In a move that might signal the eventual weaning of the Canadian venture capital industry off government subsidies, the province of Ontario has announced a moratorium on the creation of any new so-called labour-sponsored investment funds (LSIFs) and proposed a review of existing funds to determine their future.
LSIFs – whose origins go back to the 1983 formation of the Solidarity Fund in Quebec were launched as alternative sources of early-stage venture capital funding and ostensibly designed to stimulate local economic growth. Instead of an institutional and high networth individual investor base, LSIFs are retail funds marketed to individual consumers and offering up to 35 percent annual tax credits of up to C$5,000.
During the late 1990s, first-time LSIFs entered the market en masse as the tech markets boomed and interest in venture capital increased. Critics of the programme now question whether all the capital raised was wisely invested. The subsequent downturn fouled investment portfolios and left the venture capital landscape littered with numerous small-end LSIFs, whose overall performance outside of the top ten largest funds has been mediocre at best. In budget documents made public by Ontario's finance minister, the provincial government believes there are so many labour-sponsored funds currently in existence that investment capital is being spread too thinly to be effective.
Promoted by the now-defunct Canadian Federation of Labour, LSIFs originally gained their identity by being affiliated with labour unions. The funds were meant to create jobs and jump start what was then a latent venture capital industry. But many venture capitalists are now asking whether the decade-old programme needs a sunset clause. The case for doing away with LSIFs has many supporters, particularly among institutional funds, who argue that because individual investors get tax breaks, they don't demand as high a return as would, say, a state pension fund or an insurance company.
“The Canadian market can seem a scary place – there's a daunting amount of tax-driven capital washing around, potentially driving down returns,” says Paul Kedrosky, a business professor at the University of California, San Diego and Canadian venture capital expert. “Investors motivated by tax credits rather than by venture fund returns are not ideal venture fund backers.”
Retail funds are held to strict investment restrictions in order to qualify for tax incentives. No more than C$15 million, or ten percent, of the fund's assets, can be committed to one portfolio company. At least 80 percent of proceeds issued must be invested within Canada in order to receive the 15 percent federal tax credit, and individual provinces have their own geographical investment requirements if the fund is to receive matching provincial tax credits. LSIFs are also required to have 20 percent of their funds invested in a liquidity cushion, usually in the form of treasury bills.
Many in the industry find fault with the investment pacing rules imposed on LSIFs. In short, 70 percent of funds raised in any given year must be invested over a two year period. Many institutional fund managers claim that such practices lead to financing sub-par companies in order to get capital out the door and avoid penalties.
“When I invest, I only do deals that I judge are the best of the best, whereas because of pacing requirements and geographic restrictions, [LSIFs] might compromise and do the best of what they've recently seen just so they can put their money out,” says Andrew Waitman, a managing partner at Celtic House, which invests in Canada and the UK.
Many institutional managers also find fault with their retail counterparts' compensation structure. GPs at LSIFs are paid a percentage fee – normally around five percent – based on the net asset value of the fund's portfolio, just like at a mutual fund, and receive no carry as is standard in the private equity world.
Investments in LSIFs are meant to be held long term, but individual investors have the option of cashing out at any time. As a result, LSIFs must update their net asset value on a regular basis, and many industry observers believe the valuations of portfolio companies are artificially inflated in order to assure higher management fees.
“We as partners are compensated solely on realised profits, while labour funds are compensated on net asset value – it's a mutual fund,” says Bryan Kerdman, a partner at the venture arm of Toronto-based Edgestone Capital Partners. “Labour fund managers are reticent to write down investments because that would reduce their fees.”
Retail fund managers are quick to note that as with any private equity due diligence process, it is the responsibility of the investor to choose the best vehicle according to the track record of the GPs. But even LSIF managers agree that educating Canadian investors is easier said than done.
“I think people need to look past the tax credits and the marketing brochures,” says Doug Hewson, a managing partner at Ottawa-based LSIF manager Axis Capital. “They should assess whether a manager is actually in the business of venture capital and has a sound investment strategy backed up with the competency to execute on it.”