Labour funds poised for comeback?

Labour-sponsored funds are certainly not the most attractive investments these days, with languishing returns and the removal of their preferential tax treatment in Ontario, but industry watchers say there are better days ahead for the asset class.

At times in the past, labour funds were the rage among investors for their attractive tax benefits, designed to encourage venture investment. Clients making the maximum annual investment of $5,000 received a 15% credit from the federal government, plus up to another 15% depending on the province. Alberta, PEI, and Newfoundland don’t offer the additional credit and Ontario recently announced plans to phase it out by the end of the 2010 tax year.

Recently, the popularity of labour funds has plummeted with the sector’s relative and notable underperformance and a wave of active consolidation has taken hold as managers scramble to control costs.

“We have seen a lot of consolidation in the industry,” says David Fergusson, managing general partner at VenGrowth Funds. “It’ll end up being a three or four horse race. One of the challenges in the industry is that there are too many smaller funds out there that just don’t have the depth and experience and critical mass to be highly successful. The market will acknowledge that. We’re finding the fundraising is being concentrated into the hands of a few players.”

There are several forces at work contributing to the sector’s overall malaise. Primarily and fundamentally though, the way labour funds make money is currently at odds with stock market demand and conditions in the sectors that most labour funds operate in.

To make money, labour-sponsored fund managers invest heavily in private or public companies with growth potential, fewer than 500 employees and less than $50 million of total assets. Managers assume the associated liquidity risks — essentially locking money into the investments, and work to help develop the company to the point where managers can take it public and sell the shares on the open market or sell their stake in the company to another firm.

These “liquidity events” that managers strive for are what drive fund returns. Unfortunately for the sector however, virtually every IPO made in recent memory has been structured to cater to investors’ seemingly insatiable demand for income generating investments.

“The problem [for labour fund managers] is there hasn’t really been any significant opportunity to exit their private investments. That’s really where they get their returns. It’s an odd sort of pattern — you have losses for the first few years and then all of a sudden they get their run up at the end,” says Dan Hallett, president of research firm, Dan Hallett and Associates. “If you look at the list of IPOs, probably in the last five years, you’ll see the words ‘income fund’ in just about every listing.”

And although technology spending is turning around, Hallett says most companies are still in the process of cleaning house. “A lot of the tech companies, the big ones, have been nursing their wounds and clearing up their own businesses after what was probably one too many acquisitions. They have their own issues to deal with before they go out and spend money. They need to get their own businesses healthy again.”

Even though there is little demand for the products and performance has been lacklustre for the sector, at best, both Hallett and Fergusson say there are signs of life in the labour fund industry. “I definitely think there are better days ahead,” says Hallett.

Fergusson agrees. “The technology sector really lives and dies by industry spending. Spending is the catalyst, the reason why Cisco will do better or Nortel or Alcatel or Lucent. Once you have strong industry spending, then the larger companies tend to buy up the smaller venture backed businesses. That’s how we make our profit for our shareholders,” he says.

“The fortunes of the venture capital market are very much tied to the broader technology market. While we’ve been having progress with our companies, we’re not able to show those results because the IPO market for technology companies has been completely non-existent. Similarly, mergers and acquisitions by larger companies have completely fallen off by the wayside. M&As and IPOs are very cyclical.”

And even though the funds appear to be fighting headwinds, activity in the venture capital sector suggests that managers are still actively investing and pursuing business. According to the Canadian Venture Capital and Private Equity Association, venture capital investment activity rose 13% in the first quarter of 2006, compared to the first quarter of 2005. The association says the most significant boost occurred in the biopharmaceutical and life sciences sectors in Canada, with notable transactions taking place in Quebec and British Columbia. Total life science investment during the first quarter amounted to $139 million across Canada, more than triple the $37 million invested during the same period last year.

Managers are also diversifying, pursuing other opportunities and stepping outside of the technology and life science sectors. This week, both VentureLink LP and the Covington Group of Funds announced their moves to invest in NexGen Financial Limited Partnership, an independent financial services firm launched by former Mackenzie CEO, Jim Hunter.

“This asset class can and will stand on its own merits. We do it on the institutional side every day,” says Fergusson. “We have seen a lot of consolidation in the industry, but in five more years when the provincial tax credits are phased out, this asset class will still be there. Clearly, much more emphasis will be placed on performance. Which is as it should be.”

Filed by Kate McCaffery, Advisor.ca, kate.mccaffery@advisor.rogers.com