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.