Changes to the On–tario labour-sponsored investment fund tax credit program could spawn a new breed of LSIFs that invest a greater portion of their portfolios in publicly listed securities.

One such recently launched fund, Impax Funds Manage-ment Inc. -sponsored Horizons Advantaged Equity Fund, is investing in 100% public companies — a first in the LSIF market.

“As far as we are aware, Horizons Advantaged Equity Fund is the only LSIF that is currently investing in 100% public issuers,” says Peter Rizakos, managing partner of Toronto-based JovFunds Management Inc. , creator of the fund. “The fund has been specifically tailored to take advantage of the new legislation, which would most likely spur an increasing shift toward investing in public issuers.”

Until the Ontario government announced the elimination of its LSIF tax credit program in late 2005, LSIFs were prohibited from investing in listed companies if the cost of such investments exceeded 25% of the total cost of all investments made in eligible businesses — which are typically composed of private equities and mezzanine-debt financing in businesses with not more than $5 million in gross assets and 50 employees.

To soften the impact of phasing out the tax credit for existing LSIFs, the Ontario government has removed the limit on the percentage of publicly listed issuers that an LSIF may hold. Accordingly, LSIFs may now invest 60% of their equity capital in eligible public companies that have fewer than 500 employees and less than $50 million in assets.

The remaining 40% of assets — typically considered the “reserves” of the fund — may be invested in shares listed on a Canadian or foreign stock exchange prescribed under the Income Tax Act.

In Canada, prescribed exchanges include the Toronto Stock Ex-change, the TSX Venture Exchange and the Montreal Exchange.

Prescribed foreign exchanges include major stock exchanges in developed countries, such as Nasdaq, the New York Stock Exchange, the London Stock Exchange, the Australian Stock Exchange, Euronext Paris and the Frankfurt Stock Exchange.

The 15% Ontario LSIF tax credit will remain intact in 2007 and 2008, but will be reduced to 10% in 2009, to 5% in 2010 and completely phased out in 2011. Currently, investors in Ontario-based LSIFs may also be eligible for a 15% federal tax credit on investments of up to $5,000 and an additional 5% credit for purchasing shares of certain research-oriented small companies, for a total of up to 35% in credits. Investments must be held for at least eight years to keep the credits.

LSIF tax credits vary from province to province, except in Alberta, which does not have an LSIF program.

Horizons Advantaged Equity Fund will invest 60% in eligible small- and mid-cap stocks and 40% in large-cap stocks. The fund will maintain broad diversification across economic sectors and geographical regions.

The small-/mid-cap portion of the portfolio will be managed by Jim Huang, former portfolio manager with Altamira Management Ltd. and the current president of T.I.P Wealth Manager Inc. in Toronto.

The large-cap allocation will be managed by Toronto-based Leon Frazer & Associates Inc. , the oldest independent investment organization in Ontario. The primary focus of the large-cap portfolio will be on companies with high dividends and distributions.

“We’ve created a diversified Canadian equities fund that provides investors with the same exposure as a small-cap Canadian mutual fund, with the added benefit of a 30% tax credit,” says Rizakos.

Further, Rizakos contends, the fund addresses some of the concerns that investors have had with LSIFs, primarily with respect to liquidity and valuation of private holdings: “Most LSIF portfolios consist of private companies, which cannot be traded easily and are often difficult to value. With a portfolio of publicly listed issuers, these factors are no longer a concern.”

Arguably, valuation of private issuers has indeed been a major concern. The collapse of Manitoba-based LSIF Crocus Investment Fund last year is a good example of the problems that can be caused by weak valuation methods.

In spite of the relaxation of the investment rules, opinions differ as to whether other LSIFs will readily take advantage of the opportunity to increase their exposure to public companies, although some funds have already made the shift. For instance, the reserve portion of Toronto-based Dynamic Funds Management Ltd. ’s Dynamic Venture Opportunities Fund held the stocks of three major Canadian banks in its top 10 holdings at the end of last year.

@page_break@Meanwhile, Jay Heller, general partner of VenGrowth Asset Management Inc. in Toronto, the largest family of LSIFs in Canada, says: “It is somewhat likely that we may consider increasing our holdings in public issuers in our more mature funds. But it will not be a huge move.”

However, he does not see this happening in the immediate future, as holdings in existing funds must mature or be redeemed to free up investible cash. Although VenGrowth, which is among the largest fundraisers in the LSIF industry, could invest “new money” in public issuers, it currently sees better opportunities in the private-equities market.

On the other hand, John Sterling, CEO of Toronto-based ROI Capital Ltd. , which focuses on mezzanine-debt financing, will not consider moving into public issuers. “Even if we were starting from scratch, we wouldn’t do it because venture capital has the best deals,” Sterling says, adding that there is a huge demand for mezzanine-debt financing, which offers “planned, predictable returns” compared with the greater volatility in the equities markets.

Sterling adds that investing 60% of an LSIF portfolio in “eligible” companies that have only $50 million in assets does not necessarily offer any significant advantage because companies of such size may still be illiquid.

Heller adds that investing in public companies will be a problem for smaller LSIFs, which do not have sufficient funds to take advantage of the rule changes, as their assets would be “tied up.”

In fact, more than 75% of 124 LSIFs surveyed had assets of less than $10 million at the end of January — meaning that the rule change might be irrelevant for these funds unless they raise new money.

The Horizons LSIF is able to invest in a portfolio of public issuers because it is a new fund that aims to attract new money, according to Rizakos.

The fund was formed this past De-cember through the merger of two Toronto-based LSIFs — Impax Venture Fund Inc. and Impax Venture Income Fund Inc.

Although private equities and debt financing remain attractive for LSIFs, the risk is relatively greater compared with investing in public issuers.

Typically, the reward should also be higher, but more than half of all LSIFs had negative three-year returns as of the end of 2006.

The tax credit acts as an incentive for investors to take the underlying risk; whether increased investment in public issuers will reverse the fortunes of LSIFs remains to be seen. IE