Latest / How Canadian Markets Work / Episode 56: The Exempt Market (The Price of Illiquidity)

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Episode 56: The Exempt Market (The Price of Illiquidity) · How Canadian Markets Work

0:00
Imagine, if you will, a massive impenetrable
0:05
wall. It's built out of thousands of pages of
0:08
legal text and rigorous financial audits. Right.
0:11
Exhaust of regulatory reviews. Exactly. In the
0:14
public financial markets, this wall is called
0:16
the prospectus. It's essentially the defining
0:20
document of an IPO. An initial public offering.
0:22
Right. Which is basically a financial autopsy
0:25
of a company before the general public is ever
0:28
allowed to buy a single share. It is. And it
0:30
is a highly regulated, incredibly expensive,
0:35
and deliberately slow document. Yes. And it exists
0:37
for one singular reason really. to protect the
0:40
everyday investor from stepping into a financial
0:43
void. It is the ultimate safety net. I mean,
0:45
the prospectus demands full, true, and plain
0:48
disclosure of every material fact. Right. And
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crucially, it carries severe career -ending legal
0:54
liability for the executives and the auditors
0:56
who sign it if they attempt to hide the truth.
0:59
But, you know, looking at the stack of regulatory
1:01
enforcement files and auditor reports we've gathered
1:03
for today's Deep Dive, one thing becomes strikingly
1:06
clear. It really does. Right next to this massive,
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heavily guarded wall. The regulatory system has
1:12
quietly installed a series of specialized doors.
1:15
Yeah, they have. And every single day, massive
1:19
volumes of securities. I mean, we are talking
1:22
billions of dollars worth are sold legally through
1:25
those doors, completely bypassing the perspective.
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There's no public safety net. No. There is no
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daily stock ticker. None of it. It is an entirely
1:35
parallel financial universe. And today, our mission
1:39
is to gently open those doors. We are going to
1:42
explore what is known as the exempt market. Yes.
1:45
We need to understand exactly who is allowed
1:47
to walk into this space, why the regulators permit
1:49
them to bypass the standard rules. And most importantly,
1:53
we need to expose the defining risk that waits
1:55
in the quiet on the other side. The very heavy
1:57
price of illiquidity. Exactly. So the regulatory
2:00
burden creates this massive wall to protect.
2:02
everyday people but then they install these specialized
2:05
doors for certain investors to just kind of casually
2:07
stroll right through. Completely unanchored,
2:09
yeah. Completely unanchored. Let's unpack the
2:12
logic here because if the prospectus is so fundamentally
2:15
important for investor protection, why do regulators
2:19
allow these doors to exist at all? Well, it seems
2:23
like a direct contradiction of their own mandate,
2:25
doesn't it? It does seem contradictory until
2:27
you look at the actual mechanics of capital formation.
2:30
OK. If we force every single transaction through
2:33
the filter of a multimillion dollar prospectus,
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we would essentially suffocate small and medium
2:39
sized Congress. I see. Think about a small local
2:43
company trying to raise $200 ,000 to build a
2:46
community wind farm. Right. They just want to
2:48
raise it from six local investors who already
2:51
know the founder. Oh, right. So if you force
2:53
that tiny company to produce a national level
2:56
IPO document, the legal and auditing costs would
3:00
literally bankrupt the wind farm before a single
3:03
turbine is ever ordered. Precisely. It is a calculated
3:05
trade -off between absolute safety and actual
3:08
commerce. The exemptions exist for specific scenarios
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where regulators have carefully decided that
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the full heavy protection of a prospectus simply
3:17
isn't feasible. Right. Or, you know, theoretically
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isn't. necessary. Which brings us to the largest
3:23
of these specialized doors. From looking through
3:26
these files, the vast majority of the money flows
3:29
through something called the accredited investor
3:32
exemption. Yes, the accredited investor exemption.
3:35
And the way this works is purely mathematical,
3:37
right? If an investor meets specific financial
3:40
thresholds, usually a certain high level of annual
3:44
income or a very high net worth in financial
3:46
assets, they are handed the key. They can buy
3:49
private securities without a prospectus. Right.
3:52
The regulatory logic seems to be that if you
3:54
have this much wealth, you can afford to absorb
3:56
potential losses. Exactly. You have the resources
3:59
to hire professional advisors, and you have the
4:01
leverage to demand your own financial information
4:04
from the company. That is the exact regulatory
4:06
theory. They assume financial resources equate
4:09
to financial resilience. Yes, they do. But looking
4:12
at the actual enforcement files... I mean, there
4:15
is a massive flaw in that proxy. There is. The
4:18
regulators are measuring wealth, and they are
4:21
using it as a direct substitute for financial
4:24
understanding. That feels incredibly dangerous
4:28
to me. It's like assuming anyone who could afford
4:32
to buy a Formula One race car automatically knows
4:34
the telemetry data. or the tire pressure dynamics
4:37
and how to rebuild the engine on a track. It
4:40
is a beautiful way to phrase it, and it really
4:43
exposes the structural vulnerability in the rule,
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because the test measures your bank account simply
4:49
because a bank account is an objective, mathematically
4:52
verifiable number. Right, it's easy to check.
4:54
Exactly. True financial sophistication, on the
4:56
other hand, is subjective. It is incredibly difficult
5:00
to measure on a mass scale. Because you could
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easily have a brilliantly talented neurosurgeon.
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who makes an enormous income in medicine. Absolutely.
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They easily clear the income threshold to be
5:10
an accredited investor. Right. Or, you know,
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you could have someone who inherited a massive
5:14
estate from a relative. They have the raw wealth.
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But just because they have money does not mean
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they have spent a single hour studying the mechanics
5:22
of complex private finance. Right. They might
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not know the first thing about corporate debt
5:27
structuring or senior secured versus unsecured
5:31
lending. Exactly. And what's fascinating here
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is that the regulators are entirely aware of
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this compromise. Are they? Yes, it is a known
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vulnerability in the system. Wow. The result
5:43
is that highly successful wealthy individuals
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regularly walk into complex private investments
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completely unaware of the structural disadvantages
5:52
they are accepting. Right. They see the high
5:55
projected yield, but they just don't see the
5:57
missing safety mechanisms. Precisely. So we have
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the millionaires and the high income earners
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walking through the accredited investor door.
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But the exempt market isn't just a playground
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for the ultra wealthy, is it? No, not at all.
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Because looking at the data, thousands of non
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-accredited everyday investors end up in these
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waters, too. They do. And they come in through
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the other doors, which intentionally widen the
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net. The next major pathway. is the family, friends,
6:23
and business associate's exemption. This allows
6:27
a company founder to raise capital from people
6:29
with whom they have a genuine pre -existing close
6:33
relationship. The theory shifts here. Instead
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of relying on wealth, The regulation assumes
6:39
that if you are investing in your sister's startup,
6:42
you're relying on your lifelong knowledge of
6:44
her character and her competence. Rather than
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relying on a dense regulatory filing. Exactly.
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I mean, I can see the logic for a family, but
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the business associate loophole feels incredibly
6:56
elastic to me. It can seem that way. What prevents
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a charismatic founder from just inviting someone
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to a high -end industry conference, shaking their
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hand over a coffee, pitching a deal and suddenly
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calling them a business associate? Just to legally
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take their money without a prospectus? Well,
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it is very tempting for people selling these
7:13
securities to view it that way. I bet. But the
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law definitely does not. Oh, really? No. The
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regulatory framework has a very specific, strict
7:20
definition of what constitutes a close business
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associate. It requires a shared history, a sufficient
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prior relationship where you have genuinely been
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in a position to assess their business capabilities
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over time. So a handshake at a conference or
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a few polite emails doesn't cut it. Absolutely
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not. And when issuers try to stretch that definition,
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it frequently gets tested in regulatory enforcement
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cases. Right. Regulators will literally dissect
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emails, text messages, and meeting histories
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to prove whether a genuine long -standing relationship
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actually existed before the money changed hands.
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Wow. If it didn't, the exemption fails and the
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sale was illegal. Okay, so the regulators do
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genuinely police that boundary. They do. But
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there is one more big door that I found in these
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files, and it seems to let... the widest group
8:08
of everyday people in, the offering memorandum
8:11
exemption. Yes. Think of an offering memorandum
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as a lighter, heavily streamlined version of
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a prospectus. It provides a structured disclosure
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document, but it is much less onerous and significantly
8:23
less expensive for the company to produce. And
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in exchange for providing this document, the
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company is allowed to sell securities to a much
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wider group of people, including non -accredited
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retail investors. Wait, if it's just a lighter
8:35
prospectus. Who decides what gets left out? Well,
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that's the thing. Isn't that just a permission
8:41
slip for a company to hide the ugly financial
8:44
realities behind a glossy cover? That is the
8:47
exact tension of the offering memorandum. Yeah.
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The regulator sets a framework of what must be
8:53
disclosed, usually the business model, the risks,
8:55
and the audited financials. But the company paints
8:57
the picture. It is a stripped down chassis. It
9:01
lacks the continuous ongoing reporting requirements
9:04
of a public company. Right. To mitigate that
9:06
risk, the regulators impose strict limits. Limits
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on how much people can invest. Precisely. Non
9:12
-accredited purchasers are usually capped on
9:15
how much money they can invest under this exemption
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in a given year. OK. The regulators are essentially
9:19
saying, we know this document provides less protection
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and we know this market is dangerous, so we are
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going to legally cap the maximum amount of damage
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you can do to your own life savings. Wow. It
9:30
is incredibly paternalistic, but I suppose mathematically
9:34
necessary. So we've mapped out the doors. We
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know how investors get into this parallel market.
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They sit across from a charismatic salesperson.
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They look at a beautifully designed brochure,
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and they are promised a yield that is substantially
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higher than anything they can find in the public
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bond market. Let's dim the lights a bit and unpack
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the actual mechanics of the traps waiting inside.
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And those traps are profound. There are three
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defining risks of private investing in the exempt
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market and they behave very differently than
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the risks in public markets. The first one detailed
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in all of these source files and it seems to
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be the most devastating is the risk of illiquidity.
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permanent resale restrictions. It is the defining
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characteristic of the exempt market. When you
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buy a stock on a public exchange, you know that
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on any given Tuesday morning, you can tap a button
10:23
on your phone and sell it to a stranger at the
10:25
market price. The friction is basically zero.
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Exactly. In the exempt market, there is no public
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market. There is no central exchange. There is
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no daily crowd of buyers. So if I buy a private
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security, I am legally restricted from just transferring
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it to someone else. Completely. The securities
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you acquire under these exemptions are legally
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restricted from being resold without meeting
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very specific... This is the one that really
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stood out to me in the auditor reports. Yeah.
10:51
Because in the public markets, the price of a
10:55
stock moves every second. Right. You watch the
10:58
ticker, it's volatile, it causes anxiety. But
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in the exempt market, a retail investor might
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receive a beautifully printed statement in the
11:07
mail every single quarter. and they look at the
11:11
value of their private investment, and it just
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shows a perfectly stable straight line. Up 1
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% this quarter, up 1 % the next. Exactly. It
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feels incredibly safe. But you have to ask yourself,
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you know, how is that number being generated?
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Right. It's exactly like checking the estimated
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value of your house on a real estate website.
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Oh, that's a great comparison. You log on, and
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the algorithm tells you your house is worth $800
11:34
,000. And that number just sits there on the
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screen looking incredibly stable and deeply comforting
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month after month. But that number is a total
11:44
illusion. It is a fabricated estimate. The actual
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true value of your house is entirely unknown
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until the exact agonizing moment you put a for
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sale sign on the lawn and a living, breathing
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human being actually writes you a check. That
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is a phenomenal analogy, and we can actually
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push it even further. Imagine if all 50 people
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on your street tried to convert their online
12:09
house estimates into actual cash on the exact
12:11
same Tuesday. Oh, wow. the market would flood,
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panic would set in, and the actual clearing price
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would plummet far below the estimate. Exactly.
12:19
The number on your exempt market statement is
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an estimate, and crucially, it is an estimate
12:23
provided by the issuer themselves. Right, or
12:26
their manager. Yes. It is not a true market price
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forged by the friction of thousands of buyers
12:32
and sellers competing. It has never been tested
12:34
by a real transaction. No, it hasn't. So that
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beautiful straight line of value, it is comforting,
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yes, but it is entirely untested. And when trouble
12:42
hits a private company, that valuation doesn't
12:45
slowly, organically trend downward like a public
12:48
stock. Because there are no daily buyers to slowly
12:51
price in the bad news. Right. The private statement
12:55
stays perfectly flat for years, maintaining the
12:57
illusion, and then overnight when the auditor
13:01
forces are right down or the company defaults,
13:04
the value drops to zero in a single quarter.
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The illusion violently shatters. It does. Which
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brings us to the third trap, the concentration
13:12
trap. And this is purely a function of the math
13:15
required to get through those doors. Yes, because
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the minimum investments in the exempt market
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are often very, very large. Right. a public index
13:24
fund might let you start with $50. But in the
13:26
private market, it might be $25 ,000, $50 ,000,
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or $100 ,000 just to gain entry to the fund.
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So if a retail investor only has $200 ,000 in
13:36
total life savings, and the salesperson convinces
13:39
them to meet a $50 ,000 minimum buy -in for a
13:42
private real estate trust, they have just accidentally
13:45
locked 25 % of their entire net worth into one
13:48
single private venture. Exactly. They have bypassed
13:52
diversification entirely. In a public portfolio
13:55
of broad index funds holding thousands of companies,
13:58
a single company going bankrupt is just a rounding
14:02
error. The investor won't even notice it on their
14:04
monthly statement. Right. But in the private
14:06
market, because of that sheer concentration,
14:10
one single default can be fatal. Yeah. If that
14:13
one private real estate development goes under,
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a quarter of that investor's life savings vanishes
14:18
instantly. with no way to recover it. Checking
14:21
registration makes sense on the front end, but
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once you're sitting at that mahogany desk looking
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at the glossy brochure, how do you verify the
14:29
liquidity they're promising isn't just a mirage?
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I want to transition into the practical defenses
14:35
here based on the cautionary tales in our sources.
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What are the non -negotiable steps an investor
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must take before their pen ever touches that
14:43
contract? Right. There are three practical defenses
14:45
and you must apply them without hesitation. Okay.
14:48
First, verify the registration. Do not take the
14:50
salesperson's business card or their confident
14:52
demeanor at face value. You must use the national
14:55
regulatory search database to ensure the specific
14:58
person selling you this product is actually registered.
15:01
And specifically registered in the category of
15:04
exempt market dealer, right? Yes. So if I look
15:07
them up and they are only registered to sell
15:09
standard mutual funds, what does that actually
15:11
mean? It means they are legally operating outside
15:15
their lane. They are not authorized to assess
15:18
or sell you private securities and you must walk
15:20
away immediately. It takes 30 seconds to check
15:23
and it is entirely free. Okay, so they pass the
15:26
registration check. What is the second defense?
15:28
This is the most crucial one, ask the real cash
15:31
question. The real cash question. And you must
15:34
be highly specific regarding the mechanics. Do
15:36
not ask them what the legal terms of the contract
15:39
permit. Right. Ask them directly, while looking
15:42
them in the eye, how and exactly when can I get
15:45
my money out? And tell me, has anyone actually
15:48
requested and successfully completed a cash redemption
15:51
in the last six months? Let me push back on that
15:54
a little bit. Because salespeople are incredibly
15:57
smooth and they are highly trained to handle
15:59
objections. What if I ask that exact question
16:02
and the salesperson just smiles, flips to page
16:06
47 of the glossy brochure, points to a heavily
16:09
bolded clause and says, as you can see right
16:11
here, redemptions are completely allowed on a
16:14
quarterly basis. They answered the question on
16:16
paper, but they dodged the reality of the cash
16:20
leaving the building. That is the exact moment
16:22
the alarm bell should ring. Really? If they point
16:24
to a legal clause but dodge the question about
16:27
real human beings receiving real cash, you close
16:30
the brochure and you leave the room. Let's explain
16:33
the mechanics of why they dodge that question.
16:35
How does a fund legally allow redemptions, but
16:39
mathematically fail to pay them. Well, it comes
16:41
down to the underlying assets. Let's say it is
16:43
a private real estate fund. The fund owns concrete,
16:47
glass and land. Right. It is deeply illiquid
16:50
by nature. If 10 percent of the investors suddenly
16:53
ask for cash in the same quarter, the fund simply
16:56
doesn't have the cash sitting around. They can't
16:58
just saw off the third floor of an office building
17:00
and sell it by Friday to pay you. Precisely.
17:03
So the fund is forced into a corner. They either
17:06
sell the entire building at a massive discount
17:08
and a fire sale, which destroys the value for
17:11
everyone else left in the fund. Or they drop
17:13
the gates. Exactly. They invoke a clause to suspend
17:16
redemptions to quote unquote protect the portfolio.
17:19
Right. What's fascinating here is that illiquidity
17:23
is almost always invisible on the way in. It
17:26
is. It is only when investors try to head for
17:29
the exit that the gates suddenly drop. Illiquidity
17:33
that only reveals itself on the way out is the
17:36
single biggest source of financial regret in
17:39
the exempt market. So vague answers about cash
17:41
mean you do not invest. Period. Period. That
17:44
is incredibly clear. Concrete and glass cannot
17:46
be liquidated overnight. And the third defense.
17:49
We've talked about the accredited investor threshold
17:51
and wealth. Does wealth waive the dealer's responsibility?
17:55
It absolutely does not. The third defense is
17:57
remembering that suitability still legally applies.
18:00
Even if you are a multimillionaire, even if you
18:03
easily clear the highest hurdles to qualify as
18:05
an accredited investor, the registered dealer
18:08
sitting across from you still legally owes you
18:11
a suitability check. So they can't just say,
18:14
You're rich. You're on your own sign here. Correct.
18:17
They are required by law to ensure that this
18:19
specific, highly illiquid, highly concentrated
18:22
investment actually makes sense for your specific
18:26
life circumstances. Your time horizon and your
18:29
true capacity to absorb a total loss. Exactly.
18:32
That is a fascinating legal dynamic. It means
18:35
the investor isn't just swimming with sharks,
18:37
completely unprotected. No. The dealer still
18:40
has a leash. even in the exempt market. They
18:43
have to mathematically prove this private asset
18:45
fits into your broader financial picture without
18:48
destabilizing it. They do. And you must force
18:51
them to acknowledge it. Ask them explicitly,
18:53
how does this fit my suitability profile? Make
18:56
them articulate the defense of the investment.
18:58
Let's step back and look at the entire landscape
19:00
we've mapped out today for this deep dive. The
19:02
exempt market is a parallel financial universe.
19:06
It completely strips away the monumental safety
19:09
net of the prospectus. And it entirely removes
19:11
the daily liquidity of the public exchanges.
19:14
Exactly. When you walk through those specialized
19:16
doors, whether through wealth, relationships,
19:19
or an offering memorandum, you are making a very
19:22
specific permanent trade. You are trading transparency,
19:26
and you are trading the freedom to exit at will,
19:29
all for the chance at a higher yield. You are
19:31
taking on the heavy silent price of permanent
19:34
illiquidity. You are subjecting yourself to the
19:37
soothing but dangerous valuation illusion where
19:39
your statement lies to you until it drops to
19:42
zero. Yes. And you are exposing yourself to the
19:44
perilous concentration trap where a single default
19:47
can wipe out a quarter of your net worth. That
19:49
is the perfect distillation of the mechanics.
19:52
You are operating entirely without the safety
19:54
mechanisms that define the public markets. Which
19:57
brings us to a rather profound lingering thought
19:59
to close out our deep dive today. drawn straight
20:02
from the broader market research in our sources.
20:04
Over the last decade, private markets have grown
20:06
enormously. We are seeing companies choosing
20:09
to stay private much, much longer than they historically
20:12
used to. If we connect this to the bigger picture,
20:15
it fundamentally changes the entire landscape
20:18
of modern wealth creation. Exactly. Thirty years
20:20
ago, companies went public early in their lifecycle,
20:23
which meant everyday retail investors got to
20:25
participate in their explosive growth. But today,
20:30
companies are raising hundreds of millions in
20:32
the exempt market, avoiding the public scrutiny
20:34
of an IPO until they're already massive, fully
20:37
mature corporations. The highest growth phase
20:40
happens entirely in the shadows. Right. So if
20:43
the absolute highest growth, most explosive phase
20:46
of tomorrow's great companies now happens almost
20:49
exclusively behind the closed doors of the exempt
20:51
market, a room where only the wealthy, the well
20:54
-connected, and the accredited investors are
20:56
structurally allowed to play. It leaves us with
20:59
a deeply unsettling question. It does. Are everyday
21:03
retail investors, the people dutifully buying
21:06
public index funds and playing by the standard
21:08
rules, simply being left with nothing but the
21:10
slow growing leftovers? Well, let that quietly
21:13
sit with you until next time.