MRI Fund rumors come true

As you get older, you tend to be harder to surprise. In the case of today’s $205 million Ontario Government MRI fund (re)announcement, there were no surprises to speak of and the previously disclosed rumours appear to have come true (sorry Alpha, you lose the bet):

1. The MRI Fund was able to grow the initial December 2007 $165 million commitment by just forty million bucks over the past six months. The Ontario government can now attest to just how hard it really is to raise fresh capital in this country.

TD Bank came in with a $30 million commitment (Quebec’s FSTQ is the likely candidate to have put in the other $10MM, and I’m not sure why the LP name wasn’t disclosed); for reasons that are unknown, TD didn’t join their confreres last December when RBC agreed to put up $20-$25 million at the first close of the then $165 million MRI Fund. Even though the Premier himself was in attendance for the launch.

Did VC investing become more attractive over the past six months? We’re big fans of Ed Clark, and he’s not known to be asleep at the switch (see prior post “Betting on the jockey is working at TD Bank” October 4-07).

Not historically known to be a big player in VC LP investing, TD Bank literally came out of the blue to be the new lead external investor. Coincidentially, TD’s in-house private equity fund-of-fund arm was announced as the manager of the $205 million cash pile (see #2 below) today as well. Hmmmm. I think Dr. Henry Kissinger had a term for that: “linkage“.

The press release made great hay about “unanimous” agreement between the LPs regarding the choice of managers, and the rigorous process to choose a manager, and one can imagine that it was. These people are pros, after all. But, at the end of the day, none of the original December 2007 LPs (BDC, Manulife, OMERS and RBC) have their own Fund-of-Fund division. So, to get TD into the boat as the new lead investor, why not award them the management contract as well? Ok. Maybe I’m being cynical and it’s all just a happy coincidence.

2. TD Capital Private Equity Partners was awarded the mandate to be the fund manager, as we anticipated (see prior posts “$165MM MRI Fund: blessing or curse?” December 3-07 and “Rumours swirl on $165 million MRI Fund” May 29-08). Despite managing the same program for CPP Investment Board, TD will now be the defining voice when it comes to which VC Funds will raise LP capital over the next five years and which will, literally, be starved out of business.

A Toronto VC Fund Chief recently posed the natural question: “what’s wrong with having one Fund of Fund manager do it all”? My perspective isn’t very complicated, but it’s based on real world experience.

First off, Fund of Fund commitments aren’t “sticky”. Unlike pension funds or life insurance companies with multi-decade investment allocation strategies and external advisors, Fund of Fund managers have no actual capital of their own. They can only deploy what others give them, which means that they can only be there on your next fundraising effort if their clients have maintained their capital with them. If that capital evaporates, your returns don’t matter. Your success is irrelevant. The follow-on commitment is gone. Not your fault, but painful nonetheless.

Moreover, the lack of a multi-decade investment allocation strategy makes the Fund-of-Fund business invariably more personality driven. That’s often dangerous, as investing with your friends can be even more dangerous than investing with someone who once turned you down for a job.

I don’t believe the Canadian ecosystem is well served with one key door to knock on. What if, God forbid, they don’t like the head of the VC Fund’s team? Or the entrepreneur in residence you’ve got on staff? Where are you left to turn?

Simply put, Ontario politicians wouldn’t want a single voter deciding who the next Premier will be, so why should we have faith that a single CEO of a single Fund of Fund can assiduously wield the power to decide who lives or dies in VC land? And that’s not a comment on the top fellow at TD Private Equity Partners. It’s just a philosophical discomfort with the idea of one-man rule.

3. As feared (see prior post “Rumours swirl on $165 million MRI Fund” May 29-08), the MRI Fund will be investing in more than just “venture capital”. The press release refers to the fund’s mandate to “invest primarily in Ontario-focused venture capital and growth funds”. Well, growth funds would certainly include a debt fund such as ours; we’ve trademarked the phrase “True Growth Capital” after all. But merchant banks will also appropriately lay claim to the mantle of being “growth” investors.

Canada’s merchant banks, such as Birch Hill, Clairvest, Edgestone, ONCAP and TriWest, all provide capital to assist with the “growth” on domestic businesses. No doubt some funds of this ilk will get the nod; but how will anyone know without public acknowledgement?

It’ll be interesting to see how the MRI Fund deals with the public disclosure of their GPs and the returns they’re providing. CPP IB is a great template to follow (see prior post “CPPIB Canadian general partner Q4 2007 performance numbers“), although TD does not unilaterally disclose which GPs have earned commitments from them in the past. With $90 million of the $205 million raised coming from Ontario taxpayers, transparency will undoubtedly be required on that front.

4. Of the $205 million, up to 20% can be committed to funds based anywhere in the world. Another 20% will be set aside for co-investments. With some of the remaining capital also available for merchant banks and other “growth” type funds, you can quickly see that up to 70% of the capital may go anywhere but local VC firms and the local entrepreneurs that the MRI Fund was supposed to back.

If only 30% ($60 million) of the MRI Fund is going into VC-type funds (see prior post “Rumours swirl on $165 million MRI Fund” May 29-08), then this effort will be a grave disappointment to every technology, clean tech, alternative energy and bio tech entrepreneur in Ontario.

If it takes TD Private Equity Partners just three years to find the fund managers (managers have to be looking to raise a new fund, don’t forget), and it takes the chosen VCs another five years to get the capital out — a reasonable estimate for the active cycle of a domestic tech fund — that’s just $12 million of incremental VC funding a year between 2011 and 2016. You can see why the entrepreneurial crowd (and the voters) will have a difficult time standing up to cheer for the allocation strategy.

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On the bright side, at least some of the Provincial Government’s senior public servants recognize that this is not “the silver bullet”. To quote the Ministry’s own press release “Early stage venture capital — funding to emerging Ontario companies looking to grow — declined from $1.5 billion in 2000 to $236 million in 2007”.

I had to read that sentence a second time. It isn’t often that you’ll see a sitting government admit in their own press bumpf that something got worse during their watch. Kudos for the honesty. The VC industry is in a crisis (see prior post “Venture Capital Crisis in Canada?” March 12-08). Having now admitted that fact, let’s fix it.

The CVCA has been trying for some time to get this point across, both privately and publicly, and our own team has been anxious to help preserve the Tech ecosystem before a generation of entrepreneurs is lost to our southern neighbour (see prior post “Ontario politicians asked to address deteriorating VC climate” October 1-07).

Much of this blog’s space in 2007 was devoted to the disturbing decline in VC funding, particularly in Ontario (see prior representative posts “Waterloo investing trends” February 8-07, “Brutal venture capital stats for H1 2007” August 1-07 and “VC stats for Q3” October 17-07).

Now that the Ontario government has responded to the industry’s sad reality with this initial effort, more must be done (see prior post “Solving the Start-up & VC malaise part 2” February 6-08).

Here are just a few of the ideas we already surfaced in earlier posts and meetings with Governments of various stripes:

A. Encourage risk-taking

The current tax code benefits the winners but not the losers. The lifetime capital gains exemption had its root, some would say, in the problem that family farmers once had in handing their properties over to their offspring. If a son or daughter bought the Roseville, Ontario-based dairy farm from their parents for $500,000, and their parents were going to finance part of that purchase with a vendor take-back loan, they’d have to pay tax on the transaction – even if they didn’t get any money from their child as a result of the sale.

Today, any investor that has held an investment for a prescribed period of time can enjoy no capital gains tax on the first $750,000 earned.

Oddly, losses of investment capital can only be written off against capital gains. The impact is pretty clear to the venture capital world. An Angel investor who invests $100,000 in each of three start-ups can only realize a tax loss on the ones that didn’t work out if he/she has a gain on something else down the road. If each of the first three investments goes to zero, the hit is $300,000 after tax as there is nothing to deduct those losses against.

How many would-be Angel investors – or their spouses – could keep hope alive, believing that the 4th Start-up would make it? With so much start-up money coming from “friends and family”, this tax policy is one of the reasons why Angel investing for some people is a lot like charity, but without the tax receipt.

If that same investor had put $300,000 into his/her own backyard honey bee business, they could write off that entire sum against other employment income as an “Allowable Business Loss”, provided that he/she had a day job with taxable income to offset the losses. As such, the honey bee loss is diminished at whatever tax rate that person had on their normal employment income.

If VC-backable deals require a robust Start-up environment, a creative thing to do is for CRA to create a category of a “Lifetime Capital Loss” that can be used for Canadian-controlled Private Corps. Perhaps $250,000 or $300,000 per adult, but it would be designed to be a “pool” that would always exist:

• If your first few start-ups failed, then you could access it up to the capital loss limit, and write off that loss against other income. But if you had a capital gain down the road then you would be able to switch the write-off to the capital side, and pay the tax on the “prior other income” in the normal way. You’d once again have a new pool of “Lifetime Capital Losses” to utilize should the next Angel investments fail.

From a tax policy standpoint, it is lost on me why the Lifetime Capital Gains exemption even exists, as most Canadian will never have the good fortune to take advantage of it. If the point is no more complicated than: “reward people who take investment risks”, than one has to wonder why we penalize those who take investment risks that don’t pan out. No wonder the rich always get richer!

As most Start-ups fail, the tax code is actually crafted to frustrate this much-needed part of the economy.

B. Enhance the SR&ED Program

Rather than refunding 75% or 80% of the funds spent on advancement, why not 100% (or 150%) in the case where the application is less than $5 million, for example?

C. Reduce the paper burden on foreign investors

As recently outlined by Deloitte (see prior post “Deloitte’s study on Canadian VC Crisis is well-timed” December 6-07), Canada continues to impose tax filing requirements in circumstances where no taxes are payable by foreign institutional investors. When a foreign VC sells an investment, they must file a Canadian tax return even if they do not owe any taxes in Canada. Each individual investor in some of these foreign VCs may also need to comply with these filing requirements, which can result in literally hundreds of pages of documents that are required for signature and processing for a single corporate sale.

D. Loan Guarantees

If it’s good enough for the Ontario auto industry, why not the New Economy? Rather than have the Business Development Bank of Canada (aka Bruce the Mindless Eating Machine) compete for business with the private sector (see prior post “BDC Fact #1” December 3-07), why don’t they mirror the role that Investissement Québec plays and guarantee certain loans that are advanced by the private sector to technology, biotech and clean tech firms, for example?

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The MRI Fund rumours sadly came true, and we didn’t succeed in our lobbying to make it a pure VC fund. And then there are the flaws in the execution strategy.

But have no fear, Tech land, there are plenty of kicks left at the can. The good news (read: elation) is that Ontario’s key Provincial Cabinet Ministers and their advisors seem open to good ideas, and they recognize that the days of building and growing the Ontario economy around the McLaughlin Buick are over. The industry still has to get better traction in Ottawa, but that will come.

Just as with a VC deal, good ideas will eventually win the day with these folks. And if not, the next election is not that far away.

MRM
(disclosure – we own TD Bank in our household)