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Seeking portfolio diversification? Try exempt market securities

Beyond the public capital markets lurk investment opportunities you may have never encountered – securities sold privately. Businesses in need of capital raise money privately if they do not meet the criteria to list on a public exchange, or wish to avoid the time and cost of raising money in public markets.

Private capital investments, commonly known as exempt market securities, encompass a range of debt and equity instruments as varied as bonds, mortgages, real-estate partnerships, income funds, oil and gas flow-through shares and hedge funds.

They fall into the category of alternative investments and offer portfolio diversification beyond the standard assets of cash, stocks and bonds. They also hold out the possibility of high returns. For example, a recent offering, a diversified income fund, advertised a target preferred return of 8 to 10 per cent a year plus potential profit sharing.

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But taking the time to understand these securities before buying them is vital to your financial health.

To start, money invested in private capital markets is not liquid. Unlike publicly traded stocks, private investments are generally subject to resale restrictions for a certain time and there is no established resale market. Investors might have limited or no redemption rights. Your money could be tied up for years, or indefinitely.

Companies that tap private markets to raise money tend to be newer and smaller. Some of these businesses will fail, and investors who bought the firm's securities will lose all their money. The risk of this happening is not insignificant. About 50 per cent of new businesses fail within five years of startup, according to a 2010 Industry Canada report.

Investors in public-market securities are given a prospectus, a disclosure document that provides detailed information about the security and the issuer's business.

Exempt market securities are so named because, by regulation, the issuer is exempt from preparing a prospectus under certain conditions. Investors may receive an offering memorandum, but this document does not require the same level of disclosure as a prospectus. In general, investors in exempt market securities receive less information than those who buy publicly traded stocks.

Regulations dictate how much money a retail investor can commit to exempt market securities. These rules are substantially harmonized across the country.

Individuals who are defined as high net worth – those with a net worth of $5,000,000 or at least $1,000,000 in financial assets – qualify as accredited investors and are not limited in the amount they can invest. Those who are less wealthy face limits. For example, in most provinces, an investor with a net worth of less than $400,000 and earning less than $75,000 annually (or less than $125,000 combined spousal income) is allowed to invest up to $10,000 in a 12-month period.

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Investment firms and their advisors who sell stocks, bonds and/or funds are usually not registered with the applicable provincial securities commission to sell exempt market investments. These securities are normally sold by advisors called dealing representatives, who work for firms registered as exempt market dealers.

If you decide to open an account at an exempt market dealer, take the same care and due diligence you would exercise when selecting a traditional financial advisor and firm.

Both exempt market dealers and their representatives have a duty to know their clients and offer them only investments that suit their personal circumstances. Anyone contemplating the purchase of an exempt market security should still complete their own independent due diligence.

Private capital investments can serve as portfolio diversifiers and yield healthy returns. They do, however, fall into the higher-risk end of the investing spectrum. These securities should be purchased only if they suit your risk tolerance and fit your investment plan.

Ms. Bebee is a personal finance writer and author of No Hype – The Straight Goods on Investing Your Money. Through her writing, speaking and teaching, she shows people how to take control of their money and achieve their financial goals. Her website is www.gailbebee.com

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