This year, venture capital fund-raising in Canada could make a comeback, if U.S. LPs have anything to do about it.
But don’t look at recent numbers for any trends. In 2004, Canadian venture capital fund-raising fell for the third year in a row as Canadian VC firms raised less than $1.4 billion in new capital, compared to $1.6 billion in 2003. Thomson Macdonald and the Canadian Venture Capital Association (CVCA) attribute the decline to reduced sales by public, government-backed retail funds. The declining numbers in the last few years do not match what’s taking place in the United States, where VC firms have seen fund-raising rise steadily since 2002.
But many observers say the last few years are not any indication of the future. They say that Canadian fund-raising activity is poised for a revival, and 2005 may be the year that the decline is finally stopped in its tracks. They cite Ventures West Management of Vancouver closing recently on $202 million; and Celtic House Venture Partners of Kanata, Ontario, which raised $225 million for its third fund in March, as positive signs that Canadian firms can score sizable funds.
But the reason why fund-raising could pick up, industry observers say, is that U.S. LPs are making inroads into the country. For example, the latest fund of Vancouver-based Chrysalix Energy Management was purposely designed to bring in American institutional investors. The Chrysalix managers marketed the vehicle specifically for U.S. investors (by naming it Chrysalix Energy II U.S. Limited Partnership), and the fund was structured so its investment strategy would ape American funds by having the fund invest in more overseas deals. Chrysalix hopes to raise between $60 million and $100 million before the end of 2005.
U.S. vs. Canada
Andrew Waitman, managing partner at Celtic House Venture Partners, says his firm recently closed a $200 million fund that included investors from the United States. He notes that one advantage Celtic offers to U.S. limited is that his fund will go further if spent in Canada. The Canadian dollar is cheaper than the U.S. dollar, he says, and Canadian salaries are lower. Plus, the government offers tax incentives as much as 30% for R&D. Canadian companies are a bargain by any measure, he says. “You get double the people for half the price of an investment in the U.S.,” he says.
Still, it’s tough to make comparisons. Canadian VC is not just a smaller version of its southern neighbor. It is also a much younger industry in comparison, and it is still going through growing pains. A young firm is less appealing to limited partners, who prefer to put their money into funds managed by firms with long and proven track records.
But the differences between U.S. and Canadian firms do not stop with age. Part of the reason for Canada’s VC fund-raising drop in recent years has to do with the way the Canadian LP structure is formulated. Whereas pensions and endowments constitute about 70% of U.S. venture funds, Canadian VCs only received about 20% of their funding from pensions and endowments. But nearly 70% of Canadian funds are raised from individuals.
Needless to say, the Canadian venture capital market is dependent on individuals, which is why an increase of U.S. LPs is so encouraging for the long-term health of Canadian VC.
In Canada, individuals invest in venture capital funds known as labor-sponsored funds. Last year, labor-sponsored funds raised $889 million, which was more than 60% of the $1.4 billion raised by Canadian venture capital firms.
If an individual investor invests in a VC fund through a Registered Retirement Savings Plan (the RRSP is Canada’s version of an IRA account), the funds are subsidized with tax credits of 15% by the Canadian federal government and an additional 15% by their respective provincial government. This gives the investor a total tax break of 30% on their money invested, a rate that can go up to 35% if they invest in a risky research-oriented investment fund.
Despite strong public support, the current picture of labor-sponsored funds is not all bread and roses.
Each province governs its area VC firms with its own set of rules. But most require that a labor-sponsored fund invests a majority of its holdings into the local province. In addition, the tax credits are available only for residents and a labor union or federation appoints a majority of the portfolio company’s board. The funds are required to invest a certain percentage of their funds every year, and they are also restricted in how much they can invest in certain sectors. About 20% of a labor fund’s assets must be reserved as cash for redemption if needed.
The downside to these allocation requirements is that labor-backed funds are slower to invest and can’t invest as much as their American counterparts. Labor-sponsored funds also lack the freedom to invest the way an institutionally backed VC does, like those that populate the United State. They can’t chase good deals across province lines, in most cases, and they also may be rushed to invest at other times.
In addition, individual-backed funds are not as reliable. Individual investors may find themselves flush with cash one year, but without the disposable income needed the next year to invest in a VC fund. There are also competing investment vehicles in Canada that offer tax breaks, but have a lower risk profile.
Canadian institutional investors, which participate in backing venture funds, tend to put more of their money into funds based outside of Canada. For example, Teachers’ Merchant Bank-the private equity arm of the Ontario Teachers’ Pension Plan-invests more than one-third of its venture capital and private equity money in Canada. The firm splits the rest of its assets between the United States and Europe. “I don’t feel any nationalistic obligation,” says Jim Leech senior vice president of Teachers’ Merchant Bank. “Our obligation is to our pensioners to make sure they get the best returns possible. We’re going to go for performance.”
Robin Louis, president of the Canadian Venture Capital Association and of Ventures West Management, doesn’t begrudge Teachers’ Merchant Bank for their asset allocations. He says it is up to the VC industry to mature and make themselves more attractive to Canadian institutional investors. “These pension funds are not in the economic development business. They’re in the investment business and they have a fiduciary duty to get the best returns,” he says. “What we’re trying to do is get those that do not invest in venture and private equity to think about the asset class. The Canadian funds have to go in and make the good investments.”
Private VC Rising
Despite consecutive years of fund-raising decline for Canadian VCs, there is some good news in the latest Canadian VC fund raising data. Thomson Macdonald and the CVCA report a 67% growth in new commitments to independent private venture capital funds, from $215 million in 2003 to $360 million last year.
A survey completed in 2003 by Thomson Macdonald also documents a growing acceptance and enthusiasm for venture capital and private equity among LPs. It found that institutional investors were increasingly entering the venture space, pushed in large part by declining or stagnant public equities. It also found that institutional investors will likely include venture investments as part of their broader private equity programs.
“We see a definite interest that was not necessarily there a few years ago,” says Sylvain Gareau, vice president of Caisse de depot et placement du Quebec. The firm, which formerly did venture deals, but now acts solely as a limited partner to VC funds, is more active in partnering with American LPs and GPs. “As we’re speaking there are four or five groups from U.S. establishing in Canada this year,” Gareau says.
Gareau says that in addition to American LPs bringing a lot of money, they have the expertise and other resources that will benefit Canadian VC.
“And that is something this industry needs,” he says.