Labour fund moratorium
Ontario budget puts LSIFs on review

Greg Sorbara tabled his first budget as Ontario's finance minister. Aside from the much-disliked health care tax, there were a couple of tidbits relevant to investors - venture capital investors to be exact. Personally, I was hoping that capital repayment LSIFs would finally be killed as proposed by the previous government. While that didn't happen, some positive measures were contained in Paper C (see Part 4) of the full budget papers regarding this popular class of funds.

Insufficient assets

A key observation of the recent budget was as follows: "In the last several sales seasons, a number of newly registered LSIFs have failed to raise sufficient capital to be viable investment companies for the long term. LSIF capital is spread too thinly among too many LSIFs and many of the existing LSIFs are too small to be viable long-term investors."

There are two key criteria when it comes to LSIFs. I do not recommend LSIFs with assets below $50 million. It's a general rule of thumb based on an estimate of a bare minimum asset level required for a LSIF to properly diversify its investment portfolio and remain cost-competitive.

Another major criterion is to never recommend brand new LSIFs because there is too much uncertainty regarding how much money a fund will raise. Given that a $50 million asset base is a must, I have to be reasonably confident of a fund's ability to raise $50 million within three years or so. A fund's first fund raising year - along with the 'buzz' on the street - will give very clear insight into whether or not a fund can attain this goal.

The aggressively marketed Terra Firma LSIFs nicely illustrate this risk. Launched early this year, the goal was to bring more of an institutional venture capital market to the LSIF retail universe. Part of their structure included lowering fees in this pricey class of funds. The funds attracted just $1.25 million in total across all three offerings. As a result, the funds have taken the cost-cutting measure of terminating their relationships with the two previously engaged venture capital managers. As it is, either the funds will have extraordinarily high costs, or the fund's sponsor (IPM Funds Inc.) will have to pick up the tab on excess fees for a while. Neither option is sustainable for very long and the funds simply don't have enough capital to really execute the planned strategy, in my opinion.

LSIF fund mergers

It's exactly this kind of situation that spurred a few LSIF fund mergers in the late 1990s. First Ontario Fund, for example, absorbed the old Trillium Growth and FESA Enterprise LSIFs. But there are significant hurdles to LSIF mergers thanks to both tax and legal implications. For instance, some funds are registered in only one province while others are registered nationally. Mergers also impact required investment levels.

Proposed measures will allow funds to merge via a purchase of the 'terminating' fund's assets. This will also avoid the unfavourable outcome that mergers have on investment pacing requirements.

More importantly, making LSIF mergers easier will help shareholders in funds with insufficient asset bases.

Other proposals

It was also proposed that LSIFs would be allowed to hold controlling positions in investee companies, which is not currently allowed. Also, for up to 1/4 of its venture portfolio, LSIFs will be permitted to buy public companies.

Interestingly, the province introduced new proposals to allow a new type of fund to raise capital from institutional, corporate and accredited investors. The Ontario Commercialization Investment Fund (OCIF) would focus on the commercialization of the innovation born in research institutes. The institutes - including universities, colleges of applied arts and technology, Centres of Excellence and hospital research institutes in Ontario - would also sponsor the funds and occupy seats on each fund's board of directors. LSIFs would be precluded from investing in OCIFs but, otherwise, they sound an awful lot like the current community small business investment funds.