It may not be worth trum-peting, but there is a positive tune to hum for the labour-sponsored investment fund sector in this year’s RRSP season.

This hard-luck asset class, created by the federal government in 1988 to provide seed investment to venture-capital companies and smaller Canadian businesses, is basking in a shaft of sunlight these days: some LSIFs are finding some of their long-term equity investments are starting to pay off.

“You’re seeing more companies exit from their investments,” says Dan Hallett, president of Windsor, Ont.-based fund analyst Dan Hallett & Associates Inc. , who has followed LSIFs since their inception. “We knew it would happen eventually. They couldn’t all be lousy investments.”

Slightly more than one-third of the 91 funds in the $4-billion asset class tracked by Morningstar Canada show a positive annual return in the three years ending Dec. 31, 2006. That’s up from just two positive three-year performers a year ago.

One good-news story involves the $60-million B.E.S.T. Discoveries Fund I, which returned 25.2% in 2006, a year in which it sold three investments in all-cash deals, boosting its returns to top of the class.

“Remarkably, we’re seeing in-flows from various channels,” says John Richardson, CEO, president and co-founder of B.E.S.T. Discoveries Fund and B.E.S.T. Total Return Fund, based in Toronto. “On the basis of our performance, people are coming forward.”

The Discoveries fund’s asset sales also show the model can work: AssetMetrix Inc. was acquired by Microsoft Corp. in April 2006; SunGard Data Systems Inc. bought part of data manager Soliton Inc.’s business in October; and, in December, EVault Inc., an online data protection company, was sold to California-based Seagate Technology LLC.

“It’s a good time to invest in equity-type deals,” says Richardson. “We’ve gone through some of the tough times, and the companies weathered the storms.”

The LSIF program is remarkably diverse, varying from province to province and fund to fund. Crocus Investment Fund in Manitoba, for instance, suffered a high-profile collapse — but it had a mandate to invest money in public programs, which are notorious sinkholes.

Saskatoon-based, $110-million Golden Opportunities Fund has several investments in the oil, energy and resources services sector in its portfolio, which returned 3.1% in three years to the end of Dec. 31. The fund has played a part in developing Saskatchewan’s strong energy and resources sector.

LSIFs, which originally came with a 15% federal tax credit, gained popularity in the late 1990s after provincial governments added tax credits to provide more incentive to invest. But many LSIFs were caught up in providing early-stage venture capital during the technology bubble. By early 2000, the bubble was deflating and many of the funds’ equity investments burned out.

Provincial tax credits — ranging up to 15% — are available in every province except Alberta, which never built an LSIF program. The Ontario government has opted to drop its provincial credit to 10% from 15% for the 2009 taxation year, to 5% in 2010 and then to zero in 2011. The industry lobby hopes to persuade Ontario’s Liberal government to reverse its position.

“We continue to gather facts about how much LSIFs are contributing to the economy, in terms of growth, development of intellectual property and commercialization of ideas from our universities,” says Richardson. “Combined with positive results of the funds, hopefully, it will be enough of an argument to reverse some of that legislation.”

Without a provincial tax credit to counter losses, the funds are riskier. Investments in the funds have declined each year since the announcement, meaning a greater proportion of their companies will wither on the vine.

On the bright side, when LSIFs aren’t invested in equity, they are invested in mezzanine debt financing, an investment class that is relatively conservative compared with equity venture capital. About 60% of all LSIF assets are invested in debt financing, according to John Sterling, chief executive of Toronto-based ROI Capital Ltd. ROI took aim at this niche market when it started investing in 2002, just after the tech meltdown.

“With mezzanine financing, we have a much bigger market,” says Sterling, noting that most equity deals in Ontario used to be invested in Ottawa-based tech ventures. “There’s a huge demand for the type of financing we’re doing.”

Along with Vancouver-based VenGrowth Private Equity Partners Inc. , ROI is among the biggest fundraisers in the LSIF industry; last year it raised $39 million — more than 30% of the cash went into the LSIF market. Its $66-million Return on Innovation Fund I returned 3.8% in the three years to the end of 2006.

@page_break@Sterling says mezzanine debt deals are structured in many ways, so advisors should ask about the covenants of the deals. “We usually get an equity return upside,” he says. “If our debtors do well on their net income side, we’ll get to participate in either equity or cash flow.”

The effective interest rate on this type of debt can reach toward 20%, but default rates are high. Hallett says virtually all mezzanine debt is high on the risk scale for average retail investors: “Just out of prudence, you have to view them as an almost speculative asset class.”

(If you’re wondering where all that yield disappears to, look to the punishingly high management expense ratios on LSIFs, which range from 2% to 9%, for an average of more than 5%.)

Part of the reason for investing heavily in mezzanine debt stems from the fact investors must stay invested for eight years to claim the tax credit. That time limit is on the horizon for many of the investments made during the tech boom, for which the funds will have to meet potential redemptions.

It’s far easier to time debt maturity to a redemption schedule than to time an equity exit to redemptions, explains Geoff Horton, managing partner at Toronto-based VentureLink LP. In the event that a debtor can’t meet its payments, it’s also easier to take a claim through the courts to recover at least some of your capital.

“In theory, it is a lower-risk pro-position,” says Horton. “It may not be 100% secure, but you’re taking some sort of cash flow or recognized asset in the business, so that means your chance of loss is lower.”

VentureLink has about $200 million invested in eight funds, the largest of which is VentureLink Financial Services Innovation Fund, which has returned 12% in the year ending Dec. 31. IE