Under The Microscope | An Analytical Research Process for an Exempt Market Dealer
By: Bill McNarland
Investors in exempt market products have often experienced much higher returns than available in the traditional capital markets. Unfortunately, some investors have experienced total loss of principal. This high-risk, high-return environment means that investing in exempt market products requires a higher level of due diligence than traditional investments like mutual or segregated funds. This article provides an overview of some of the steps taken by our research team at Pinnacle.
- Upon initial approach by an issuer, the first task is to determine if there is investor interest in the issuer’s niche market. For example, there is currently more investor interest in income over equity investments. At present, there is little demand from investors for speculative investments. Many opportunities that do not meet investors’ appetite will not require further consideration.
- Second, if an issue is in an area of interest, what are the initial views of its quality? A fair amount can be determined through a brief overview which would eliminate the need for further due diligence. Between the initial screens mentioned in points one or two, a high percentage of issues would not go through further due diligence.
- At this point, the issues not eliminated through step one or two would go through a full due diligence review. This is a time-consuming and expensive process that requires a large commitment by both the dealer and the issuer. If both parties agree to go through with the due diligence process, an agreement is put in place.
- The first step of the process is to design a customized questionnaire that will be the basis for a formal interview. There are many boilerplate questionnaires, but a customized one will eliminate the irrelevant material found in these. Typically, a questionnaire covers 150 to 200 areas that require formal responses from the issuers.
- The questionnaire forms the basis for a formal interview. We hold these interviews via a recorded conference call. Often these interviews can take up to four hours! The information recorded is then transcribed into a document that can be more than 100 pages long.
- A member of our research team will conduct an on-site visit to confirm some of the representations made in the conference call that require verification. Past experience has taught that these visits are invaluable.
- Next, the formal due diligence report is summarized in a comprehensive research report. These documents are typically 50 to 70 pages long.
- A short summary is then created, which highlights the key “Know Your Product” points that securities regulators would be looking for as expressed in CSA Notice 33-315.
- The Ultimate Designated Person and Chief Compliance Officer would not rely solely on the opinions of the research team in approving products. An assigned product approval committee would review the materials and make a decision on the products to be offered by the dealer.
- Before a product is offered, an agreement on future reporting and due diligence has to be executed.
- The process of exempt market due diligence is still evolving, and has come a long way from a few years ago. Going forward we are working to bring additional positive changes to the marketplace.
Some of the ideas we are working on now include:
- An analytical framework designed for the exempt market that allows for easier comparisons between all exempt market products.
- An administration process that separates investors’ assets from issuers’ discretion.
- Independent board and trustee roles that watch over investors’ dollars.
With a solid due diligence process, investors can benefit from the potential high returns found in the exempt market. The exempt markets could be part of a partial solution for the current income crisis in the traditional capital markets.