LABOURINVAIN:THELOOMINGRETURNOFLSIFS

LABOUR-SPONSOREDFUNDSCOULDBEMAKINGACOMEBACK, BUTINVESTORSSHOULDBECAREFULABOUTWHATOTHERSWISHFOR

“HAD THE FUNDS BEEN SUCCESSFUL ON THEIR OWN, THEY WOULD HAVE SURVIVED WITHOUT TAX CREDITS, BUT THEY WERE NOT SUCCESSFUL”

The Liberals promised a lot in advance of this year’s federal election, perhaps more than all the other federal parties combined. It was textbook pork barrel politicking and it obviously worked. But among the plethora of Liberal promises, it was pretty easy to miss the one about bringing back the tax credit for Labour Sponsored Investment Funds( LSIFs).

This dubious promise slipped under the radar, but it was made. Dubious because LSIFs, also know as Labour Sponsored Venture Capital Corporations ( LSVCCs or VCCs for short), have what could most kindly be described as a spotty track record in Canada. According to some investment advisors, these risk-capital vehicles, tailored for retail investors who want something a little spicier than an equity growth fund in their portfolio, have been an unmitigated disaster.

“Get out while you still can, if you can,” Dan Hallett, vice-president and principal at private-wealth management company High View Financial Group, says of LSIFs. “A good performer was one that didn’t lose money.” Hallett adds that if Justin Trudeau’s Liberals reinstate the federal tax credit without making any other changes, such as improving the governance and investment criteria of LSIFs, then they’re making a“big mistake .”

Nevertheless, the Liberals are not backing away from their promise to resurrect them, though there wasn’ t any mention of them in the new government’ s opening salvos. Perhaps that’ s fitting as many investors never understood them in the first place.

Categorized as mutual funds under securities legislation, the mandate of LS IF sis to invest in small to medium-sized private Canadian enterprises( SMEs)— typically with no more than 500 employees and $50 million in assets. Each LSIF must be sponsored by a specific labour organization, presumably to give the funds a social mandate and for the investor to qualify for federal and provincial tax credits. On a combined basis, these credits normally amount up to about 30% of the invested value in the year of purchase, giving a nice immediate pay back.

But LSIFs are long-term investments that require a holding period of five to eight years to avoid any tax credit claw back. The trouble is that most funds were unable to get companies to a liquidity event, like a takeover by a larger company oran I PO, during this window. Once the lock up period ended, many LSIFs did not have enough cash on hand to cover redemptions, forcing them to either limit redemptions, or sell off their best companies to other venture-capital investors at deep discounts. On top of that, LSIFs were charging steep management fees of 3% to 6%, roughly double to triple that of mutual fund fees. But investors aren’ t the only ones getting a rough ride.

“People look at Canada and laugh at how stupid we are to offer these tax credits ,” says Douglas Cumming, an associate professor of finance and entrepreneurship at York University’ s Schulich School of Business in Toronto. “They make our venture-capital industry a laughing stock around the world .”

In addition to liquidity problems and exorbitantly high management fees, LSIFs tend to crowd out private venture capital and lower returns in the industry as a whole by bidding up the value of the companies they invest in.

Nearly 20 years ago, however, LSIFs were highly attractive investment vehicles operating in the middle of a hot IPO market and rolling in money as retail investors lined up to get in. In their hey day in the late 1990 s, when every province except Alberta and Newfoundland matched the federal program, $5,000 invested in an LSIF could generate a return in excess of 300% in the year of investment, says Cumming, who has published a number of academic papers on the subject. This was achieved by stacking LSIF and RSP tax credit son top of each other, which resulted in being out of pocket just $1,180 ona $5,000 investment.

With such a huge return guaranteed up

“WHEN TAX CREDIT SUPPORT WAS PULLED, PEOPLE STOPPED PUTTING MONEY INTO LS IF S; THAT KILLED A LOT OF PRODUCTS”

front, no one much cared whether the actual funds made or lost money over the life of the investment. However, the fact that LSIFs were performing poorly and making it difficult for private VC funds to raise money made it difficult to justify the tax breaks.

Eventually, the party ended. In Ontario, where LS IF sf or a time became the principal form of VC financing, the government in 2005 announced plans to phase out tax credits by 2012. Ottawa was slower off the mark, but pledged to do the same by the endof 2016, but reducing it to 10% in 2015 and 5% in 2016.“When tax credit support was pulled, people stopped putting money into LSIFs; that killed a lot of products,” says Hallett at Windsor-based High View Financial Group, a company that manages family portfolios of $1 million and up.

So why would Trudeau No. 2 revive a discredited federal program that originally offered a 15% tax credit and at its height was costing Ottawa $1 billion in tax revenue per year? The answer lies in Quebec with the Fonds de solidarité FTQ —the country’s biggest LSIF and one controlled by the province’ s biggest and most influential labour group, the FTQ or Quebec Federation of Labour.

The FTQ has some 500,000 members, who account for 44% of the unionized workers in Quebec. Its $11.1-billion Fonds de solidarité FTQ is not only the country’s biggest LSIF, but also Canada’ s single biggest pool of venture capital. When it speaks, people listen. (Fonds chairman Robert Parize au is brother of former Quebec premier and separatist Jacques Parize au .)

Trudeau needed to win Quebec in order to secure a majority. Quite possibly the promise he made to the Fond sand the province’s influential federation of labour provided the underpinning for his national victory .“We talked to the NDP and Liberal parties, both came out quickly with promise store instate tax credits ,” says Patrick McQuil ken, a senior advisor at the Fonds.

In explaining their reason for reviving the federal tax credit, the Liberals noted that labour-sponsored funds in Quebec help 650,000 workers save for retirement, more than any other province. That’s not surprising because the whole movement started in Quebec in the early 1980s as a way to invest in S ME sand create jobs following a bad recession.

Today, the Fonds are invested in 2,250 companies that employ 176,000 people, according to McQuilken. And, unlike in there st of Canada, they make money. The Fonds reported a record $992 million in net income, ora 9.8% return, for the fiscal year ended May 31,2015. The compound annual return, excluding tax credits, was 7.7%, 6.9% and 4% over the last three, five and 10 years, respectively.

One reason the Fonds have outperformed LSIFs in the rest of Canada is because they have greater diversification and they invest a portion of their holdings in th ir d-party VC funds with exposure outside Quebec, including the U.S. and Europe. Another reason is that an investment in the Fonds, with few exceptions, must be held to retirement, giving the Fonds more time to realize capital gains.

In Ontario, the fact that the Liberals have restored the tax credit for labour funds will not stop them from being wound down. “Had the funds been successful on their own, they would have survived without tax credits, but they were not successful on their own,” says Geoff Horton, managing partner at Toronto’s Venturelink Funds. His LSIF is valued at $70 million, down from $250 millionin 2010, and will likely be fully redeemed by 2018. Its three-year return was -0.9% for the period ended Nov. 30, 2015. The MER is 5.9%.

In provinces where the tax credits for LSIFs are still being offered, such as B.C. and Saskatchewan, the Liberals’ promise to restore the federal portion is probably good news, at least for fund managers. But it’s probably not sound economic policy.