Labour-sponsored venture capital funds aren’t doing the job they were set up to do: they’re performing below par, they’re costing billions of dollars in lost tax revenue and they’re hurting private VC funds in the process, according to a recent report from the Fraser Institute in British Columbia.

“Tax savings are driving the investment, not returns on investment,” says Douglas Cumming, co-author of the report and Ontario research chair in economics and public policy at York University’s Schulich School of Business. “The tax monies that individual investors get is so generous even without a return on investment, you’d still keep putting your money in.”

In labour-sponsored funds, provincial tax credits are combined with matching federal tax credits to give investors an immediate financial benefit, Cumming notes in the report, entitled Crowding Out Private Equity: Canadian Evidence. For example, if a provincial and federal government each give a 15% tax credit, the norm across Canada, a $5,000 investment would generate a tax credit of $750 from each government, totalling $1,500.

The report contends that these tax credits have cost Canadians billions of dollars since their introduction. In 2006 alone, they cost about $300 million, note Cumming and co-author Jeffrey MacIntosh, a member of the University of Toronto’s Faculty of Law.

Such tax savings go a long way toward making investors happy — and less focused on performance, which is dismal, Cumming says: “Performance has traditionally been worse than that of a 30-day treasury bill index. That’s the easiest benchmark to beat. It’s your minimum hurdle.”

Part of the performance problem is linked to inexperienced managers and high fees. “For labour funds, the average management expense ratio is in excess of 5%,” Cumming says. “The fund managers pay themselves really well and they don’t generate any return. Investors don’t care because they’re getting tax breaks. It’s a bizarre situation. It’s scandalous.”

Cumming is equally outraged that labour-sponsored venture capital corporations (LSVCCs) actually hurt VC efforts in Canada. The funds are set up to compete with private funds, he notes.

“LSVCCs have displaced more effective VC funds and have even lowered the level of capital available to Canadian entrepreneurs,” Cumming concludes in the report. “In fact, federal LSVCCs alone have resulted in more than 400 fewer venture capital investments per year [Canada wide], representing almost $1 billion.”

However, according to the Canadian Retail Venture Capital Association, which published its own rebuttal to the report, nothing could be further from truth: “The authors have ignored the most recent and topical information on the Canadian VC industry, and chosen instead to rehash data from their own prior, and dated, publications.”

On the issue of crowding out, the association’s critique notes that the Fraser Institute report “neglects to mention that the Canadian VC market share of foreign investors increased to 28% in 2001 from 3% in 1996. This was led by U.S. VCs, which can invest anywhere in the world, but nonetheless chose Canada at a time when Cumming would have us believe that LSIFs were at their peak-of-market-distorting overinvestment. Cumming cannot explain why they were not crowded out.”

The CRVCA is equally perplexed about why recent return on investment data is not included in the Fraser Institute’s report. The association cites findings from a recent Gilles Durufle study that was commissioned by Canada’s Venture Capital & Private Equity Association (CVCA) that showed labour-sponsored investment funds have, in fact, outperformed institutional VC funds over the past 10 years, as well as in shorter periods.

“Durufle’s study is the only one of which we are aware of that analyzes this point — and the performance results that he found undermine most of what Crowding Out Private Equity has to say about LSIFs,” the CRVCA says in its formal response. “It is hard to believe that Cumming and MacIntosh were unaware of the Durufle study; their report allegedly relies on ‘anecdotal evidence,’ and Durufle’s research has been much talked about in the VC industry in the past year. Why did they ignore the most current and relevant piece of research?”

In the end, the question remains: How well are labour-sponsored VC funds really performing? The answer, it appears, may lie somewhere between the Fraser Institute’s report and the CRVCA’s response. “The program has probably not delivered everything policy-makers had hoped,” says John Cook, managing partner with Investeco Corp. in Toronto. “Returns in the last five years have been much better in other areas of private equity,”

@page_break@However, “it’s not fair to paint the whole program as a total disaster,” he adds.

One reason for the below-par performance may be the “extremely” high fees charged by the funds, Cook acknowledges. “They have affected return. More experienced funds would not allow all these expenses to be charged back.”

The federal government, for one, is not concerned about return on investment. That’s not why the funds were established. “The LSVCC tax credit was introduced to foster entrepreneurship by encouraging investment by individuals in labour-sponsored VC organizations set up to maintain or create jobs and stimulate the economy,” says a finance department official.

“Tax provisions do not require LSVCCs to report on performance,” the official adds.

Ultimately, the debate over labour-sponsored VC funds is not helpful; in fact, it may be harmful, Cook says: “The argument has gone on for ages. The problem with the argument is that it distracts us from the real issue — we don’t have enough VC in the Canadian marketplace.”

That lack of VC is most apparent in Ontario. During the quarter ended June 30, investment activity in Ontario dropped to 14th place on the ranking of all U.S. states and Canadian provinces, falling behind traditionally much smaller markets such as Colorado, Minnesota, Virginia, Florida, and North Carolina, according to the CVCA.

“Since 2002, Ontario has experienced a dramatic decline in VC investing and there is no end in sight,” says Mark McQueen, president and chief executive officer of Wellington Financial LP in Toronto.

In 2002, Ontario attracted $1.4 billion of venture capital. That figure dipped to roughly $600 over the following years. Last year, it was only $483 million. And this year, through the end of August (and excluding one unusually large transaction), there have been only $237 million of VC-backed deals, according to Thomson Financial.

Labour-sponsored funds were designed to help reverse this trend. Whether they’re doing that depends on which report you read IE