Already vulnerable to the volatile technology sector and investors’ tendency to chase returns in higher-performing asset classes, labour-sponsored investment funds in Ontario bore the brunt of a 2005 policy change to phase out the provincial LSIF tax credit by the end of the 2010 taxation year.

So, it’s no wonder major LSIF players, such as Toronto-based VenGrowth Asset Management Inc. , with more than $1 billion in assets under management, and Vancouver-based GrowthWorks Capital Ltd. , with more than $800 million in AUM, are celebrating Ontario’s decision in December to extend the phase-out of the LSIF tax credit by one year and increase the maximum investment that qualifies for the provincial tax credit to $7,500 from $5,000, effective Jan. 1, 2007.

“We’re obviously very pleased with the government’s decision,” says Les Lyall, president of the Canadian Retail Venture Capital Association and chief operating officer at GrowthWorks. “We think that it’s good for the asset class — and it’s good for investment advi-sors and their clients.”

The updated LSIF tax credit phase-out schedule in Ontario maintains the 15% tax credit rate until the end of the 2009 tax year, then reduces it to 10% for the 2010 tax year and to 5% for the 2011 tax year. The credit will be eliminated for the 2012 tax year and thereafter. Ontario believes these changes will give LSIFs time to develop investment strategies and provide continuing support to the portfolio of companies in which they have invested.

In addition to the provincial tax credit, Ontario LSIF investors — as with LSIF investors across the country — benefit from a federal tax credit of 15%, to a maximum of $750. LSIF investors must hold their investments for a minimum of eight years or face an early-redemption penalty. As well, inves-tors who put LSIFs in their RRSPs are entitled to the corresponding deduction.

David Ferguson, managing general partner at VenGrowth, calls the Ontario government’s decision “a positive step.” The difficulty, as he sees it, is that up-and-coming entrepreneurs building knowledge-based businesses continue to compete for a shrinking pool of venture capital.

“There’s 93% less start-up funding available to Ontario entrepreneurs than there was five years ago,” says Ferguson, “What you really want to have is a sizable and relatively constant pool of venture capital available to entrepreneurs.”

Much of that pool comes from LSIFs. The CRVCA reports that retail funds contributed 55% of all new venture-capital commitments in 2006. But total funds raised that year were just $1.6 billion, compared with more than $3 billion in 2002.

The shortage of funding is a country-wide problem, but there are some signs the tide is turning. Canada’s Venture Capital & Private Equity Association (CVCA) reported in November that investment activity in Canada’s venture-capital industry in the third quarter of 2007 was $512 million — up 17% over the previous quarter and up 47% over the same period in 2006. Ontario attracted $288 million in the third quarter and bounced back to fifth place among North American markets from its 14th-place ranking in the second quarter.

Government policy may be part of a long-term funding solution. On top of the Ontario government’s LSIF tax credit extension, Richard Rémillard, the CVCA’s executive director, points out that Ontario, British Columbia and Alberta are all moving forward on fund-of-funds vehicles that bring government and private-sector partners together to invest in venture-capital funds. Meanwhile, New Brunswick announced in December that it is preparing to amend its Income Tax Act to allow investors to buy venture-capital funds for their RRSPs, something not allowed in previous years.

“Many governments are recognizing that the venture-capital industry is having a challenging time raising funds. That raises the risk of investment in new ventures not being as robust as it could and should be,” says Rémillard. “Knowledge-based industries are increasingly a motor of our economy. To get knowledge-based firms properly funded so that managers don’t spend all their time looking to raise that next round of money but actually run their companies and develop new products, you have to have a Canadian venture-capital industry that is robust and appropriately funded itself.”

According to CVCA data, during the first three quarters of 2007, more than 55% of all venture capital invested in Ontario came from the U.S. and other foreign funds — well above the national average of 41%. That’s clearly good for growing companies because it demonstrates an established pattern of access to a larger pool of potential investors.

@page_break@However, Ferguson observes, foreign investors tend to shy away from investing unless there is also strong interest from local venture capitalists. As well, he says, foreign venture-capital investment tends to focus on companies that have already been developed to a certain stage, leaving the early funding of start-ups to domestic investors.

Those domestic investors are, of course, encouraged to take the risk by the LSIF tax credit. Without substantial federal and provincial tax credits, it’s hard to make the case for investment in venture-capital funds, which, the CVCA reports, collectively returned just 2% a year for the 10 years ended June 30, 2007.

In making a case for the continuation of Ontario’s LSIF tax credit and a further increase in the maximum qualifying investment to $10,000, Ferguson says: “If you want a diversified economic base, you really want to promote the knowledge-based sector. We have the people. We have the ideas. What we really need is the capital to be able to support those companies.” IE