offer great opportunities, an investor always needs to be cautious. An investor needs a trusted advisor. A trusted advisor is someone who is competent, puts the client’s needs before their own, offers full disclosure, and works with an exempt market dealership that has a solid business model for selecting products they offer clients. “I think our industry is misunderstood in that there have been some big names go down and as such all offerings get painted with the same brush. There are numerous offerings that are brilliant, have significant alignment, and an excellent track record of delivering returns.” states Kyle Jacober, Vice President of sales at Raintree Financial Solutions, an Alberta based Exempt Market Dealer with offices in four Western provinces.
Investors are braving a changing world, and the global economic storm is not going away for some time; but with change always comes opportunity. This is the perfect time to explore other investment opportunities. Diversify. Explore alternatives in the Exempt Market. Arming yourself with information, a trusted advisor and a tactical asset allocation can help investors survive, thrive and utilize the storm.