Covington wind-up questioned

Covington Group of Funds once described its Covington Fund I as being “the most mature, stable LSIF in Canada.” But as the fund begins an orderly wind-up of operations, most investors who held the labour-sponsored investment fund might question that description.

An analysis of the fund shows that if not for the 30% worth of federal and provincial tax credits that reduced the net cost of the investment, a majority of investors would not have made any money off Covington Fund I.

Still, if the fund hasn’t wowed investors during its 11-year run, Covington Group of Funds hopes it can in its wind-up. Covington Fund I is the first LSIF to wind up operations.

“In that respect, we are leaders in the asset class and we’ve come up with what we really feel is a strong solution on how to wind up the fund and return capital to shareholders,” says Fiona Robertson, Covington’s vice-president of marketing communications.

In June, Covington announced its decision to wind up the fund by selling its private venture portfolio holdings to Toronto-based Birch Hill Equity Partners for $41 million. The firm will sell off the fund’s public holdings at current market prices.

If everything goes as planned, shareholders should receive $7.14 to $7.20 per share by May 2007. The current NAV of the fund is about $7.40.

Covington Fund I invested in venture capital, and it is known that such funds at have a finite lifespan, says Robertson. The LSIF wrapper doesn’t change that, she adds.

The decision to wind down the fund primarily responds to most shareholders’ eligibility to redeem their units. Covington also wasn’t making any new investments in the fund.

Chip Vallis, CEO of Covington Capital Corp. and manager of Covington Fund I, said in June that the fund had reached the end of its lifecycle. “The maturity of the portfolio, coupled with the strong position of a number of investments in the portfolio, makes this the optimal time to execute our wind-up strategy.”

Fund analyst Dan Hallett of Dan Hallett & Associates, however, doesn’t buy Covington’s explanation. “Clearly this is more of a forced wind-up,” he writes in a recent research bulletin.

Hallett also isn’t overly impressed by the price Covington is getting for its private assets. “The sale price of $41 million is 4% below Covington I’s carrying value and 7% above its cost,” he writes. “The portfolio’s age of 11 years makes the sale price seem quite modest relative to what investors and advisors expect from one of the better LSIF managers.”

He adds: “This deal does not instill a great deal of confidence in the asset class.”

The phase-out of the Ontario tax credit for LISF has been suggested as another factor decreasing confidence in LSIFs, but Robertson thinks that was less of an issue with Covington Fund I.

The performance of this fund hasn’t been anything to get excited about. According to Globefund, the Covington Fund I has lost almost 4% in the past 10 years. The loss in the last five years is even greater, down about 9%. Since inception, the fund has lost about 2.5%. These are hardly the returns investors likely expected from an investment that aimed to provide long-term capital appreciation.

Indeed, the fund’s heady days were between 1999 and 2001, although few investors would have enjoyed those gains, as few made redemptions through this period.

According to the fund’s 2001 annual report, 1.5 million of the more than 14 million outstanding units were redeemed in 2001 for approximately $17 million. In 2000, which was Covington Fund I’s best performing year, less than 400,000 units were redeemed for approximately $4 million.

Perhaps investors can’t be faulted for holding on to their units. By 1999, the fund was a mere four years old. Investors who tried to sell their position in the fund within eight years of the date of issue were charged an early redemption fee. As such, the earliest investors would have been able to redeem their units without penalty would have been 2003.

Unfortunately, by 2002 almost all of the gains in the fund had been wiped out as the unit’s NAV slipped from $20.39 in 2000 down to $11.30.

Investors can take solace knowing that the wind-up of the fund will likely minimize transaction costs and avoid tax credit clawbacks.

The new Ontario LSIF provisions introduced last November to phase out the 15% tax credit for these investment vehicles also contained provisions permitting LSIFs to wind up without triggering any clawbacks, writes Hallett in a recent research bulletin.

He adds the federal credits shouldn’t pose much of a problem either. On October 17, Covington I applied to have its status as an LSIF under the federal Income Tax Act voluntarily revoked. “That way,” Hallett notes, “upon wind-up, it would no longer be a federal LSIF and, as such, should not be subject to tax credit clawbacks.”

The issue of tax credit clawbacks affects only investors who purchased the fund when it was reopened, specifically, those purchasing between February 2005 and June 16, 2006. If the federal government doesn’t revoke Covington Fund I’s status as an LSIF, Robertson says the company will investigate other options to try to ensure their clients’ returns are not eroded by clawbacks.

Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com

(10/25/06)