Extra due diligence on private investing

The private market is used by public and private companies to raise money. Most of the money raised comes from investment funds and institutional investors. However, a relatively small percentage is used to finance venture companies and start-ups, which can be risky investments for the average retail investor. This is especially true when compared to investing in long-established companies that trade in the public market.

Private start-up companies have a high probability of failure. It’s also possible for fraudsters to exploit investors who don’t understand this type of investment. However, whether a private market investment is a fraud or simply fails, the financial impact is equally devastating. Investors need to be aware of the risks involved in the private market and protect themselves by researching their investments, and understanding their risk tolerance. When it comes to the private market, don’t invest more than you can afford to lose.

PUBLIC MARKET

The public market is effectively the stock market, where investments trade openly. In order for a company to issue the securities (as part of an Initial Public Offering), they must issue a document called a prospectus. The prospectus includes the company’s audited financial statements, and must disclose aspects of the investment such as relevant risks and material information about officers and directors. The issuance of the prospectus is required for the shares to trade on the stock market. Public companies are also required to make ongoing disclosure of material facts and changes to their business.

PRIVATE MARKET

Also commonly referred to as the exempt market, this is where companies sell their securities under various exemptions from the prospectus and registration requirements outlined in The Securities Act and Rules. Many private real estate investment corporations and mortgage pools would be considered the private market. The Securities Act and Rules provide for a number of exemptions from the registration and prospectus requirements of publicly traded companies. Some examples of exemptions used by the private market include selling to the following individuals: close family, friends, business associates of a principal, people with a minimum of $1 million in financial assets, individuals with net income before taxes of more than $200,000 (or $300,000 when combined with spouse), and individuals with net assets of at least $5 million. One of the bizarre exemption rules is that if you can invest $150,000, and pay cash at the time of the trade, then you are exempt (even if this means that you pulled every dime together to make the purchase happen).

If someone doesn’t qualify for one of the above exemptions, then there is always the offering memorandum exemption. The “OM” can be used to sell securities to anyone, provided the investor sign a risk acknowledgement form. At times, the people selling private investments have abused these exemptions in order to have the uninformed investor become eligible.

RESALE RESTRICTIONS

One of the biggest challenges with private investments is trying to sell the investment after you have purchased it. Private investments are normally illiquid and have restrictions on resale. 

GREATER DUE DILIGENCE

When considering a private investment you should ask if the person is licensed with the Investment Industry Regulatory Organization of Canada (IIROC) or the Mutual Fund Dealers Association (MFDA). These can easily be confirmed by phoning IIROC or the MFDA directly. Another method to check registration is to go to the Canadian Securities Administrators (CSA) website (www.securities-administrators.ca). Unregistered salespeople are allowed to sell private securities. Many investors are unaware that unregistered salespeople are not bound by the same suitability requirements as registrants and are under no obligation to ensure that the investment is suitable for your investing needs. You will have very little recourse if the investment goes badly. If you are dealing with an unregistered salesperson then more due diligence is required.

POSITION SIZE

If a client calls with a request to execute an unsolicited buy order on a higher risk stock, I always suggest keeping the position size small. Unfortunately, when it comes to private investments, the above disciplined position size approach is often ignored. Putting all of your savings into one investment is simply not prudent risk management, but this happens more often than it should. The saddest stories involve individuals who were encouraged to take out a home equity loan and use the proceeds to purchase the private investments. It is so important for investors to be honest with themselves about their risk tolerance, and to thoroughly understand the level of risk they are taking on with their investments.

ACCOUNTING

Many private investments do not have audited financial statements provided to investors, although these are required if the investments are sold under an offering memorandum. Compounding this lack of accountability, we often hear of a complex web of companies or transactions that would be impossible for outside investors to obtain a clear picture of the financial stability. A good rule of thumb is to remember that there is rarely a good business case to be made for complexity. If an investment is difficult to understand, or if the person offering it can’t explain it clearly, you might be better to walk away.

SECURED VS. UNSECURED

Prior to investing, understand where you rank in the hierarchy if the investment fails. Owners of common shares are usually the last investors to be paid if things go wrong. Primary and secured creditors (often large financial institutions or institutional investors) will be first in line to be repaid. Primary creditors may have specific security over the main assets. The individuals or companies that are first in line would force a liquidation event on various grounds such as violation of covenants, if they felt they were not going to get their full piece of the pie. This often leaves nothing for the average retail investor.

Before investing in the private market, I suggest reading the BCSC’s Private Placement Guide and reviewing investright.org, the BCSC’s consumer protection sight. If you suspect that an investment may be a fraud and need assistance, phone the commission at 1-800-373-6393.