Investment in Canada’s venture-capital market grew in 2011, but storm clouds are forming on the horizon.

There was $1.5 billion invested in the sector for the year ended Dec. 31, 2011, up from $1.1 billion the year prior, according to a new report from the Canada’s Venture Capital & Private Equity Association, a.k.a. the CVCA.

The number of firms that secured one or more rounds of financing also increased, to 444 last year from 357 in 2010 — a jump of 24%.

VC fundraising activity, however, wasn’t nearly as robust. New capital raised for domestic VC funds was $1 billion in 2011, up by just 2% from the year prior, the report says.

That combination spells trouble for both innovative entrepreneurs and the Canadian economy, says Greg Smith, president of the CVCA and managing partner of Toronto-based Brookfield Financial Corp., a private-equity investment firm with $150 billion in assets under management.

TROUBLING SIGNS

“You can’t have a gap in the capital markets ecosystem and still grow companies,” Smith says. “In Canada, small and medium-sized businesses are the job engines of the economy.”

Current fundraising is the leading indicator of VC investment activity for the next two to three years, Smith says, pointing out: “You can’t continue to invest at a $1.5 billion pace [annually] if you’re only raising $1 billion.

“You’re seeing a surging demand,” he continues, “from en-tre-preneurs to finance innovation, products, ideas and technology. That’s the concern. We’ve had a shrinking investment climate for entrepreneurs for the past 10 years.”

The competitive gap in VC financing on both sides of the border is also troubling.

In 2011, innovative companies in Canada had received only 37% of the level of VC financing that similar firms in the U.S. did, down from 39% in 2010, Smith says. That capital shortfall prevents many such companies from taking advantage of the global market opportunities that lie before them and from reaching the full potential of their ideas.

“You can’t have a circumstance like that for a prolonged basis,” Smith says, “and have a thriving innovation economy.”

Without a forward-thinking environment in which young companies can get properly capitalized and invest in the commercialization of their products, the risk is they’ll pick up and leave for other jurisdictions — most notably, the U.S.

“People and capital are mobile,” Smith says. “They’ll go where the capital exists.”

Smith has made this point on multiple occasions with federal government officials, maintaining that Ottawa needs to play a substantial role in ensuring the correct policies are enacted to keep Canada’s VC market vibrant. IE