New OSC Opportunity For Retail Investors

In October 2024, the Ontario Securities Commission (“OSC”) released a Consultation Paper 81-737 (the Proposal) for comment to enable retail investors access to illiquid long-term assets through a new type of prospectus-qualified investment fund.

The “Ontario Long-Term Fund” (“OLTF”) would invest in long-term assets through shares in collective investment vehicles (“CIVs”) with at least one institutional, cornerstone investor (like a pension fund) that holds at least 10% of the CIV’s equity. Ownership by OLTFs in a CIV would be limited to 10% of a CIV’s equity. This is part of an international development to “democratize investing”, to “unlock” retail investor savings.

The OSC Proposal provides an opportunity to enable modest-income retail investors to access long-term assets, and illiquid funds investing in private capital. These investments are typically only available to accredited investors, high-net-worth investors who can afford to wait for returns and can accept the risk of a large loss. This is accomplished by wrapping the risky assets in a mutual fund (the OLTF), placing limits on redemptions (amount and timing) and imposing a long hold period—up to 10 years.

The OSC consultation paper suggests that retail investors might benefit from diversification opportunities via investing in long-term assets. Examples provided include venture capital, private equity, private debt, mortgages, and real estate. Of course, increasing the allocation of capital to long-term assets will benefit the owners and managers of such assets.

The OSC also indicates that the Ontario government is considering innovative ways to finance transportation, housing, energy and municipal services. The OSC Proposal provides a path that could support such projects. However, the OSC did not provide any market research data suggesting there is unmet retail investor demand for illiquid, long-term assets.

For the Proposal, “long-term assets” are “illiquid assets”, defined as assets that cannot be readily disposed of, may be difficult to value and generally have a longer investment horizon than more liquid assets. Under the Proposal, the definition of “long-term assets” is broad to facilitate the greatest possible exposure for retail investors in a range of illiquid assets. For investor advocates, this is a concern.

The reaction from the investor advocacy community has been less than supportive on the basis there is no need for such fund, as there are plenty of opportunities to diversify portfolios without using a risky, illiquid mutual fund with associated fees. The average retail mutual fund account size has been estimated at $125,000.

Questions have also been raised about the much debated “illiquidity premium” (providing a higher reward for being patient), the basis for putting forward the Proposal.¹

When the consultation talks about diversification benefits, I note that, for example, adding private debt often means lending to smaller, riskier borrowers. It does not necessarily mean broadening exposure to different sectors of the economy.

There is a concern that OLTF will not only not enhance the retail investor investing experience but also make investing more complex, risky and expensive without a after-fees material improvement in portfolio return. It has been argued that the inclusion of OLTF could make keeping the portfolio balanced and aligned with Know Your Client (KYC) and suitability more difficult.

As these investment funds would be publicly-offered reporting issuers in Ontario, the funds would be required to have a registered investment fund manager and a registered portfolio manager, and the funds would be required to calculate a net asset value (NAV). Depending on the redemption terms of the funds, these could either be a mutual fund or a non-redeemable investment fund.

The funds could also be either a fixed-term or evergreen funds if liquidity risks are effectively managed. Funding infrastructure projects and other development projects with an expected completion date would be considered a fixed-term. Evergreen OLTFs may be appropriate for investing in rolling pools of private equity, real estate, or for holding commercialized and operational infrastructure assets.

OLTFs would be required to hold a minimum and maximum percentage (50-90%) of long-term assets to ensure sufficient liquidity to meet investor redemption requests.

The consultation asks 24 questions, looking for ways to best implement the framework. It seeks stakeholder input on the proposed OLTF. As such, it is not clear what the final version will look like, but it appears the OSC is determined to create a new fund category. The comments provided here reflect a viewpoint based on the current thinking, which possibly has already been run by industry stakeholders.

Here’s my take on the OLTF:

The framework is an endeavour by the OSC to make, via intermediation, assets that would normally require accredited investor status accessible to non-accredited investors. The fund would not be sold to investors with a need for ongoing income, a short time horizon, low-risk tolerance, inadequate risk capacity or those investors who are uncomfortable with tying money up for long periods. Retirees or those living on fixed income would likely not be attracted to OLTF.

The prospectus will provide a fulsome disclosure of all unique aspects of OLTF. Fund Facts disclosure would be enhanced to account for the unique nature of OLTF.

The OLTF would have a corporate structure governed by a Board with a majority of independent Directors to effect governance over operations, valuation, liquidity management and conflict of interest.

The OLTF is only available to Ontario residents, so if you move to another province, you may have to somehow dispose of the OLTF as it is not an eligible security outside of Ontario.

If the fund is restricted to Ontario-based assets that could be an unduly limited choice of assets.

The OLTF could be sold by a Canadian Investment Regulatory Organization (CIRO) mutual fund sales licensee or a CIRO Registered Representative without a fiduciary obligation and portfolio managers.

The role of the investment advisor will involve selecting OLTFs that have the requisite size, demonstrated access to promising investment opportunities along with seasoned investment and portfolio management expertise to realize the benefits of private market investments subject to enhanced KYC assessment.

The fund could add, for example, private debt/mortgages involving riskier loans than that permitted by regular mutual funds. The retail investor may, however, have to hold on for the long term to be rewarded by the illiquidity premium.

Because of the need for some liquidity to enable limited redemptions, as little as 50% of the fund could be invested in long-term assets, meaning that only half your investment dollars are at work to seize the potential illiquidity premium.

Like any mutual fund, the OLTF fund will charge fees for as long as you own the fund, and you will also have to pay a fee when making a redemption.

The valuation of illiquid assets will be challenging, especially since the OLTF will not have direct control of the asset. At least once a year, an independent valuation of assets will be conducted with costs chargeable to the fund.

The ability to redeem will be limited and require over a month to receive cash. The initial view is that redemptions should be no more frequent than monthly and no less frequently than annually, with NAV calculations being aligned with the timing of redemptions.

Redemption restrictions would be allowed, to the extent the OLTF needs them to manage liquidity and satisfy reporting needs.

Should the redemption demand exceed prescribed caps, the fund would be empowered to cease the right to redeem funds to protect the OLTF. In extreme cases, the OLTF could cease redemptions altogether until stability is achieved. The timeline could be a year or more. Mutual fund fees, however, would continue during the period of redemption cessation.

If redemptions exceed a threshold over two years, the fund will have to be wound up.

At this time, it is unlikely that the OLTF will be permitted to be traded via a discount broker.

Depending on the amount of the OLTF held in the portfolio, there could be conditions where portfolio balancing and rebalancing could not be affected.

If not held in a registered account, a successful OLTF could result in outsized capital gains taxes at the end of the hold period.

As OSC-registered Dealers can sell OLTF, the Ombudsman for Banking Services and Investments’ (OBSI) loss calculation methodology will be applicable for unsuitable illiquid security sales.

In the event of the client's death, the estate settlement process might need to wait out any remaining portion of the hold period unless an exception is granted.

And finally, OLTF investors will have to accept the risks of the underlying assets, which will generally be higher than the risks associated with publicly traded securities.

Investor advocates have a few questions of their own. These include, but are not limited to:

§ Will the OSC commit to impactful OLTF investor education?
§ What advisor compensation model will be used?
§ How will the OLTF be risk-rated?
§ How will robust Know Your Product obligations be met with the limited disclosure information available from the OLTF/CIV?
§ Will investor hardship redemption cases be considered?
§ Do mutual fund sales licensed individuals have the necessary professional skills to advise portfolios containing OLTF?
§ How will regulators address periodic investor portfolio imbalances?
§ What impact will a fund wind-down have on OLTF investors?
§ Should there be restrictions on the percentage of a retail investor portfolio containing OLTF?

The beneficiaries of this initiative include the Canadian fund industry, the Ontario government, the OLTF, the CIV, the owners of the asset and the retail investor who gets what’s left after fees. The OSC gets kudos for delivering on its fostering capital formation mandate.

The question is: does all this complexity amount to an enhanced investor experience and an opportunity for above-average after-fee returns for the small retail investor?

Ken Kivenko, Peng (retired), President , Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com.

1 If you want to learn more about the illiquidity premium read The Ins and Outs of Investing in Illiquid Assets https://caia.org/sites/default/files/AIAR_Q2_2016_05_InsandOuts.pdf