In the News...

Jonathan Chevreau

Labour sponsored investment funds (LSIFs) got blasted again yesterday by their own industry executives. With just three weeks left in the annual RRSP sales season, IPM Funds Inc. managing director Julie Makepeace criticized her industry's emphasis on asset gathering and the resulting "dismal performance" of its funds.

Ironically, she says, the chronically poor performance of labour funds has finally started to hurt cash inflows. Sales in the glutted Ontario market plunged from $649-million in 2001 to $267-million in 2003.

After 14 years in venture capital, Makepeace is well qualified to comment on the shortcomings of the LSIF business. It was created by a bizarre mixture of venture capital talent, government tax credits and sponsorship by unions, all in the name of job creation. Ottawa provides a 15% tax credit for a maximum $5,000 investment in a labour fund, a credit matched by another 15% in several provinces.

Because investors get $1,500 in tax credits for a $5,000 investment, they have been forgiving of the high fees, poor performance and the requirement to hold the funds eight years (or repay tax credits). But clearly, their patience has been nearly exhausted.

"Numbers don't lie. The average performance of labour-sponsored funds in Ontario has been negative across one, three, five and 10-year periods to December 31, 2003 at -5.22%, -12.93%, -3.08%, and -3.40%, respectively," Makepeace says.

What should make investors' blood boil is the fact this pathetic performance is far below the returns of U.S. institutional venture capital. The average five-year return to June, 2003 for early stage venture capital in the U.S. is 47.9%, and is 18.6% for balanced and 7.3% for later-stage venture capital.

However, the U.S. figures are "investor" returns net of management and performance fees. Neither U.S. nor Canadian institutional VC funds are hampered by the 20% cash requirement for LSIF redemptions. Even so, Canadian venture capital performance in general (and not just the LSIFs accounting for half its activity) is still below U.S. levels, says Dan Hallett, president of Windsor-based Dan Hallett & Associates Inc. He has just released his fourth annual report on labour-sponsored funds.

LSIFs have failed to deliver for three reasons, Makepeace says. They must invest 70% of the capital they raise within 22 months, making due diligence difficult. Once investments are made, "the sheer volume of portfolio companies compromises the ability of large LSIFs to engage in the sort of hands-on, company-building added value that sets good venture capital investment management firms apart."

A third weakness is the continuous offering structure and pre-occupation with "critical mass" which exists with many LSIFs --combined with a manager-paid-first approach.

IPM's new Terra Firma LSIFs aim to revolutionize the industry, lowering fees and creating a closed structure with a maturity date on the eighth anniversary. IPM does not pay manager performance bonuses unless shareholders get 75% of net realized gains through cash dividends. Bravo to that -- too many LSIF executives are multi-millionaires while their impoverished clients ask "Where are the customers' yachts?"

Hallett likes Terra Firma's approach because its shareholder friendly approach should mean lower fees. "However it is not without its risks and limitations."

Closing funds after just one sales season may be risky, since the concentrated nature of LSIF sales may not add up to a sufficient amount of new money for their three new funds, Hallett says.

LSIFs have been innovative the past year, notably with the venture debt LSIF, pioneered by ROI Fund, since imitated by VenGrowth and others. The debt story has appeal but Hallett raises two issues.

He wonders why profitable, stable firms would pay a coupon rate of 12% to 18% a year. And he questions whether such funds can generate high enough returns to compensate for the high LSIF fees.

Thus, ROI Fund boasts a gross yield of 14% on its $11-million portfolio but its MER is above 11%. Venture debt may have less risk than straight common equity, but "it's equity risk nonetheless," Hallett says.

Where does this leave the once-bitten, twice-shy prospective LSIF investor? I've invested in several LSIFs myself and confess I'm unsure I will do so again this year. If tempted to emulate Charlie Brown by taking one last run at the LSIF football held by Lucy, I'd go along with Hallett's advice to hold equity LSIFs outside registered plans.

If the only money I had were inside an RRSP and I were tempted by the industry's "double whammy" lure of RRSP receipts and LSIF tax credits, I'd consider the venture debt fund with the lowest MER.

Despite their negatives, Hallett still believes "LSIFs are worthy investments ... They have good promise in a taxable account --particularly near what seems like a bottom in this segment."

He recommends several established equity LSIFs, many technology-oriented. In alphabetical order they are B.E.S.T., Dynamic Venture Opportunities, Ensis Growth [in Manitoba], First Ontario, GrowthWorks Working Ventures Canadian, VenGrowth II and [in B.C. only] Working Opportunity.

Honorable mentions include Canadian Medical Discoveries, Capital Alliance Ventures and Lawrence Enterprise.
Let's just hope the industry starts living up to the word "honourable."