Thursday, September 20, 2007

Still looking for an alternative for LSIFs

Continuing on LSIFs ...

Some background: LSIFs operate like VC funds except that they raise money from individuals (or "retail investors") instead of institutions. They have been a popular option for Ontarians at RRSP time, since -- in addition to the usual benefits of putting money into an RRSP -- LSIFs have also offered a 15% federal tax credit and a 15% provincial tax credit. They began in Quebec and federal tax credits were introduced in 1987. Four years later, Ontario tax credits were added under Bob Rae's government.

The funds ended up coming under attack from the left and the right, from sources as diverse as Buzz Hargrove and the C.D. Howe Institute. Within the investment community, the most common complaints were that LSIFs delivered poor returns while spending a high percentage of the invested funds on management fees.

Dalton McGuinty's government declared a moratorium on LSIFs in 2004, saying it would review the program to see if LSIFs were still "an appropriate vehicle" for increasing VC investment. In August 2005, it announced that the tax credits would be eliminated. Initially, this was to happen right away. Some people cheered the decision, but after an outcry from the LSIF industry and some parts of the tech business community, the government adjusted its plans and decided to phase out the tax credit over several years. The 15% tax credit is now scheduled to drop 5% each year starting in 2009, disappearing entirely in 2011.

According to the government, LSIFs were no longer needed because "Ontario's venture capital market is much healthier now" with "200 private sector venture capital funds and close to 200 U.S. funds investing in Ontario companies over the past six years." It had no plans to replace LSIFs with another government-supported program to help raise venture capital from individuals.

The main defender of LSIFs, not surprisingly, has been the LSIF industry, initially under the banner of the Association of Labour Sponsored Investment Funds -- a name that was changed earlier this year to the Canadian Retail Venture Capital Association after LSIF had become a tainted term.

The most prominent critic, at least as far as writing full reports attacking LSIFs, has been Douglas Cumming. He first started getting attention years ago with a paper he wrote claiming that LSIFs unfairly "crowd out" other VCs from the market. He's been repeating the same message year after year since then and found a receptive audience, particularly among those with an ideological predisposition to support his views.

The two have debated each other, sort of, in their respective reports and responses and in the pages of the National Post. They often seem to be talking past each other. Responding to Cumming's C.D. Howe paper, CRVCA gets off to a poor start, flipping out over Cumming's comparison of the return on treasury bills to that of LSIFs. Somehow, the CRVCA completely misses Cumming's point and suggests that he doesn't understand the difference between no-risk t-bills and high-risk venture investments. Of course he knows the difference, in fact, it forms the entire basis of his point: the so-called "high-risk, high-return" LSIF couldn't even match the lowly t-bill for ROI over a 12-year period. Like back in the bust era when people would say they should have kept their money under their mattress. I'm sure Cumming would have used that, but his data show LSIFs slightly outperforming mattresses, so he moved one step up to t-bills. It's such an obvious point that it's hard to believe the CRVCA report was vetted by many eyes before its release. (This is supported by its use of "light years" as a measure of time. You'd think that it wouldn't take too many reviewers to spot this error.)

Cumming talks about the inefficiency of LSIFs, with a higher percentage of the funds being spent on management expenses than you'd find in other VC funds or with mutual funds. The CRVCA lists some of the added expenses of an LSIF versus an institutional VC fund -- all true, but not speaking to Cumming's point that it's an inefficient system with money going to administrative expenses instead of being invested. He wasn't accusing LSIFs of throwing the money into a bonfire and his charge of inefficiency isn't answered by receipts.

But the CRVCA does provide weightier rebuttal, particularly in its discussion of Cumming's "crowding out" accusations, which were never strongly backed by evidence. With the future of LSIFs in doubt, we should be seeing institutionally-backed VCs expanding their market presence, if they were previously being crowded out. We haven't seen anything like that -- just the opposite, actually, as the CRVCA points out. Buried in the last paragraph of a section on page 5 is an interesting statistic that deserves much more prominence. The CRVCA says that of all reported VC deals of $10 million or more in Canada between 2005 and 2007, 61% of them were with companies that already had an LSIF investor. If accurate, it's a statistic that should be highlighted in any attempt to persuade the Ontario government to change its mind about LSIFs, or at least about retail VC funds.

The CRVCA also makes some good points on portfolio size and governance. It does what it can to respond to accusations of high management fees. The CRVCA would be able to discuss in detail how those fees are spent, but it doesn't do so in its report, which suggests that it doesn't believe it would be helpful to its case. In discussing LSIF performance, the CRVCA cites a 2006 report from the Canadian Venture Capital & Private Equity Association (CVCA) which includes a graph showing retail VC funds outperforming other VC funds in 10-year returns. But that report also showed LSIFs with a -1.4% return (while U.S. VCs were said to have a +27.6% return over the same period) so it may not be much to brag about. But the numbers do underscore how important the tax credits have been for LSIF fundraising.

But the problems of LSIF returns and management fees are familiar criticisms. We didn't need to read an academic paper (or six variations on the same paper) to know about these issues. What is original in Cumming's papers seems to be a weakly-supported ideological stance built on spinning data that is dubious when it's not stale.

At the same time, the familiar criticisms are still valid and it's easy to see why many investors had soured on LSIFs -- even before the moratorium in Ontario (not to mention the Crocus experience in Manitoba). It's not as easy to understand why the government would pull the plug on the tax credit, especially at a time when it was creating a new innovation ministry and making investments into the infrastructure to support new tech companies. Trying to increase the number of these companies while simultaneously reducing the funding options they'll have seems like odd policy. We have an election coming up shortly in Ontario and none of the parties has said that it would keep the LSIF tax credit or replace it with something similar. Institutions have been pulling back from investing in Canadian VC funds, and now the retail market has taken a big hit in Ontario.

I wasn't sad to hear the Ontario government's announcement that it was discontinuing the LSIF tax credit, but that was partly because I thought the industry and government would work together to figure out a replacement. The LSIF tag had started to carry a lot of baggage, both with investors and with government, so this seemed to be a good opportunity to start pitching an alternative. But that was two years ago, and there's been little apparent movement in that direction. It was encouraging to see ALSIF change its name to CRVCA and start using the term "retail venture capital" -- that's what needs to be promoted, not LSIFs, which is just one form of a RVC fund. The whole "labour-sponsored" gimmick could certainly be scrapped. In Ontario, at least, these funds have little to do with unions or unionized workers. But it seems that most of the focus has been on saving LSIFs as they are instead of coming up with a more palatable replacement. It will be a shame if we lose an entire pool of potential investors for early-stage technology companies in Ontario.

Tuesday, September 18, 2007

LSIF critic spins tales for Fraser, Howe instututes

The Fraser Institute just published a report on labour-sposored investment funds (LSIFs) that is almost identical to a report published earlier this year by the C.D. Howe Institute. And with good reason: both papers have the same lead author -- Douglas Cumming.

Cumming doesn't think much of LSIFs and thinks governments in Canada at provincial and federal levels should discontinue the tax credits provided to LSIF investors. Ontario has already announced that it is phasing out the LSIF tax credit.

There are legitimate criticisms that can be made of LSIFs, but for years Cumming has been augmenting these bona fide critiques with ideologically-driven spin on what is often dubious data to begin with.

Reports from Howe and Fraser are usually so driven by ideology that you rarely have to read past the title to know what they're going to say. That's particularly true for these reports, since Cumming has been distributing different versions of the same report for the last seven years.

The Canadian VC industry has seen a lot of changes over that time, but as an ideologue trying to support his views, Cumming is always able to draw the same conclusions. To use a Stephen Colbert line, "he believes the same thing Wednesday that he believed on Monday, no matter what happened Tuesday." And, in this case, Tuesday is the last seven years, and a lot has happened, but Cumming has been a rock of consistency throughout these wildly-changing times.

Which isn't all that surprising, seeing how stale much of his data is. He has claimed for years that LSIFs "crowd out" other VC funds from the market. The most recent data he uses in this analysis is now six years old. He actually uses data from more years in the 1970s than in the 2000s.

While Cumming will occasionally mention techniques like regression analysis to provide a veneer of legitimacy, his favourite tool is spin. For example, Cumming says that LSIF managers -- on average -- have more than twice the number of companies in their portfolio as VC managers. The conclusion he chooses to draw from this is that LSIF managers are just too swamped to become involved in meaningful ways with their companies and, therefore, fall behind on the learning curve compared to VC managers.

But this is one of those great "facts" (and it's questionable whether it's a fact at all, even though it would be fairly easy to check) that can be used to support whatever you want it to. If you're an LSIF supporter, you can conclude that LSIF managers, by being involved with more companies, get to see more situations, interact with more entrepreneurs, and deal with more business issues in a shorter period of time than their VC counterparts. That would put them ahead on the learning curve. It's not any more reasonable than Cumming's position, but neither is it any less-supported by the data he cites.

Another example: Cumming says that LSIFs don't have to be as concerned about ROI as other VCs (because investors get the tax credits no matter how the fund performs), and this enables them to spend more to attract deals in a non-level playing field where VCs can't easily compete. Okay, but if it's true that LSIFs can spend more, then -- for the same reasons -- they should be able to outbid VC firms for management talent. That would mean that LSIFs should be able to attract a more talented team than VCs. But that's not a conclusion Cumming wants to promote, so he doesn't mention it -- even though it's as much a consequence of his assumptions as the point of view that he does want to support.

One more, and then I'll stop. Cumming points out that individual LSIF investors only account for a tiny percentage of the amounts put into any fund, as opposed to a limited partner of a VC fund, who would account for a far higher percentage of the total fund. The conclusion he wants to promote is that LSIF investors have much less control over fund management than VC investors and exert less pressure on managers to perform. And that's reasonable enough, but an LSIF supporter could take that very same data, and point out that LSIFs have to raise money on a continuing basis (or, more realistically, an an annual basis when RRSP season comes around) and, therefore, have to face the market every year and convince them to invest. The pressure to perform would be continual. And LSIF investors typically commit for a slightly shorter period than LPs with VCs, which again makes it easier for them to walk away from a poor performer. I don't buy that argument either, but it's as reasonable as Cumming's.

That's the great thing about "data" -- with a little selectivity and spin, you can reach just about any plausible conclusion you want ... as long as you're not too thorough or rigorous.

I'll continue with this topic -- and the LSIF industry's response to Cumming (also flawed) -- in a future post.

Wednesday, September 12, 2007

How much funding for Canadian startups?

How much money have investors poured into Canadian startup companies so far in 2007? You may think you've read that number recently, but you haven't. The actual answer is "nobody knows." Of course, no one likes that response, so they go count the things they can count and then pretend they know the answer. It's like the old joke about the guy looking for his car keys under the street light -- "this isn't where I lost them, but the light's so much better here."

Whenever you read about the aggregate level of venture capital investment, the main source of that information is news releases and other voluntary disclosures, either from the company receiving the funds or their investors. There are also securities commission filings for some investments -- some funds have to put their financial information on SEDAR and, in Ontario, many deals will will be listed in the OSC Bulletin. But most investors are not required to make any public disclosure. They often choose to do so because it would be good for the company and its image as a growing business with dependable financial backing.

In Waterloo, I work with companies every week that have closed rounds of funding that were never publicly disclosed. One of them just raised about $2 million, but you haven't read about it and it's unlikely that you ever will. Several have raised between $0.5-2 million, but those numbers won't appear in any reports you'll see.

Several months ago, Industry Canada told me they were dissatisfied with the existing estimates of venture capital deals and were going to try to come up with their own reports. So far, they're still just publishing the same numbers you'll see elsewhere. Maybe they've found that it's not easy to measure these kind of investments. I wouldn't be surprised if most -- maybe all -- of the eight-figure deals get disclosed somewhere, but there are many six- and seven-figure deals that are just between the company and their investors, and whomever they happen to tell.

In the summer I read somewhere that only one deal had been done in Waterloo Region over the first half of the year. I had no trouble coming up with six that had been publicly disclosed, and know of others worth millions of dollars that weren't. If the reported numbers are that far off for Waterloo, how inaccurate must they be for all of Canada?

And then there are companies that receive offers but turn them down. I don't mean they choose another offer instead, they just decide not to take funding. Sometimes they come to regret it, but often they're happy to grow their business without additional equity investments. You can't count that in your investment totals, but it's something that needs to be taken into account when discussing the number of companies being funded.

So, when I say that the actual answer is "nobody knows" the follow-up question would be: is that "nobody knows precisely, but we have a pretty good estimate" or is it "we really don't know, other than it's at least $X." I'm sure many people will say that it's the former, but having seen how badly the numbers have been underestimated in my area, I'm not confident that it is.

Can Windsor use a non-snub to energize a focus on innovation?

OMG, did you hear? There's a new $100 million "Innovation SuperCorridor" initiative from the province introduced in the budget...