A proposed investment fund category is highlighting the financial services industry’s mixed views about giving retail investors more access to private markets, with observers expressing everything from excitement to serious skepticism.
The Ontario Securities Commission (OSC) is considering the creation of a new fund category called the Ontario Long-Term Asset Fund (OLTF). These funds would allow investors in the province to gain exposure to illiquid assets such as private debt, private equity, infrastructure and natural resource projects in a vehicle similar to a mutual fund.
The regulator’s consultation on the new category, which ends Friday, presents this as “an opportunity to improve retail investor access to long-term assets through investment fund product structures.” But not everyone believes this is a good idea.
“We’re very concerned that the OSC wants to open this up to the retail investor,” said Ken Kivenko, president of Kenmar Associates, an Ontario-based investor advocacy organization.
Kivenko said he gets nervous whenever the industry tries to expand access to investments outside the mainstream to retail investors, especially after incidents such as the collapse of the asset-backed commercial paper market in Canada in 2007.
The proposed framework would allow for a new type of investment fund that could hold a larger percentage of illiquid assets in its portfolio than currently allowed for mutual funds and non-redeemable investment funds (NRIFs) under National Instrument 81-102.
As it stands, mutual funds (excluding alternative mutual funds) and NRIFs are prohibited from purchasing an illiquid asset, if immediately after the purchase, more than 10% or 20%, respectively, of their net asset value (NAV) would be made up of illiquid assets. They’re also prohibited from purchasing certain types of long-term assets, including real property and non-guaranteed mortgages.
Under the proposal, OLTFs would be required to invest between 50% and 90% of NAV in illiquid assets, with the rest invested in liquid assets to allow the fund to manage its liquidity needs. And the fund would be required to disclose the type of illiquid assets it holds and explain its investment objectives.
Among other things, the OSC is also proposing that OLTFs would exist in the form of a fixed-term fund or an evergreen fund, with redemptions limited to monthly, quarterly, semi-annually or annually, and that OLTFs “would include capital-intensive assets in Ontario” but not be limited to assets located within the province.
The consultation paper noted that the Ontario government is “looking at innovative ways to finance transportation, housing, energy and municipal services, including through the ‘crowding in’ of private sector investment from pension funds and other institutions.”
The OSC did not respond to a request for comment about the motivations behind the proposal and investor advocates’ concerns that OLTFs present too much risk for retail investors.
However, in its consultation paper, the regulator said its role is not to “comment on the merits” of illiquid assets, but rather to “ensure there is clarity about the benefits and risks of such investments as we determine whether, and how, to develop a regulatory framework that would permit greater retail investor access” to them.
Heightened risks
While giving retail investors access to opportunities that exist for other types of investors is a “laudable objective,” private-market investments are riskier, said Jean-Paul Bureaud, executive director, president and CEO of investor advocacy organization FAIR Canada.
“I think the real question going forward in the terms of the proposal that is outlined by the OSC is whether what they’re proposing fully and adequately addresses those heightened risks,” Bureaud said.
Some of these risks include less transparency in private markets than in the public markets, as well as valuations occurring less frequently on private market investments, making fair value difficult to assess, he noted.
Illiquidity is another notable risk.
Retail investors don’t have as much money to lock up over longer time periods or absorb potentially large losses as institutional and high-net-worth investors, who have long invested in long-term assets, said Jason Pereira, portfolio manager with IPC Securities Corp. in Toronto.
“Here’s the real question: people with smaller sums, should they be taking illiquid bets like this when they are more likely to need to draw down or access that capital in shorter, near-term periods? Or have they even necessarily taken care of more basic fundamental retirement needs?” he said.
Pereira said this reminds him of how some prospective clients will ask him about high-risk investments because they think they can make “gangbuster returns” even though they don’t have any money set aside in TFSAs or RRSPs.
“Is this the behaviour we’re encouraging?” he said.
As well, Pereira questioned whether Ontario should expand investor access to private markets, given the “massive private investment fiascos” that have occurred in the province and beyond. He pointed to the Bridging Finance Inc. case. Last fall, the province’s Capital Markets Tribunal ruled that the founders of the failed alternative fund manager engaged in fraud, and the firm’s collapse is expected to result in more than $1 billion in investor losses.
Harold Geller is a lawyer at Geller Law whose practice focuses on the retail distribution of financial products and financial loss. He said he can imagine very few investors who have the risk capacity to invest in illiquid private assets and funds holding them.
“Without a doubt, investing in these companies and funds is a blind gamble. It’s a gamble few can afford,” Geller said in an email.
Retail investors and financial advisors do not have the same level of expertise and resources as pension funds and large asset managers to conduct independent due diligence on such complex products, Geller added.
To address this concern, the OSC is proposing that retail investors could invest in the funds alongside experienced asset managers, institutional investors and other sophisticated “cornerstone” investors. This could “mitigate the difficulties OLTFs would face in calculating NAV and bolster confidence in the valuation of their portfolio assets,” the consultation paper said.
Marc-André Lewis, president and chief investment officer of CI Global Asset Management (CI GAM), is seeking clarity on who would be considered “cornerstone” investors by the OSC, and what incentive these investors would have to invest in OLTFs alongside retail investors.
He also suggested that OLTFs would benefit from a wider scope in asset allocation and a larger pool of investors that extends beyond the borders of Ontario.
Overall, though, Lewis welcomed the OSC’s proposal, describing it as a step toward “democratizing” access to long-term private-market investment strategies. His firm is one of many in Canada that offers private-market funds to accredited investors and he said “the next logical step” is making these products available to a broader audience.
“For me, as long as the product is well constructed, which it seems to be [in this proposal], I think it’s a good development for the capital markets industry and for the investment or the asset management industry in Canada,” he said. “Like everything new, it comes with its own new, specific sets of risks. And I think it’s important that people understand them, and I think that they’re very well outlined in the consultation paper.”
Lewis acknowledged that private assets are often perceived as riskier than public assets, but emphasized that a well-calibrated allocation can diversify portfolios, making them “more robust.”
Further, he said nobody should invest in these products unless they’re willing and able to have their capital locked up for a designated period, and that having limited liquidity can be beneficial in certain cases where investors overreact to market volatility.
Tom Bradley, chair and co-founder of Steadyhand Investment Management Ltd., said he hopes the OSC will address the “opaque” nature of private-market investments with OLTFs.
“I agree with the intent” of the proposal, he said. “Hopefully it isn’t crippling to the industry, but I think we need more transparency.”
Weakening public markets
The OSC said stakeholder feedback will be taken into consideration in the next phase for the proposal, which it anticipates will be the publication for comment of proposed rule amendments and policy changes that would support the implementation of long-term asset fund product structures.
The consultation has received multiple comment letters questioning the purpose of diverting money away from and weakening public markets. They also include comments suggesting the OLTF proposal is “being driven by the supply side, not clients.”
Kivenko, for one, said it seems to be driven by the mutual fund industry, which has been under threat in recent years due to the rapidly growing ETF industry.
He also doubts the legitimacy of the illiquidity premium that’s cited in the proposal, noting that studies report mixed results and that management fees and performance-based fees on long-term asset funds could chip away at the premium. The consultation paper said the “illiquidity premium is intended to compensate investors for the risk of not being able to quickly liquidate these assets, especially during volatile market periods.”
Lewis, of CI GAM, said it’s common for an asset class to offer a higher illiquidity premium when it has first been introduced in the market, but as the market becomes more mature and efficient, the premium tends to narrow. Therefore, he cautioned against extrapolating data for illiquid assets from several years ago and expecting the same level of returns, but he said he wouldn’t go so far as to say there’s no premium left in these assets anymore.
Kivenko questions why the OSC has put forward the long-term private asset funds proposal on its own, rather than working with regulators across the country.
“We don’t understand. It’s very rare that something that’s [considered] so positive for retail investors, the other provinces and territories don’t want to be part of it.”