The Exempt Market Offering Memorandum Is Worth Your Time to Understand
One of the main differences between public and private investment offerings is the document used to inform a potential investor about the product. Public securities, such mutual funds, use what is called a prospectus. Exempt market issuers use an offering memorandum (OM). As the most successful investor is one who is empowered with the right information and perspective, here is a simple guide to understanding the OM, and important areas to focus on.
For information on avoiding costly investment mistakes, see the article here.
The front page will provide a summary of the offering. Some points to focus on:
- Amount of $ Raised and Minimum Amount Required to Invest- This is self-explanatory. Note that minimum amounts to invest are normally much higher than traditional investments such as mutual funds.
- Tax Consequences- There will normally be a statement informing you if the units are eligible for registered plans such as RRSPs.
- Selling Agent- An explanation as to how securities are being distributed. There may be a single or multiple investment dealers involved. Also, how much commission is being paid to the investment dealer, as a percentage of your initial investment. It is important that you weigh commissions paid vs. expected risk and return.
- Resale Restrictions- If you purchase units of this product, there is no stock exchange or other secondary market providing liquidity, therefore the units will most likely not redeem until the project exits. Some products provide provisions for early exit or redemption of units, however there is no guarantee this will occur. If the project fails, there will be no exit, and no redemption at all.
Inside The Offering Memorandum
Many investors, understandably, tend to become intimidated by thick legal documents. In reality it’s not that bad. Once you flip the cover, here are some things to be aware of:
Forward-Looking Statements Page
Management is basically letting you know that they are going to use some assumptions and projections regarding the project. Simply understand that none of these assumptions and projections can be taken as a guarantee. They may be wrong, to varying degrees, and this will have an impact on the success or failure of the fund.
Glossary of Terms
There is quite a bit of legal and financial terminology contained in the OM. If you don’t understand a term, refer to the glossary, as it will help a lot. If you still do not understand, your lawyer, advisor, or dealing representative should be able to easily clear this up.
Use of Available Funds
This basically tells you the amount raised, commissions and fees, and the amount left over to invest in the project.
Many investors look at this and immediately balk at the amount they regard as “high commission”. First, you must realize that a 10% commission, for a 5 year project, equals 2% per year. For comparison, a mutual fund, for example charging 2% MER per year, the total equals 10% as well. Second, you may be investing in a project where the expected profit margins are 15, 25, or even 50% per year. For example, the math can work out to pay commission, plus pay you a 10% annual yield on your principle, plus retain profits for management. Understand that the return expectations associated with many of these products are vastly superior to return expectations most investors are familiar with in the traditional markets. To compensate for additional risk you expect additional returns.
Business of The Fund
This is where many people get confused, as there are terms relating to the legal structure, trustees, potential conflicts of interest, etc. An investor must understand that, although all of this information is extremely important, much of the legal language is standard, and will apply across a number of offerings. When in doubt, consult your lawyer or tax advisor, to clarify the relevance of various legal and tax points.
This tells you when the investment was created, length of term, rights of management and the investor, ongoing management fees (if any), back-end profit-sharing (if any), and other important details unique to this offering.
An explanation of the business model of the fund, including an explanation of the opportunity, and exactly how management intends to utilize investor funds, will be described as well.
For practical purposes, most of the structures I have seen are called Limited Partnerships (LPs). The LP will have some main components:
a) Limited Partner- the investors who put up their capital for investment. Their investment risk of loss is limited to the amount invested.
b) General Partner- the management that is essentially hired by the pool of investors to allocate capital. The GP takes on unlimited liability, and this liability can theoretically exceed the total amount of money raised, therefore the GP is taking on greater risk than many investors realize.
As an investor, you would like to find out how long management intends to use the money, and the method to execute an investment strategy.
You must understand the general risks inherent in any exempt market product. They include, but are not limited to:
Blind Pool Risk– Capital is raised before it is invested, therefore many times an investor will not know exactly which assets are being acquired beforehand, and trust in management’s ability to execute is required.
General Business Risk
Liquidity Risk (due to no secondary market for units)
Key Person Risk– If most management decisions are made by one or two individuals, there is a risk of those individuals becoming incapacitated, for whatever reasons, and this can affect the success of the project.
Specific Project Risk– The risk of concentrating funds into a single venture.
No Guaranteed Return– Management can never offer a guarantee as to a positive return, or even a return of your invested principle.
In reality, the only investment which offer guarantees are GICs (up to a certain limit), government bonds, and certain insurance contracts. No mutual fund or stock portfolio is guaranteed either. Many times an investor will ask the question “So the 8% is guaranteed for how long?” Right away I understand that they require a bit of education on exactly what is guaranteed and what is not.
To find out how one astute investor was able to create an ideal portfolio by using proper risk assessment, click here.
Understand that exempt market products are not reporting issuers. Most investors are used to regular disclosure, quarterly reporting, etc. associated with stocks and mutual funds. Exempt products do not have the same obligations, therefore an investor should not expect the same level of information. Annual required tax slips, and perhaps an annual audited report, are what can generally be expected.
The lack of timely information and communication is a real issue in the exempt market today. For most of my career, I was involved in traditional stocks, bonds, mutual funds, and insurance. The level of reporting in the traditional world is, for the most part, exceptional and improving all the time. Many exempt market issuers simply do not understand the concept of regular client communication and disclosure. They almost treat this as an afterthought.
However, more are starting to come around, and realize that keeping investors happy is important, not just producing large returns. A high quality investment dealer and representative are invaluable in this regard.
In my opinion, the OM is an important starting point for any investment considered, to be used in conjunction with other important criteria in assessment.. An OM is a document that will let you know about all of the features associated with an exempt market product, however this is only a part of the big picture. It would be next to impossible to place two OMs side by side and determine which project is going to be more successful.
While not exhaustive, this brief guide to the offering memorandum should help you to better understand any exempt market investment you are considering.
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