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The Failure of Labour Sponsored Funds

Appeared in the Windsor Star and the Halifax Chronicle Herald
Release Date: October 3, 2007

The level of entrepreneurial activity is increasingly being seen as a critical determinant of a prosperous economy. To encourage more entrepreneurial firms, many Canadian governments have created Labour Sponsored Venture Capital Corporations, commonly referred to as labour sponsored funds.

But despite good intentions, labour sponsored funds have turned out to be a significant waste of tax dollars, costing Canadian taxpayers nearly $300 million per year and failing to increase the amount of funding available to entrepreneurs. If Canadian governments wish to stimulate investment in entrepreneurial activity, then the elimination of labour sponsored funds would be a good place to start.

Labour sponsored funds are tax-subsidized investment funds that attract contributions from individual investors through generous tax incentives and invest the funds in entrepreneurial businesses. These tax credits result in a significant cost to the federal and provincial governments in the form of foregone tax revenue – a cost ultimately borne by Canadian taxpayers. In 2006, the federal tax credit for labour sponsored funds cost the federal government $150 million in 2006. Quebec spent significantly more credits than any other province at $98 million, while Ontario and British Columbia both spent $20 million. The total spent by Canadian governments to support labour sponsored funds was approximately $300 million in 2006.

Unfortunately, Canadian taxpayers receive little to no value for the $300 million “spent” each year. Most critically, the generous tax credits provided to investors of labour sponsored funds do not actually increase the total amount of money available for Canadian entrepreneurs. Rather, they displace money from private venture capital funds and evidence suggests that they may have even lowered the total amount of money available to entrepreneurs. In fact, federal labour-sponsored funds resulted in a decrease of more than 400 venture capital investments per year (Canada wide), representing nearly $1 billion in value.

Generous tax credits are ultimately the reason why labour funds discourage the presence of private venture capital. Since these credits are not available to investors of private, non-labour funds, the required rate of return on labour sponsored funds can be lower than the comparable rate for private funds. In effect, the tax credit partially substitutes for a rate of return and allows labour sponsored funds to outbid private funds.

Labour sponsored funds also tend to maintain large amounts of cash (uninvested capital) since they raise billions more then they actually invest. This uninvested capital is partly the result of a requirement that labour sponsored funds hold between 20 and 40 percent of per cent of all contributions in low-risk investments like government bonds. As a result, fewer businesses are being created than would be the case is labour sponsored funds actively invested all of the money they raised.

Another striking fact about labour sponsored funds is their poor rates of return which are consistently below those of risk-free investments, such as 30-day Treasury Bills. While it is reasonable that some of the new firms that labour sponsored funds invest in will fail, overall, fund managers should be expected to make good decisions and generate reasonable rates of return for investors. Ultimately, the poor rate of return of labour sponsored funds indicates they have not been successful at financing high-growth entrepreneurial businesses.

Shockingly, labour sponsored funds charge investors significantly more than private funds to invest their money. That is, labour sponsored funds have high expense ratios despite the poor performance. According to the median labour sponsored fund management expense ratio is 5.5%, or more than twice that of the average managed mutual fund in Canada.

It’s clear then that Canadians are investing in labour sponsored fund to get generous tax credits, not because they want to invest in Canadian entrepreneurs or expect to earn a high rate of return.

Ensuring that Canadian high-growth entrepreneurial firms have access to sufficient capital is critically important to the health of our economy. Labour Sponsored Venture Capital Corporations however are not the answer. It’s time for Canadian governments to eliminate tax subsidies to labour sponsored funds and consider other more effective policy options.