Market improving for LSIFs, TD says

(January 31, 2005) Despite a recent rough patch, the outlook for labour-sponsored investment funds (LSIF) is improving, as the exit opportunities become more frequent and valuations more reasonable, according to a report from TD Waterhouse.

Equity markets over the past few years have not been exactly conducive to exiting positions in the companies LSIFs invest most heavily in: technology, telecoms and biotech.

“Even companies that have been relatively successful in LSIF portfolios are being hampered by a cold exit market, including a lack of mergers and acquisitions as well as a cool IPO market,” says Peter Shippen, CFA, investment fund analyst at TD Waterhouse Investment Advice in his report, titled “Alternative Investment Spotlight: Labour Sponsored Funds.”

But while the climate for these investments may be improving, the research note warns that investors too frequently buy them simply for the tax-credit they carry.

“So often, labour funds are purchased solely for the tax benefit, without assessing the underlying management of the fund,” Shippen says. “It is obvious from the past five years, that there is wide variance in the quality between labour funds.”

But there are ways to winnow through the chaff to find the best- run funds. One telltale sign is deal flow. The best-run funds’ experience in guiding management toward an IPO makes them highly sought after. If a venture capitalist develops a solid track record in taking private companies to market, private firms will seek them out when they require their services.

“It is our view that the best funded VCs, with the deepest management teams, will be favoured by the most sought-after entrepreneurs and their ventures,” says Shippen. “For this reason, we favour LSIFs whose analysts are specialists, not generalists, and have adequate capital to invest in, and support their deals.”

Trailing returns can be another indicator of a fund’s quality, although TD suggests the poorer the numbers, the healthier the fund may in fact be. Funds that appear to be outperforming could actually be simply applying more liberal valuations to their holdings.

While it seems counter-intuitive, many of the portfolios in the labour fund area that may benefit investors who are adding capital today are the well-managed portfolios, those which have been most prudent in marking down the carrying value of their holdings over the past number of years,” he says. “Conservative valuations manifest themselves in poor trailing return numbers.

“Increasing the value of a private company within a venture capital portfolio requires that there is an exit event where the company is sold or goes public, or that there is an arms-length transaction where a third-party values the investee company at a higher level.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com