Report urges governments to end tax support for labour-sponsored venture capital funds

A new report from the CD Howe Institute slams labour-sponsored venture capital corporations (LSVCCs) and calls for government to end their tax subsidies in favour of other mechanisms for stimulating the growth of innovative firms. Entitled Financing Entrepreneurs: Better Canadian Policy for Venture Capital, it argues that Ontario was correct in its decision to abandon tax subsidies to LSVCCs and presents compelling evidence that the federal and other provincial governments should follow suit.

Since their spectacular rise in the 1990s, labour-sponsored funds (LSFs) have cost Canadian governments more than $3 billion in foregone revenue. But instead of fulfilling their objectives of maximizing employment, shareholder value and economic development, LSFs have performed badly, achieving an average rate of return of nearly -7% between 2001 and 2005. In addition, management expense ratios have averaged 4.2%, nearly double the ratios for Canadian mutual funds.

LSVCCs — the majority focused on tech-based firms — currently account for about half of all venture capital (VC) in Canada. But report author Dr Douglas Cumming says the poor performance of LSFs has distorted the whole industry in Canada, driving up deal prices, limiting initial public offerings (IPOs) and preventing other incentive options from being explored.

"The rest of the world blinks their eyes in disbelief when they hear about labour-sponsored funds and wonder who would try such a thing," says Cumming, who is returning to Canada from the US to become an associate professor at York Univ's Schulich School of Business and an Ontario Research Chair holder in economics and public policy. "The returns have been very poor and these kinds of investments don't end up with good exit outcomes."

just three funds generate returns

The report says that only three LSVCCs out of more than 100 have achieved positive rates of returns in the past five years. That includes the Solidarity Fund QFL, Canada's first LSVCC founded in 1983. Cumming acknowledges that Solidarity's success may be due to the peculiarities of the Quebec VC market but says that didn't justify other governments jumping on the bandwagon.

"Solidarity has generated positive economic returns but that doesn't make the case for saying this is a smart way to subsidize venture capital," he says. ""There's been a huge direct cost and the indirect costs are even larger in terms of the VC market we could have had and the crowding out of private investment. The result has been fewer new jobs and fewer public companies."

LSVCCs are open only to individual investors who receive an immediate 30% on their investments in the year they contribute. Investors are locked in for eight years. In 2005 there were 125 LSFs — 16 federal funds, 67 in Ontario, 28 in Atlantic Canada, 7 in British Columbia, 3 in Quebec and 2 each in Saskatchewan and Manitoba.

"Tax subsidies enable LSVCCs to out-bid other venture capital funds for investee companies, thereby discouraging institutional investors and private fund managers from starting private venture capital funds, since LSVCCs effectively drive up deal prices and lower returns to the market." — CD Howe report

Although LSVCC data are difficult to refute, at least one veteran of the industry says there are mitigating circumstances to consider before condemning LSFs outright. Angel investor and high-tech entrepreneur Dr Denzil Doyle was a key player in the Ottawa-based Capital Alliance Venture Inc (CAVI) LSF (now part of GrowthWorks Canadian Fund Ltd). He says mistakes made by some of the early funds followed by the tightening of investment regulations must be considered when assessing their overall performance.

"The LSVCC program might have succeeded if some of the early entrants to the game had gotten busy and made more investments in their early years. Instead, they let the money pile up and collected their management fees on investments in GICs – not exactly what the government had in mind," he says. "The government then put in very strict regulations on hold times on money raised and this was just when the (tech) bubble was bursting. Many LSVCCs had to make investments which they knew were overpriced and entrepreneurs got very aggressive on valuations."

Doyle asserts that increasing demands by government raised the cost of managing LSVCCs, promoting a consolidation that saw the smaller funds gobbled up by larger funds. The result was a trend towards larger investments, contrary to what they were originally intended to do. "(Amalgamation) is also causing the industry to migrate back to the large financial centres. It is what the VC industry in the US looked like about 50 years ago when it was all located in New York City."

Canada is virtually alone in its use of a tax subsidized mechanism like the LSVCC, although the UK introduced a similar mechanism in 1995 that has also generated poor results. Cumming says it's time for Canada to dump them and try a new approach, either by modifying tax and securities laws or creating direct subsidy programs (see chart). He points to Australia and the US for examples of both approaches that appear to have achieved their objectives.

"Direct subsidy programs tend to be potentially harmful and hard to undo if you make a mistake. They're a more risky avenue but the SBIR program in the US works very well," he says. Changing tax and securities laws are easier and quicker and more efficient."

Cumming points to the Australian approach of a graduated subsidy incentive, with a higher rebate for incremental R&D. He says Canada should consider similar premium concessions to R&D performing firms. "It introduces a performance element. There are ways to design tax policy to make the incentive high-powered," he says. "R&D spending has sky-rocketed in Australia in the last couple of years because of this incentive."

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