A toxic combination of lagging performance, future tax-credit cuts in Ontario and the receivership of Crocus Investment Fund in Manitoba are being blamed for a less than spectacular RRSP season for labour-sponsored investment funds across the country.

Final sales figures for the four-month 2005-06 RRSP season are still being tallied, but estimates based on information from many of the main LSIF players points to a decline of perhaps 10% from the $175 million in sales recorded a year ago.

Virtually all LSIF sales are destined for RRSPs, and the bulk of annual sales occur in the last two weeks of February each year. Designed to provide early capital to small companies, LSIFs offer provincial and federal tax credits totalling as much as 30% to investors to compensate for the higher risk associated with venture investing. Investors who contribute LSIFs to RRSPs also receive the corresponding RRSP tax deductions. The majority of LSIFs invest in private technology companies without track records.

Fund analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. , says sales expectations heading into the RRSP season had been largely dampened by the Ontario government’s announcement last year that it would phase out the 15% provincial tax credit by the end of the 2011 RRSP season.

VenGrowth Capital Management Inc. in Toronto was the top-selling LSIF company during the four-month RRSP season, with sales of $54 million — down from $68 million a year ago, but still good enough to be the market leader in Ontario for the ninth consecutive year.

The sector won’t be able to recreate anything close to the glory days of the late 1990s and early 2000s, says David Ferguson, managing general partner at VenGrowth, without first turning around a half-decade of underperformance.

“The bulk of the funds do technology investing. That’s a very cyclical asset class and, for the past five years, it has been a very difficult sector,” he says. “The performance compared with the Toronto Stock Exchange just isn’t there.”

Ferguson says retail clients this season were increasingly interested in LSIFs pursuing investment strategies such as mezzanine financing. Investors appear to favour “large well-capitalized firms with lots of experience,” he says.

David Levi, CEO of Vancouver-based GrowthWorks Capital Ltd. , says its related funds across the country raised $44 million this season, down from slightly less than $55 million a year ago. He lays part of the blame at the feet of the Ontario government, but says the actions of Toronto-based Retrocom Growth Fund Inc. in January, certainly didn’t help matters.

In December, Retrocom suspended redemption payments for its Class A shares because Ontario’s announcement regarding the tax credit phase-out had accelerated redemption requests from its shareholders. A month later, it announced a “significant” reduction in its net asset value would be required following an independent valuation of its investments.

This rekindled fears about the sector that had first arisen when Crocus did the same thing more than a year before, and the combination caused many investors to seek other opportunities, Levi says.

“The fact the Ontario government moved on the funds in the first place with the tax-credit phase-out put the spotlight back on Crocus. Then it went further with Retrocom,” he says. “That combination made for a weaker year than we had hoped. It left a lot of people saying, ‘Maybe we’ll wait a year and see how things shake out’.”

Hallett predicts the eventual shake-out will include the downfall of many LSIFs because their key fundraising incentive will have been taken away by Canada’s largest province.

“If that does indeed happen, most of these funds probably won’t survive,” he says. “Clearly, getting bigger and securing a steady flow of fundraising will be key to the survival of LSIFs.”

But the sales picture in the RRSP season was not uniformly grim. ROI Fund, managed by Toronto-based Return on Innovation Fund Inc. , was a strong seller this RRSP season with $39 million in sales vs $28 million last year.

CEO John Sterling credits much of the fund’s success to the company’s policy of mezzanine financing, a lower-risk strategy that he says is more suited to the LSIF sector than taking equity stakes in small companies.

ROI makes loans to established companies for five years to help them build their businesses, and receives monthly cheques that cover principal and interest in return. The strategy offers automatic exit opportunities, in contrast to most other LSIFs, which must find buyers for their holdings. “At the end of five years, we’re completely out of the [investee] companies,” he says.

@page_break@As for the eventual elimination of the Ontario tax credit, Sterling says, he’ll deal with that when the time comes. Meanwhile, he’s expecting some big years for ROI Fund: “People will want to get in while they can get the 30% tax credit.”

John Varghese, managing partner of VentureLink LP in Toronto, is another fan of the mezzanine route. He credits it for that LSIF’s success in posting sales of slightly less than $20 million this season, up almost 15% from 12 months ago. “We think debt is the way to go in this space. It’s conservative investing. We kick out steady returns with no volatility,” he says.

Varghese was happy with the season’s performance, especially considering his group only bought out its management contract from Skylon Advisors Inc. , a subsidiary of CI Financial Inc., in December. “We were pretty late coming to the game. We only hired our sales force in November and we were competing against others who had been running the full year,” he says.

Varghese predicts a good year next season because consolidation is continuing and funds are getting bigger. “From the clients’ perspective, that’s important,” he says. “We can keep our costs down. The smaller you are in size, the less you’ll be able to raise capital effectively. The bigger you are, the more scale you have and, theoretically, you’ll have proven yourself.”

VenGrowth’s Ferguson is also very bullish about his fund’s prospects; he thinks a tech recovery is around the corner: “Venture capital is a cyclical asset class. When the returns are there, people are very interested. The technology market is as big as the oil and gas sector. For a client to have a diversified portfolio, he or she should have some exposure.” IE