Canada’s Currency Crunch

Few venture capitalists claim to be currency experts, but the strength of the Canadian dollar against its U.S. counterpart is causing some VCs to take notice and adjust their strategies.

To be sure, most VCs don’t follow what they believe to be fluctuations in the foreign exchange markets. “It doesn’t really drive a market where you’re looking for a 10X return on your investment,” says Rick Nathan, president of Canada’s Venture Capital and Private Equity Association. “A 5% currency swing is barely noticed.”

And perhaps nobody would notice if the Canadian dollar had only moved 5 percent. But the currency has appreciated 50% over the last five years, hitting a 30-year high against the U.S. dollar. The growth stems mainly from the commodities market. U.S. businesses are paying more for natural resources, especially gold and oil, which make up about half of the Canada’s export value. The Canadian dollar has also been getting a boost from rate cuts enacted by the U.S. Federal Reserve to bolster slowing economic growth.

Combine those factors with a weak U.S. dollar and you get a slew of weird effects on cross border investment, stage allocations, portfolio valuations, profit margins, a firm’s ability to syndicate deals and venture fund-raising efforts.

“It used to be that people assumed a U.S. dollar was worth $1.50 Canadian,” says David Adderley, Partner and COO of Kanata, Ontario-based Celtic House Venture Partners. “They aren’t doing that anymore.” Today a U.S. buck is worth less than $1 Canadian and is likely to stay around that level for the foreseeable future.

Cross-Border Investment

It would make sense for Canadian VC firms to send more of their money south to U.S.-based startups to take advantage of the favorable exchange rate. After all, each loonie—the nickname for the Canadian dollar coin—has 50% more purchasing power than it used to. But Canadian VCs invested just $200 million in U.S. startups during the first eight months of 2007, almost exactly the same amount they invested in all of 2006, according to data from Thomson Financial (publisher of VCJ).

Canadian VCs have upped their deal activity by 10% during the first eight months of 2007. But they have actually cut their allocation to U.S. startups. They put nearly 38% of their total investment dollars to work in the United States during the first eight months of 2007, compared to nearly 43% during all of 2006, according to Thomson Financial.

So even though U.S. startups are now cheaper for Canadian VCs than at any point in the last 30 years, thanks to the favorable exchange rates, most Canucks have chosen to keep their dollars close to home. Nathan attributes this to pressure from local limited partners, who he says want to do their own geographic allocations.

“There are some VCs who probably positioned themselves to LPs as Canadian and the LPs saw they were investing elsewhere and decided to pull back,” he says.

Meanwhile, U.S. firms are clearly feeling the effects of the depressed dollar and eschewing Canadian startups because of it. That’s making it harder for Canadian venture firms to find syndication partners and may be slowing the speed at which deals are getting done.

U.S. VCs have scaled back their activity in Canadian companies, investing $274 million in Canadian startups through the end of August, according to Thomson Financial, putting them on track to invest a little more than $410 million by the end of the year. That would be a 36% drop from the $642 million they invested in 2006.

“It’s always hard to syndicate deals with U.S. firms,” says Adderley of Celtic House. “The arguments about the cost of doing business in Canada aren’t as strong when the Canadian dollar is strong.”

Portfolio Effect

An ironic twist to how U.S. VCs are losing interest in Canadian startups is that most new companies north of the border see much of their sales stemming from the United States. But the startups pay most of their expenses, especially wages, in Canadian dollars. So when the U.S. dollar loses value, Canadian companies take less in and pay more out.

“The dollar is hurting our portfolio big time!” says Scott Clark, a managing director of Toronto-based Covington Capital, who says that the cost of goods is in Canadian dollars, though they receive many orders from the United States.

“We’re getting hit on the bottom line, which is a problem,” says Clark, who adds that it is particularly bad for software startups, his firm’s focus.

Whereas the exchange rate may be hitting portfolio companies, some Canadian VCs are not letting that change the way they invest.

“When the Canadian dollar is low, it’s a nice little bonus for the companies we back but it’s not an assumption,” says Steven Hnatiuk, a general partner at Vancouver-based Yaletown Venture Partners. For the lion’s share of tech companies in Canada, the U.S. market is their primary target, accounting for 75% of their sales. And the conversion of those dollars into Canadian dollars isn’t yielding the nice little conversion rate that it used to.

“We don’t back companies where a suppressed Canadian dollar is a contributing factor to the success of the business,” Hnatiuk says. He adds that he’ll continue to focus on companies with compelling technology that addresses a big market.

Stage Shift

Currency issues typically concern late stage companies more than their early stage counterparts, since the startups are not yet earning revenue. When companies have to sell more just to post the same profit, late stage investors delay rounds, put less money in and face higher valuations.

As a result, both Canadian and U.S. venture firms have cut investment in late stage Canadian companies as the Canadian dollar has gotten stronger. Venture firms allocated $460 million to companies raising Series B or later investment rounds during the first eight months of 2007, accounting for 69% of the total amount invested. That’s down from the $782 million invested in late stage companies, or 76% of the total, in 2006.

The drop in dollars and percent allocation shows that VCs are unwilling to put as much money into later stage companies that are facing increasingly tough margins due to currency issues.

The strength of the Canadian dollar can drive up the nominal valuation of a startup, which can scare some investors away. “There’s not a lot of late stage capital in Canada,” says Adderley of Celtic House. “And with the phasing out of tax credits for labor-sponsored venture firms, there’s even more capital being withdrawn from the system. If I were a late stage investor in the U.S., I’d be looking here.”

Fund-raising Problems

VC firms from Canada had a tough time attracting capital during the first eight months of 2007. Firms raised $662 million through August, and are on track to finish the year with less than $885 million, a 35% drop from the $1.5 billion they raised during 2006.

Part of this may be due to currency issues. Limited partners feel the same effects of the strong Canadian dollar as do general partners, namely that it’s cheaper to invest in the U.S. and more expensive to invest in Canada.

It’s difficult to know how much U.S. limited partners contribute to Canadian venture funds. Market researchers, such as Thomson Financial, do not track limited partner allocations. But there’s anecdotal evidence to suggest that large institutions and pension funds in the U.S. allocate the majority of their venture dollars to firms operating in the U.S.

“Canadian VCs just haven’t been able to convince institutions in the U.S. to invest,” says Clark of labor-sponsored Covington Capital. “It’s tough for them to see the merits of taking a risk here when they have so many options in their back yard.”

Still, some private venture funds, the ones not backed by public market investors, do collect a fair portion of their funds from U.S. limited partners. Almost half of the Ontario-based Celtic House’s $225 million third fund comes from U.S. investors, says Adderley. The firm denominates its funds in U.S. dollars because of its investor base and because “a lot of our companies are either sold to U.S. companies or end up listed on U.S. exchanges,” Adderley says. “We’re a U.S. denominated fund and we happen to pay our salaries and expenses in Canadian dollars, so obviously we have to be hedging. You have to manage it and there are a bunch of strategies for that. Any intelligent manager of a company or a GP has to be thinking about this.”

Yaletown Venture Partners, which invests in Vancouver, British Columbia, also raises a substantial portion of its LP funds from the United States. “There’s been no discussion with our limiteds about currency fluctuations changing their allocations,” Hnatiuk says. “They want to back good managers. Currency is not going to be a topic of discussion for us. They need to be managing currency risks at the portfolio level.”

Since top tier firms so drastically outperform second tier investors, it seems unlikely that institutional money would pass up the opportunity to back a good fund. “The people who invest in venture firms have certain buckets, stage buckets and geographic buckets. That’s not going to change. The real question is: ‘is it a good manager?’” Adderley asks.

Plus, Covington’s Clark and others believe that with the favorable exchange rate, now is a great time for Canadian pension funds and institutional investors to try to get in U.S. funds. After all, each Canadian dollar that they send south is worth nearly 50% more than it would have been worth five years ago.

Others are skeptical that the exchange rate plays into LP allocation decisions. “They [LPs] may very well decide they prefer to invest in Boston or Silicon Valley, but I doubt that will be the product of the currency,” says the CVCA’s Nathan. “The big institutions already have hedges against currency fluctuations. The currency goes up and down so much during the life of a fund it’s hard to say where it will go.”

Currency Futures

Canada’s currency concerns should moderate later next year, economists predict. The Canadian dollar, which is at a 30-year high (1 Canadian dollar = $1 in U.S. currency), may fall to $0.92 later next year, says Dale Orr, managing director of Canadian Macroeconomic Services at Boston-based consulting firm Global Insight.

It’s difficult to predict the relative valuations of currency 12 to 18 months from now. Still, Orr cautions that the equilibrium by 2010 will be closer to $0.92 than to the current high of about $1. That’s still a historic high when compared against the rates of the 1990s.

The short term strength of the Canadian dollar is driven, in large part, by the U.S. Federal Reserve Bank, which has cut its rate to pull the U.S. economy out of its credit-crunch tailspin. A rate decrease makes U.S. bonds a less-attractive investment and dampen investor demand for dollars to buy them with. This further weakens the U.S. dollar against its Canadian counterpart.

Commodities prices, particularly oil and natural gas, are driving a slightly longer-term strength in the dollar. “As long as the price of oil stays around $70 a barrel for the rest of the year, the Canadian dollar will not stray too far from its current level,” Orr says. Global Insight predicts the price per barrel of oil will stay above $70 for the foreseeable future.

The long-term exchange rate has more to do with the relative strength of the U.S. and Canadian economies and can be difficult to predict. Orr says that the U.S. economy is looking up, and expects that late next year its strength will help push the value of the Canadian dollar down.

The strength of the Canadian dollar is here to stay, at least for the next couple years, and VCs stationed north and south of the border will feel its effects.