Oslers: "difficult decisions" ahead for LSIF managers

As many of you know, we dedicate a bit of our real estate to the challenges that face the Canadian venture industry, including the LSIF crowd (see prior post “The great LSIF myth” July 2-08). Lawyers Geoff Taber and Chad Bayne at Osler, Hoskin & Harcourt LLP have published a good summary on what lies ahead for the Ontario Labour Sponsored Investment Fund sector:

“The overall financial and economic climate today continues to test nerves. While it is hard to imagine that any government would work to create more problems for entrepreneurs, Ontario is currently witnessing the inevitable after-effects of the Ontario Ministry of Finance’s decision, announced in August 2005, to eliminate the Ontario labour sponsored investment fund (LSIF) tax credit by the end of 2010. When the announcement was made, many people involved with venture capital (VC) in Ontario raised concerns that this move, which would likely effectively eliminate the LSIF program itself, would significantly reduce the amount of capital invested in early-stage technology companies in Ontario. Few of these people openly predicted the gathering storm now looming for Ontario-based LSIFs and the companies they funded.

LSIF Programs and Tax Credits

By way of background, an LSIF is a type of investment fund created specifically to encourage retail level investment in small- to medium-sized private companies. Approximately $3.5 billion has been invested in LSIFs across Canada and the consensus is that LSIFs make up about 35% of Ontario’s venture capital pool. Because these funds are looking to generate a significant return on investment, many LSIFs have focused on various aspects of the technology sector. Many provinces, including Ontario, established provincial LSIF programs and offered tax credits (in addition to those offered by the federal government) to further stimulate local investment.

An investor in an Ontario LSIF would receive a federal LSIF tax credit of 15% and an additional Ontario LSIF tax credit of 15% of the invested amount (up to a cap of $5,000 of the cost of the shares). In addition, many Ontario LSIFs were structured as research-oriented investment funds which allowed investors to claim an additional tax credit of 5% of the cost of the shares (provided that the fund complied with additional restrictions as to permitted investments). To ensure that invested amounts remained invested for the long term, investors are required to hold on to their investments for a minimum of 8 years. The penalty for an earlier sale of a LSIF investment was forfeiture of the tax credits previously claimed.

Investor Redemptions

The announced phase-out of Ontario LSIF tax credits has resulted in the significant reduction of investment in Ontario-based LSIFs, which has dramatically reduced the amount of capital available to LSIF managers to:

(i) invest in support of their portfolio companies;
(ii) cover ongoing costs; and
(iii) fund investor redemptions.

Since the peak fundraising years for LSIFs were at the turn of the century, the 8-year required holding period either has or is about to end for the largest LSIFs. These funds now face a potential tsunami of redemption requests.

This is an obvious problem, given that most LSIF portfolios feature large doses of illiquid private company stock. As the number of redemptions increases, Ontario-based LSIFs are expected to have to deplete their cash reserves. LSIF managers simply will not be able to realize appreciable value from the sale of their portfolio assets to replenish the relevant fund’s cash. Even when a LSIF manager can negotiate a sale transaction for the fund’s interest in a portfolio company, or for the entire company itself, the purchase price for those assets may not occur at anything other than a discount to book value, thus compounding the problem for remaining investors.

Suspension of Redemptions

Without sufficient cash for their needs, managers of Ontario-based LSIFs face the prospect of temporarily halting redemptions (an option available to them under the relevant Ontario legislation) to give themselves some breathing space to explore strategic options. Once redemptions have been suspended, the manager of the cash-strapped LSIF must then determine the most viable approach to maximize returns for all investors, which would typically include a merger or reorganization into another fund, an en-bloc or partial sale of portfolio positions, an orderly wind-down or any combination of the foregoing.

In 2008, the boards of directors of several Ontario-based LSIFs (The Canadian Medical Discoveries Fund Inc. (CMDF), The VenGrowth Investment Fund Inc., The VenGrowth Investment II Investment Fund Inc. and The Business, Engineering, Science & Technology Discoveries Fund Inc.) suspended redemptions for the prescribed time period while the board explored alternatives. In late 2008, CMDF announced that it had entered into a letter of intent with GrowthWorks Canadian Fund Ltd. for the proposed merger of the two funds. Earlier in the year, New Generation Biotech (Equity) Fund Inc., another Ontario LSIF, completed a secondary sale transaction of parts of its portfolio positions to generate cash.

Options for LSIF Managers

Given the continued trend of increasing redemptions, the circumstances of most Ontario-based LSIFs may become dire within the next 12 to 24 months. For the past year, managers of many of these funds have focused on winnowing their portfolio, realising value where possible and making difficult choices about how many of their portfolio companies they can continue to support and to what degree. Companies backed by LSIF money can no longer feel completely secure in their existing investors – completing an internal round has become more of an accomplishment in this environment.

With LSIF managers unable to distribute portfolio positions to investors without raising numerous legal and logistical issues, they will need to continue to work through their portfolio holdings. They will also need to continue to be receptive to opportunities to sell into a secondary (or other) transaction to accomplish either a merger of their fund with another, more cash-rich, fund or an orderly wind-down of the fund.

Not surprisingly, funds have been formed (and certain existing funds have allocated amounts) to realise on this opportunity; but, in our experience, companies that are perceived to be available at a “distressed” price sell at a very significant discount to book value. Combined with today’s severely adverse market conditions, an incredible opportunity exists to acquire interests in Ontario-based VC-backed technology companies (some of which are at a later stage in their evolution) for what appear to be bargain prices.”

MRM