How to Invest in the Exempt Market
The following five steps are recommended to assist you in navigating investing in the Exempt Market.
Step 1: Decide if Investing in the Exempt Market is Right For You
Before considering an investment in the Exempt Market, you need to do your research and ask yourself a number of questions including:
1) Do I want the chance to make more money if it also means I may lose money?
2) Would I rather make less and keep my principal safe?
3) How long am I comfortable holding an investment for?
4) Do I need to be able to get access to my money quickly?
Depending on your answers to those questions and how you feel about other factors specific to Exempt Market investments including valuation limitations; you may find that an investment in the Exempt Market isn't right for you. If you feel it is, then your need to further understand this market is imperative and the time to educate yourself is now.
Step 2: Decide Who to Work With
Deciding who to work with is a very personal decision. Because the relationship relies so heavily on confidentiality and mutual trust, it is very important to have an advisor you are comfortable with. Questions to ask when interviewing a Dealing Representative.
Check Advisor Registration
In Canada, it is best practises to be registered to sell securities. Before doing business with an advisor of firm, check their registration.
Where’s the fire? Ensure You Have Proper Time to Make an Educated Decision
If any financial advisor or sales person gives you a limited time to act on something, or offers you a pressure sale, it is recommend that you terminate the relationship. A credible Financial Advisor will give you enough time to consider your options and read the information presented in the document. Not only will they give you the time to do this, but will encourage you to do so. High pressure boiler room sales tactics where there is a ‘now or never’ opportunity is not appropriate for investing.
Step 3: Understanding the Risk Return Relationship
Because of the economic laws of supply and demand, projected returns for an investment is higher with higher risks. The lower the risk, the lower the return required to compensate investors. This is why Canada Savings Bonds, T-Bills, GICs, and Money Market Funds pay so little. This is also why the projected return of stocks has been historically higher, as they have market risk. Exempt Market products are absent of market risk, but most have liquidity risk and business risk. This is why an investment with a double digit principle and interest ‘guaranteed’ investment (as opposed to 2% with today’s rates) should send a red flag. Anything fully guaranteed will pay little more than the rate of inflation.
How Does the Exempt Market Compare to Other Investments in Terms of Risk?
The risk level for individual investments in the Exempt Market ranges from mid to very high risk. The dealers and issuers who are selling a relatively straightforward product could be considered medium risk. Traditionally, investment risk is mostly determined by volatility of historical returns in an investment, how much the stock price deviated from the average market price, which is a statistical measure called standard deviation. Although this is an imperfect measure in the stock markets, it is still the standard.
However, this measure is completely irrelevant in the Exempt Market as there is no way to determine market price as there is no market for existing products. The fact that there is generally no secondary market for these investments and therefore minimal liquidity makes these investment products are categorized as high risk by the Canadian provincial regulators. Second, as Exempt Market investments are not publicly traded, they do not have to meet the criteria of being accepted on a public exchange such as: ongoing reporting requirements. This makes the regulators view virtually all exempt products as high risk, no matter how conservative the overall strategy of the issuer.
How Does the Exempt Market Compare to Other Investments in Terms of Return?
There is no guarantee of return and no presentation, sales pitch, or offering document should ever be read to mean that. These are venture situations and could result in total loss. Conversely, if the plan is good, the management is sound and environmental factors are positive, the potential for returns can be substantial, even surpassing returns found with traditional investments in the public markets.
Step 4: Learn About Your Potential Investments
No one can look out for your best interests better than you. Along with working with a registered advisor, it is essential to understand what you will be investing in. This includes reading all available information about such a prospective investment, including the Offering Memorandum (OM). The OM is not sales material, and will disclose all pertinent information about the investment offering.
Understand the Investment
It is a lot of work getting to know your investments, but it is better to protect your hard earned money with informed investment choices. You should be able to understand the investment enough to explain it back to the advisor. Investing in highly complex products is an option, but they are more difficult to understand and it is hard to intuitively grasp their business models. You are the last line of defence in protecting your portfolio. It is imperative that you read all documents related to the investment and understand all potential risks before investing.
Utilize the Resources available through your Advisor
The Exempt Market Dealer and Dealing Representative you decide to work with have already looked into a product and assesses its quality before offering it for sale (called due diligence). They do their research, they study the business plan and they turn away products that they feel are not sound. If they are offering a product for sale, it is because it has passed their internal due diligence process. Ask them about that. Ask them what their criteria are and how this product stacked up against others like it. But remember, no dealer and no dealing representative can promise success or a predetermined rate of return. Any venture is subject to risks and setbacks.
How Does Everyone Get Paid?
A sign of a good investment offering is when the investor interests are placed before management’s and that compensation of management supports with investor success. You should be cautioned against an investment structure that does not provide incentive for the issuer to maximize returns for the investors.
Step 5: Know the Risks
There is a difference between Business Risk and Fraud. Business risk is the potential of an investor to lose investment value due to internal (bad management, key person loss) or external factors (decreased product demand/economic conditions) of the business. Fraud is where there is no legitimate business for the investment to fund, or part or all of the investments funds are being misdirected in dishonest or undisclosed ways. Business risk can be managed; through researching the investment, working with registered advisors, and proper diversification. Investment Fraud needs to be avoided completely. The exempt market can help diversify your portfolio, but never forget, don’t put all your eggs in one basket.
When in doubt, contact a local advisor, your lawyer or accountant, or with your local regulator.