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By Jonathan Chevreau
National Post
FP Investing
Thursday, September 08, 2005 |
Now the Ontario government has announced plans to scrap its 15% tax credit on labour-sponsored investment funds (LSIFs), the venture capital industry is anxiously waiting for the other shoe to drop.
Adrian Mastracci, investment counsel at Vancouver’s
‘fee-only’ KCM Wealth Management, says, “They were not really investment quality for the most part. They were primarily tax driven.”
That would be the end of the matching 15% federal tax credit. Former LSIF executive Denzil Doyle expects it's just a matter of time before the feds follow suit.
"My bet is the second shoe is going to fall," Doyle says. "That would be the end of the labour-sponsored program." Existing funds may survive, Doyle hastens to add, but it would "be the end of raising money."
Federal Finance spokesman David Gamble says the department is talking to its counterparts in Ontario to monitor the impact of such an action but has made no definitive decision.
David Levi, president of Vancouver-based GrowthWorks Ltd., is more optimistic. He was in Ottawa yesterday and says discussions with government officials indicate the 15% federal credit will remain intact. The same goes for the matching credit in several other provinces. It's not even clear Ontario will definitely axe its credit, since it has given the industry three weeks to discuss how it could improve the program.
Its press release caught the industry by surprise when it was issued on Aug. 29. But the timeline was ambiguous -- the tax credit is still intact for the balance of 2005 and the door appears to be open beyond then.
In its last budget, Ontario announced a moratorium on the creation of new LSIFs. Fund analyst Dan Hallett says that was necessary because there were too many small LSIFs in the province. Ontario wants to encourage existing funds to grow to a sufficient size, which is occurring through consolidation.
Doyle's Capital Alliance fund was itself absorbed by GrowthWorks and he has returned to Doyletech Consulting. But he calls the end of the provincial tax credit "extremely short sighted."
If Canada relies too much on U.S. sources of venture capital, more head offices will relocate there, Doyle says. "Technology-based enterprises are footloose and fancy free. They're not like mines and sawmills that have to stay put regardless of who their financial backers are."
Doyle blames the poor performance of many LSIFs on the pacing requirements which force funds to invest most of their capital within a year of being raised -- even if valuations are pricey.
The Canadian Venture Capital Association had a mixed reaction to Ontario's press release. The CVCA's loyalties are divided, since it represents both LSIFs and private venture capital funds whose customers invest without the lure of government tax credits: chiefly giant pension funds.
CVCA president Dr. Robin Louis says some in the VC industry view an end to the 15% Ontario tax credit as levelling the playing field. But at the same time, if the industry was already regarded as too small, "taking away one source of capital makes it worse."
Labour funds were a prisoner of their own model, says Louis, president of Vancouver-based Ventures West Management Inc. Small ticket sizes ($5,000) mean high administrative expenses and high fees.
LSIF returns are further hampered by the requirement to keep between 20% and 40% liquid in order to handle redemptions (the amount varies by province.) They must shoot for VC-style returns while investing only a portion of the capital they raise, Louis says.
As a result, few LSIF returns match the annual 20% gains private venture capital funds are expected to generate once they get beyond the ramp-up phase.
In the early days of LSIFs, investors didn't squawk, because they enjoyed upfront tax credits of 30% if both federal and provincial credits kicked in. Those combined credits were once 40%.
Cut that to 15% or even nil and it's unlikely the industry could raise the $2.5-billion it sold in LSIFs in 2003 and 2004.
"The tax credit was one of the dominant reasons investors have flocked to these funds," says Jamie Golombek, a vice-president at AIM Trimark Investments.
Many financial advisors are happy to sell LSIFs because they receive instant commissions of 6%. One advisor who doesn't recommend them is Adrian Mastracci, president of Vancouver-based KCM Wealth Management.
"I'm happy to see the Ontario government is coming to its senses in getting rid of these things," Mastracci says, "They were not really investment quality for the most part. They were primarily tax driven."
Because of the eight-year hold period, existing LSIF investors -- including yours truly -- have little choice but to hang on to the bitter end. To do otherwise means repaying the tax credits, which would add tax insult to investment injury.
The lesson investors can draw is an old and familiar one: don't let the taxation tail wave the investment dog.
Even so, angel investor Tony Humble still sees a need for a rejigged program to defray risks for affluent investors funding early stage business ventures.
In a series of articles on angel investing that debut in next Monday's Financial Post, Humble describes the need for an Innovation and Productivity Tax Credit that would be repaid to governments only after ventures prove successful.
That sounds promising. As always, the devil is in the details. Having experienced both the potential and the pitfalls of the LSIF program, let's hope a major rethink will help all sides get it right next time.
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