By: Alexander Changfoot
Recently, there has been increasing media coverage on Exempt Market deals. According to the Ontario Securities Commission (OSC), transactions in the Exempt Market almost doubled from $83 billion in 2010, to $142.9 billion in 2011. As an analyst initially trained at analyzing public companies, I would like to give some insight into the differences I have noticed when analyzing Exempt Market offerings in comparison to public offerings.
For public companies, information about the company is available on Sedar or other public sources – all this information is transparent so that investors can easily access any related documents. It is a completely different story for Exempt Market companies as documentation is not readily available. As detailed in recent regulatory press releases, there has been a major crackdown on misleading information contained in offering memorandums (OM). One of the imperative things that I demand to review for every project is documentation to support the claims made. For example, if a claim is made by management that they were directly involved in the sale of a similar type of project for $40 million, I request documentation pertaining to the transaction. If management is unable to provide this information, not only is it extremely troubling, but you can be certain that there will definitely be further analysis into their background, experience, and work history.
One of the main sources of information for investors in Exempt Market offerings is the OM. The OM contains a variety of information from share structure, management experience, project scope, and of course, distributions. In the public sector, an issuer goes to an investment bank, and a prospectus is drafted with only a preliminary and final prospectus going out to end users. From my experience dealing with OMs (they are drafted by the issuer themselves) they may be shown to us prior to being finalized, and prior to them actually being released to end users (dealers and investors) and they can be changed frequently. This is quite different from a prospectus offering where third party analysts will only get to analyze the final version. Minor changes are a given, but oftentimes, substantial changes to the OM will be made during the due diligence process. It is quite frustrating trying to analyze a company that has substantially changed their OM more than a couple times. It is also a red flag when management decides to change their OM significantly, as this indicates that they do not really know what they are doing, or they did not have investor’s best interest in mind the first time. A lot of this also has to do with the fact that the industry is still new and evolving and everyone is still learning.
In general, the track record of public companies is more transparent and easily available. Most public companies have an established performance record (as investment banks want to find a viable company to attract investors). On the other hand, the track record of Exempt Market companies and their management are not as clear cut. For example, I have come across many directors that have been a part of multiple private companies but it is difficult to find any performance records for these companies. Also, if the management claims to have sold a previous private company for a profit, it is difficult to actually obtain any documentation to support the sale (unless it was bought by a public company). In my experience, I have come across managers or directors in the exempt market that have had some sort of disciplinary action imposed on them from their past experience being involved in different offerings and previous companies they worked with. One of the things that I find worrisome is when the company decides not to disclose such matters in the OM. It leads to a loss of confidence in the management team when it is not appropriately disclosed that one of the directors was previously disciplined by a securities commission.
The most obvious difference between public and private offerings is liquidity. For the majority of publicly traded companies, there is little liquidity risk involved. For Exempt Market offerings you are usually in it for the whole nine yards. In my experience, most exempt market offerings have a ‘no redemption clause’, or ‘redemption but with fees involved” meaning that investors can only redeem their shares on the specified redemption date or in the event of a company dissolution. One thing to note is that private companies generally carry more risk but also have higher expected returns.
All in all, my experience in having the integral role in the exempt market of research analysis has certainly been an eye opener. There are many differences in the way business is done and in the structures of the public and exempt markets. As the exempt market matures, the regulatory environment will improve, and with that, more sophisticated due diligence will be required by EMD’s, overall improving the investment grade in the Exempt Market. We can already see a trend in the leading EMDs requiring third party due diligence as an initial step. Because of the above factors previously mentioned, third party due diligence is crucial in the exempt market. In the public markets, we saw past cases where the investment banks raising money for companies also issue research. Of course this leads to potential conflicts of interest. We are pleased to see that most of the exempt market dealers out there learned from this, and have chosen not to set up internal research departments, but instead, outsource the function to third parties like Fundamental Research Corp.
Our firm has been covering public companies since 2003, and we now cover almost 10% of the companies listed on the TSX/V. In 2009, we started covering exempt market securities, leveraging our expertise from the public markets to the point we have covered over 40 exempt market offerings. Our goal is to reach a point where we can provide investors with a professional third party opinion on any investment they will potentially make whether in the exempt markets or public markets.