By: David R. Kaufman, JD, CAIA
It has long been a key tenet of the mainstream advisory providers across Canada that all investments can be neatly categorized as equities or fixed income, and that only liquid equities and fixed income are necessary or appropriate for inclusion in a well-diversified investment portfolio.
During periods of bullish equity markets and declining interest rates (such as 1992-1997, 2002-2008 and 2009-2014), this approach works beautifully. In fact, during these periods, virtually no skill was required from an advisory perspective in the areas of asset allocation or security selection, since the values of practically all securities were steadily increasing.
Then there are the other periods – those in which fortunes are lost, futures are compromised, and investors are left wondering whether there isn’t a better way. During these periods, equity markets behave badly and provide investors with a higher dose of volatility than positive returns. And, although not seen in almost a generation, there are also periods when interest rates rise steadily over protracted periods of time, eating into the value of the same bonds that provide such neat and tidy growth during periods of decreasing rates.
It is during these periods of extreme stress on global financial markets; and there is a good case to be made that we are either entering or are already in the middle of one as I write – that the very foundations of the many variations on the basic 60/40 stock/bond portfolio are put into question.
In the years since the financial crisis of 2008-09, the convergence of a number of important factors, including considerable outperformance by the world’s most successful institutional investors, a proliferation of the number and quality of private investments available to individual investors, a significant increase in the number of well-qualified Exempt Market Dealers (EMDs) able to offer top-notch advice to their clients, and the tolerance (if not actual embracement) of non-prospectus issued securities on the part of securities regulators, has brought us to an important inflection point in Canadian investing.
Spring has arrived for the exempt market in Canada.
For years, followers of institutional investors have lauded the endowment model of asset allocation pioneered by David Swenson of Yale. His relatively smooth annualized return of over 10% per annum over the last 20 years leaves little doubt that trading away some liquidity and simplicity in favour of less liquid and more complex investments such as hedge funds, real estate and private equity pays off over time.
Among non-institutional investors who bought into Swenson’s approach, however, there has always been a practical obstacle that many of the strategies that were instrumental to his outsized risk-adjusted returns over time were simply unavailable for all but the largest investors.
Today, things are very different. Although ordinary investors will not be buying toll roads in Australia or utilities in Europe via direct investments any time soon, there are a plethora of well-designed, appropriately-priced investments that do a good job of giving smaller investors the opportunity to access the diversified, non-correlated returns that these types of investments provide to the big boys.
There are many Canadian-managed, low-beta hedge funds, for example, that have achieved their long-term objective of providing annualized returns in the range of 6-10%, with volatility far below that of the equity markets. Hedge fund investors, therefore, have the ability to give up high double digit returns in bull markets in exchange for avoiding dramatic losses when the markets move sharply negative.
In the area of real estate, there are many Canadian funds that offer ‘just add water’ diversification for investors of various stripes seeking predictable rental or interest income from real estate equity or mortgage funds, or higher octane returns from real estate development or land banking funds.
For entrepreneurs, investments in private equity and private debt allow returns to be derived in areas that they know and understand well, especially in the small-to-medium sized (SME) business space. As with real estate funds, these private funds can offer diversified pools of secured debt as an alternative to investment-grade bond investing, unsecured debt as an alternative to high-yield bond investing, cashflowing SMEs as an alternative to small-cap equity investing, and even swing-for-the-fences venture funds for those seeking to find the next Facebook.
Of course, the proliferation of these types of exempt market investments does not in any way guarantee their quality. Luckily, the growth in the exempt market on the product side has been matched in recent years by the emergence of a slew of EMDs strongly focused on due diligence rather than distribution alone.
These EMDs are charged with solving the 3-pronged ‘know your client / know your product / suitability’ puzzle posed by each individual investor in the exempt space. In cooperation with exempt market issuers and regulators (more on that below), this results in a framework that boasts an elevated level of professionalism in the sourcing, due diligence and distribution of exempt market products that will serve investors across the country yearning for this type of risk-return profile for years to come.
Although it was a long time in the making (a fact of which I am acutely aware, having sat on the Ontario Securities Commission’s Exempt Market Advisory Committee for three years), we now have adequate cross-province homogeneity in the rules regarding to whom and in what amounts exempt market products can be distributed to allow EMDs to branch out to a vastly increased group of potential clients.
Specifically, the adoption of the OM exemption in Ontario -- effectively widening the scope of eligible exempt market investors in dramatic fashion and potential distribution profits with it -- will allow both issuers and EMDs to invest more resources across more platforms, increasing both the scope and the quality of the products these investors will be able to purchase.
The OM exemption has been generally available to retail investors outside of Ontario for years, and has been widely (and, mostly, responsibly) used for these individuals to gain access to the exempt market. For years, issuers and EMDs alike promoted the adoption of the OM exemption in Ontario, not just to harmonize exempt market rules, but also to create greater incentive for issuers to take the exempt market – including Canada’s largest population – seriously and allow EMDs to “fish where the fish are”.
The adoption and virtual harmonization of the OM exemption in Ontario should, therefore, be a very positive development for all exempt market participants, since the more robust the market is, the more choice they will have, and the more informed their investing decisions can be. It will, no doubt, take a few years to deal with the inevitable kinks that will present themselves with the new exemptions (as is always the case with new regulatory regimes). The imposition of limits as part of the OM exemption rules, in particular, will pose a challenge to EMDs as they struggle to define how they are expected to rationalize the self-reported information received from non-accredited investors in Ontario and other jurisdictions.
Although there is ample reason to be very optimistic about the future of the exempt market and its various stakeholders, we must also be realistic about the risks that we will always face and to which we must never become indifferent. In the same way that April snowstorms rudely interrupt the arrival of spring, so too can we expect the few and short-sighted bad apples among the EMD community to present hurdles to the more widespread adoption of the notion that investing in the exempt space is every bit as legitimate in portfolio construction as the inclusion of more traditional investment products.
We must expect that the introduction of the OM exemption in Ontario will bring a renewed commitment on the part of regulators to enforce the basic requirements on all EMDs, especially in the area of the determination of suitability of these products for a widening group of investors.
Specifically, investors who are not adequately informed of the lack of liquidity in many exempt market products can be expected to turn to regulators for remediation, which will, in turn, lead to ever-increasing focus on what and how these investors are told before they make investments from which they will not be able to exit for what might be, in many cases, years to come.
It is therefore incumbent on all of us who call the exempt market home to take every precaution to ensure that we do not mishandle the immense opportunity – and responsibility - with which we are now faced. We must all be vigilant in adhering to both the letter and spirit of the laws newly in force, and embrace the fact that these regulations are created to assist us rather than hinder us from doing our best.
Spring has indeed arrived in the exempt market. While we prepare to bask in its glow, let’s also apply a little sunscreen to make sure we don’t get burned.
David Kaufman JD, CAIA, brings over 20 years of experience in the legal, real estate and investment fields to his role as President and Chief Executive Officer of Westcourt Capital Corporation. After graduating from the University of Toronto, Faculty of Law, in 1994 and completing his articles at Goodmans LLP, David held various positions in hospitality management, real estate and private equity, including leading roles at Magna International, Menkes Developments and Lynx Equity. In 2009, he founded Westcourt Capital with the goal of building an advisory firm focused on alternative approaches to portfolio construction and the sourcing, due diligence and monitoring of investment funds for high net worth and institutional clients. David is a thought leader in the alternative investment industry and often appears at industry conferences and events in the roles of keynote speaker, moderator and panelist. He is a regular contributor to the Financial Post and CBC’s The Exchange, and co-hosted BNN’s Alternative Investing from 2010 to 2011. David can be reached at firstname.lastname@example.org