Canadian Funds Offer New VC Model

An exciting new development in venture capital that originated from provinces in Canada could become a new model for the entire venture industry.

Two Canadian provinces have recently created funds of funds—the Ontario Venture Capital Fund and Quebec’s Teralys Capital—collectively with funding nearing $1 billion. Remarkably, much of the LP money for both government funds has been raised from institutional investors.

These funds of funds are an extraordinary intervention of regional government in response to a crisis in Canadian VC fund-raising and investing that has left only a handful of the private Canadian VCs as active investors. Worst still, this crisis may be more than just the bottom of a deep cycle, but a possible sign of a systemic change in the venture capital ecosystem.

Just such a possibility surfaced in a study released by McKinsey early this year of 25 global institutional investors on four continents with over $4.6 trillion under management. In a section captioned, “Get ready for direct investing by leading LPs,” the study reports that some institutional investors are now “building increasingly robust direct investment capabilities. … in a bid to achieve better net returns than they can realize through third-party managers.” In Canada a trend to “go direct” is unmistakable, as some of the most prominent Canadian institutional investors are significantly withdrawing from investing in VC and PE firms under a new policy of direct investing.

The single worst fatality in the VC industry, if this trend were to persist and grow, would be the Series A financings so critically important to the success of emerging technology companies. Typical Series A deal sizes are far too small for direct investment by most institutional investors. In the worst case, this policy of going direct would result in a devastating void in the funding cycle of technology companies, with institutional investors investing neither in the early stage VC firms that do the Series A financings, nor in the Series A deals themselves.

The new Ontario fund of funds has raised $205 million, of which Ontario provided $90 million as an LP, with the remaining $115 million coming from five prominent Canadian-based institutional investors. Quebec’s Teralys fund of funds has raised $700 million of its $825 million target, of which Quebec provided $200 million as an LP, with the remaining $500 million coming from two prominent Quebec-based institutional investors.

Learning from the Past

Prior VC firms that were publicly funded by regional governments have suffered serious failings that the Ontario and Quebec governments have attempted to avoid with the design of these two funds of funds.

The U.S. venture industry should watch with great interest how the Ontario and Quebec funds of funds move forward.”

In the past, in response to political fears of a public outcry if private industry best practices for GP compensation were adopted, GP compensation in these publicly funded regional VC funds was often set too low to attract top GPs from the private sector and was fundamentally misaligned with interests of both entrepreneurs and private-sector VC co-investors. An additional consequence of below-market GP compensation was a significant turnover of those VC fund GP managers that was disruptive to successful long-term VC investing. In contrast, both of the new Canadian funds of funds adopted private industry best practices in GP compensation, quickly attracting strong and experienced GP managers.

VC firms funded by regional governments were also susceptible to political pressures to invest in economic development and job creation, at the expense of ROI. In contrast, in their respective new funds of funds, Ontario and Quebec are minority LPs—with ROI-driven institutional LPs being in the majority.

Those same political pressures causing investment in economic development and job creation also resulted in a mandatory requirement that these publicly funded VC funds be invested solely in their home province, diminishing the investment choices and flexibility important for achieving high ROI and for developing strategic relationships with outside VC firms. In contrast, while the funding of funds of funds with significant public money cannot be politically sustainable without some investment mandate in that public money’s home jurisdiction, the Quebec fund of funds is to be applauded for allowing 50% of its capital to be invested outside of Quebec (25% in Canada and 25% outside Canada), and the Ontario fund for allowing 20% of its capital to be invested outside of Canada as well as additional amounts in “Ontario-focused” funds located elsewhere in Canada.

The fund-raising by these new funds of funds has been largely completed, and it’s a significant accomplishment. The Ontario and Quebec governments have farsightedly designed these new funds of funds as an innovative marriage of the governmental and institutional investor sectors, adhering to private industry best practices and avoiding problems of the past, with government serving as catalyst to attract the lion’s share of funding from the institutional investor world.

Lessons for the Future

The next daunting challenge is for these funds to invest in VC firms that will become the top performers—the future top-decile VC firms that typically achieve much of the gains realized by the entire VC industry.

VC firms require that their prospective portfolio companies possess truly disruptive technology. The two new Canadian funds of funds must now apply that same lesson to themselves and be truly disruptive in their investing behavior, thinking out-of the-box, boldly and proactively.

They cannot simply wait for those rare potential top-decile GPs to knock on their doors—they must knock on theirs. For instance, California has over 500,000 transplanted Canadians, including many wildly successful ones immersed in IT, media and entertainment in Silicon Valley and the Bay area. Some positions those expat Canadians now hold, or have held, include president of Cisco, president of eBay, president of Yahoo and CFO of Google. Most important, many of these talented Canadian transplants have deep ties to major U.S. customer markets and capital pools, and have deeply loyal followings in each.

Prior VC firms that were publicly funded by regional governments have suffered serious failings that the Ontario and Quebec governments have attempted to avoid with the design of these two funds of funds.”

The new funds of funds need to be highly proactive in aggressively reaching out and actively recruiting potential top-decile GPs, whether recruiting to return to Canada as GPs, Canadians in California, or elsewhere in Canada or the world. They must actually create some of the new VC firms in which they will invest.

Another example of investing boldness can be taken from the playbook of the Israeli fund of funds created in 1992. Many know something about the Israeli story, but when you put it all together, it’s staggering.

In 1992, Israel had no venture capital industry. That year, a newly formed, government-funded Israeli fund of funds proactively created 10 new venture capital firms. As a condition to providing 40% ($8 million) of the funding for each, the FoF required that each of those firms raise the remaining 60% ($12 million) from experienced foreign LPs, and some additional GPs, highly connected with deep global pools of capital and major global markets.

As an incentive to attracting these foreign investors and talent, the Israeli fund of funds gave each of these 10 new VC firms the unheard of right to buy out in five years the government’s 40% LP interest at cost plus interest, which meant the Israeli government took all the downside risk on its 40% investment and the VC firms had all the potential upside. These buybacks were fully exercised by nine of the 10 VC firms in the five-year period.

To understand the results from this bold strategy, fast forward just 10 years (the life of a typical VC firm) from 1992 to 2002. Israel, a country of 5 million people with no venture capital industry in 1992, now had 60 venture capital firms that collectively raised $10 billion, with VC investment as a percentage of GDP at the highest level in the world, and with Israel having more public companies then listed on Nasdaq than any country in the world except the United States.

The out-of-the box strategy of offering this extraordinary buy-out right was truly the tipping point in enabling the Israeli VC industry to become a successful self-sustaining ecosystem. Perhaps the new Canadian funds of funds should consider a similar bold strategy with respect to the governments’ LP interests.

The U.S. venture industry should watch with great interest how the Ontario and Quebec funds of funds move forward. If they achieve the success that is possible, they could very well become an investment model not only for other provinces in Canada, but also for the United States and for the entire VC industry, as it too embarks on its next chapter of reinvention and renewal.

Stephen A. Hurwitz, a partner in law firm of Choate Hall & Stewart LLP in Boston, specializes in Canadian-U.S. cross-border transactions involving venture capital, private equity and technology companies. He is co-founder/chair of the Quebec City Conference, a leading international VC, PE and LP conference. He may be reached at