From dog to diamond

Not all labour-sponsored venture capital funds – with their high management fees and generous tax credits – end up as investment disasters.

But to become investor favourites, the VC funds – which are in the process of being wound down in most of the country – are required to transform themselves, and in one case take a path that has not been trodden before.

Consider the path taken by the Business, Engineering Science & Engineering Discoveries (BEST) Fund, which started life in the late 1990s. It is now a publicly listed limited partnership, that pays its owners $0.50 per share per year. Shareholders of the company with $38.6 million in assets received one quarter of that payment last week.

“Under chief executive John Richardson, the fund has been transformed from a dog into a diamond,” said John Horwood, a director of wealth management at Richardson GMP, whose clients are now investors in the BEST Funds. “John is the deepest researcher of small companies I have seen.”

The transformation for the BEST fund started about eight years back when the manager, who also manages other investment funds, decided that fixed-income investments made better sense than equity investments.

One key reason for that new focus on providing senior debt to “rapidlygrowing private Canadian companies with recurring revenues,” was that such investments provided more ways for the manager to get their investment back at the end of the loan. Richardson identified four possibilities: from growth in the underlying business; through the investee company receiving tax credits; from so-called maintenance cash flow and via the sale of the business.

And the manager mitigated the risk through a “conservative” lending philosophy: once value was established, the manager would lend 10 per cent. “It has paid off,” said Richardson who estimated loan losses have been around one per cent. From the investee company’s perspective, such debt investments, which feature rates in the 10 per cen to 15 per cent range, aren’t dilutive.

Another key reason behind the change was that labour-sponsored funds had the worst of all worlds, a high cost structure, a reflection of being a public company and a mutual fund company. “We had to reduce costs,” said Richardson.

So at the time when the laboursponsored fund world was nearing its sunset years, the BEST board launched a strategic review with the idea being “to create different options that would deliver value.”

The solution: re-organize the BEST fund into a publicly listed LP that was similar to the private debt LPs it was already providing to friends and family and accredited investors. Those private active LPs were attractive because they generated active business income, were Canadian controlled, were tax efficient – and suited investor needs.

And the manager had done lots of them: typically it would raise $5 million at a time, place a 30-month term on each LP and make at least 10 investments. Those separate LPs have now been combined into an open-ended fund: the BEST Active 365.

Richardson GMP’s Horwood is positive on both the debt and equity fund. “The BEST 365 is short-term debt with 12 per cent to 15 per cent coupons and warrants. The public LP is attractive because it trades at a big discount to NAV, pays a yield of around 8 per cent with no value placed on the 40 per cent of the fund that is in equity investments.”