Labour Sponsored Funds
LSIFs carry big risks, with potential to match
Wilder stock markets swings; the expectation of lower future returns;
and plain old desire for something different have all created a market
for what' s known as alternative investments. The term describes a
class of investments that isn't mainstream, isn't suited for
everybody, but that offer attractive benefits. Namely, these benefits
are the potential for high rates of returns and diversification. For
the next two weeks, we'll talk briefly about the pros and cons of one
kind of alternative investment - labour sponsored investment funds
(LSIFs). This week, we start with a discussion of risks.
Venture capital
LSIFs are otherwise known as venture capital funds to describe the
types of companies in which they invest. Venture capital companies are
usually very young enterprises. They can range from fresh start-up
firms that consider revenues of any sort to be a luxury; to more
established firms that have developed a market for its product or
service but need money to finance the next growth phase.
In most cases, venture capital companies are private - i.e. most don't
trade on any public stock exchange like the Toronto Stock Exchange
(TSE) or the Canadian Venture Exchange (CDNX). The private nature of
most of these firms is at the root of both the risks and rewards of
this asset class.
Valuation Risk
Valuation risk is perhaps the most significant and most misunderstood
of LSIF risks and is two-dimensional. When the LSIF manager decides to
invest in a company, how can s/he be sure that a fair price is paid?
With publicly traded stocks, the stock price at any one time reflects
the aggregate opinion of thousands of market participants that have
reviewed and evaluated a company's financial information. With private
companies, the LSIF manager may be one of just a handful of people
evaluating its worth. In other words, when deciding whether or not to
invest, the LSIF manager doesn't have the public markets to use as a
point of reference - thereby making the job of assessing a fair value
that much tougher.
The other side of valuation risk refers to the ongoing valuation. Once
an investment in a venture is made, the company must be valued on an
ongoing basis to ensure the LSIF's daily unit price fairly reflects
the value of its underlying investments. This is needed to ensure that
both buyers and sellers are treated fairly. Regular mutual funds, like
Ivy Canadian, simply use the closing TSE and NYSE market prices of its
stock investments to calculate the fund's unit price. LSIFs, which all
have substantial investments in private firms, must establish internal
policies to fairly value each of its venture investments to arrive at
a unit price for the LSIF.
It may become quite obvious at this point that there is a ton of
subjectivity involved in the whole valuation process - from deciding
what to pay for ownership in a company to making sure each
investment's carrying value is reflective of reality.
Despite the subjectivity, investors should take some comfort in the
fact that a fund's valuation is subject to review by an independent
third party, usually a team of business valuation experts. If these
outside valuators disagree with the value assessed by the LSIF, the
fund may have to adjust its value (usually down). However, there are
potential conflicts of interest since a LSIF's auditor often acts at
that independent third party to perform the annual fund valuation.
To draw an analogy of how well they really check the value of each
company, suffice it to say that these independent valuators don't
reinvent the wheel, they just make sure it's still round.
Liquidity Risk
Liquidity refers to the ease with which an investment can be turned
into cash - i.e. liquidated. Since shares in private companies don't
trade on any organized exchange, there is no facility to liquidate an
investment in such firms. Hence, a large part of a LSIF's success
hinges on its ability to "bring" liquidity to its investment.
That can mean:
helping a company "go public" (i.e. help it get its shares traded on
a stock exchange);
selling its stake in the company to another firm; or
the more unusual case of the LSIF actually selling its stake back to
the company's management.
Whatever the means, exiting investments in private companies at a very
handsome profit is the ultimate goal of the LSIF manager.
Business risk
The final major risk of investing in any company, particularly private
ones, is that of business risk. Key to a company's success is its
ability to execute its business plan, which requires strong
management. Another major factor is the overall health of the industry
in which a company resides. The list of "what can go wrong" is long,
but many factors can contribute to a company's success, or lack
thereof. It is this set of critical factors that must be thoroughly
researched by the LSIF management team and taken into consideration
when assessing a company's value.
This week's discussion really just scratches the surface of the bigger
risks relating to LSIFs. Next week, we'll look at the brighter side of
venture capital investing, tax implications, and some suggestions on
how to incorporate LSIFs into your portfolio.