The 2016 federal budget includes a proposal to restore the 15% federal tax credit to Labour-Sponsored Venture Capital Corporations, also known as labour-sponsored investment funds, where provinces have matching 15% tax credits. On a $5,000 investment -- the maximum eligible annually -- an investor will get a total tax credit of $1,500.
The previous government decided to end the tax credit, and resurrecting this incentive is a bad idea in my opinion. While I was once a proponent of LSIFs for investors who understood the risks and shortcomings, my view now is that there were so many problems that they are not worth the aggravation. My advice to the premiers of provinces contemplating jumping on the bandwagon is to look at whether LSIFs previously offered in their province provided value for money. If the provinces have difficulty finding success stories to justify further tax credit subsidies, as I suspect, then they should stay away.
If provinces do go ahead and resuscitate their programs, I recommend that investment and mutual fund dealers look very carefully at LSIFs and their managements, individually and critically, before allowing their salespeople to sell them.
As for investors who think that a 30% tax credit is a great deal and that they will get in on the ground floor on the next Microsoft, Google or Facebook, the reality has been very different. Results varied widely for the many investors who jumped into LSIFS in their heyday, in the mid-to-late 1990s. Some made money while others saw dismal performance. Of course investors who invested the tax credit conservatively as a hedge may have offset their losses.
By way of background, I was the coauthor of the Labour Sponsored Investment Funds Course, a proficiency course for mutual fund salespeople who wanted to sell LSIFs. The Ontario Securities Commission recognized it in 1995 and several other securities regulators recognized it subsequently. The course stated that LSIFs were highly speculative and that it was incumbent on advisors to inform their clients of the risks.
The idea behind LSIFs was to provide sources of venture capital to small and medium-sized businesses. To establish an LSIF, a promoter has to find a labour organization to sponsor it. For example, Sportsfund Inc. had the CFL Players Association as its sponsor. The concept was initiated by the Solidarity Fund in Quebec in the early 1980s and adopted by the federal government in 1992. LSIF assets exceeded $2 billion at the end of 1995.
The actual amount invested in small and medium sized companies was much smaller than $2 billion. For one thing LSIFs generally kept about 20% of their funds in cash to cover redemptions, though investors who redeemed before the end of an eight-year hold period had to repay their credits. For another there wasn't a lot of pressure for a promoter to invest the money in venture situations quickly. I recall one fund promoting itself on the basis of superb returns, which came not from its venture investments but from investing in bonds in a period of declining interest rates. Another LSIF based its management compensation on assets gathered rather than on its successes or failures.
Added to that were the risk factors, lack of liquidity, questionable management in some cases and volatile performance. In addition, management-expense ratios tended to be much higher than for conventional mutual funds because the funds, rather than the fund managers, paid all sales commissions from money raised as well as all operating costs, sales incentives and fees paid to the sponsoring labour organization.
I found some notes for a Morningstar column I wrote in 2000. "PALTrak (Morningstar's software for financial advisors) includes 24 LSIFs as a subcategory of equity funds. One-year rates of return to June 30, 2000, for the 18 funds with one-year histories range from a high of 103.4% for Capital Alliance Ventures to 0.0% for Workers Investment Fund. Twelve of those 18 funds had one-year returns in excess of 20%. In the previous 12 months only one fund, Dynamic Venture Opportunities Fund, up 44.6%, had a rate in excess of 20%. In the 12 months ended June 30, 1998, the best performer was Crocus Investment Fund up 12.5%." Many of these funds went the way of the dinosaurs.
A subsequent column written in late 2001 stated that most LSIFs had had a rocky ride, performance wise, over the previous 12 months, along with many other market segments. For periods ended Sept. 30, 2001, one-year performance ranged from 1.2% for Retrocom Growth Fund to -57.0% for Triax Growth.
Of course, you couldn't sell those funds to lock in profits because of redemption penalties if you didn't keep them for the mandatory eight-year period. Also those rates of return should have been taken with a grain of salt… or two. LSIFs were illiquid because for the most part they held shares of companies that were not publically traded. Some were more speculative than others because they were concentrated in specific industries. Valuations were at best educated guesses, and in some cases were out of whack with reality.
A case in point is Crocus Fund, which was established in 1992 and sold only in Manitoba. Between September 2004 and April 2005, the value of Crocus's venture portfolio plunged by 47.8%, or $61.1 million, as overstated values were brought to more realistic levels. The Manitoba Securities Commission halted sales and redemptions of Crocus shares in December 2004 and the fund's receiver was still sorting out the mess a decade later.
Manitoba's auditor general at the time of the trading halt, John Singleton, released a report a few months later noting serious weaknesses in Crocus's operations and governance. A news release from his office stated, among other things, that Crocus's board lacked appropriate oversight and governance, and did not operate as effectively as was necessary given the operational and financial risks associated with the governance of an LSIF, and that the investment processes and procedures were significantly flawed. He also stated that the board of directors and senior officers failed to fulfill their responsibilities to the Fund.
