Financial advisors, portfolio managers and exempt-market dealer (EMD) representatives must take extra care in knowing their clients, knowing their products and determining suitability. That was one of the key messages delivered at the Private Capital Markets Association of Canada’s (PCMA) fourth annual PCMA Private Capital Markets Conference in Toronto on Tuesday.
In fact, private capital markets have grown considerably in recent years with the amount of capital raised through exempt-market securities distributions exceeding $100 billion a year in Canada and outpacing by far the amount raised in public markets.
However, private investments tend to be characterized by less liquidity, transparency and financial disclosure compared with public investments, which is why suitability is such a key issue, along with best practices for staying on the right side of the regulators, said Phil du Heaume, vice president, legal, with Edmonton-based EMD Raintree Financial Solutions at the conference.
“No one client is the same as another, which is why suitability is so important,” du Heaume said. “You must get the right product to the right client. That is what differentiates a ‘salesperson’s’ culture that is just trying to get as much product as possible out the door from a ‘professional’ culture.”
Advisors dealing in private investments must understand a client’s upcoming financial needs, risk tolerance and income flows particularly well when putting a client in investments that are not immediately liquid. Thus, decisions about suitability should be documented in meticulous detail in note form, du Heame said.
“We are a heavy ‘note’ culture at our firm, which can be frustrating,” he said, but compliance officers need to verify why particular investments were made. At some point, they may face the “terrifying prospect” of having to get in front of regulators and explain recommendations and decisions. As a result, notes need to contain “because” statements and explain why certain investment decisions were made, he added.
“If you don’t explain why something is suitable, regulators may determine you never did a suitability analysis,” du Heame said.
“If the analysis is there, it’s hard for regulators to refute that judgement,” added David Gilkes, president of North Star Compliance and Regulatory Solutions Inc. of Toronto and vice chairman of the PCMA.
However, an investment that’s suitable doesn’t mean it’s risk-free, Gilkes said: “If an investment was ultimately unsuccessful, that doesn’t make it unsuitable. Suitability is determined at the time of purchase.”
The risk in investing in private markets supports the principal of a diversified portfolio. There is no hard and fast rule on how much exposure a client should have to any one exempt security, but many advisors are following the example set by pension funds and mutual funds of having no more than 10% of their assets in any one security.
A guidance document issued by the Canadian Securities Administrators (CSA) in 2014 said CSA staff will consider investments — either individually or taken together with prior investments — in securities of a single issuer or group of related issuers that represent more than 10% of the investor’s net financial assets as potentially raising suitability concerns due to concentration.
Although this guidance is not a rule or law, there’s some concern that regulators may interpret it as such, Gilkes said, even though there may be circumstances in which having more than 10% of a client’s portfolio exposed to a single private investment is reasonable.
“If the client is doing something that doesn’t fit into a neat little box, such as having an allocation that goes beyond 10%, this can be allowed, but you need to explain why a higher concentration is appropriate for this client,” du Heaume said. “You must address the negatives and talk to clients about the risks, and get it all into your notes.”
In fact, Janice Wright, a lawyer and partner with Wright Temelini LLP in Toronto, warned that recent case law is setting a precedent that could make it difficult for advisors to justify to regulators having clients with more than 10% exposure to a single private holding — and documentation is essential in these instances.
“If you’re going to do above 10%, you’ll be like a fish trying to swim upstream,” Wright said. “It’s almost seen as the industry norm. There are too many ‘experts’ out there that will opine that 10% is the limit, and to go above that may be a risk not worth taking. It will be questioned and probed, and regulators will start from the premise that [the investment] is considered offside and not an acceptable risk.”