Montreal, May 13, 2008 – Tax credits provided on investments in labour-sponsored venture capital funds no longer have a justification. These programs have been called into question in several other provinces. In its first two decades, the program under which they operate led to tax expenditures which can be estimated at about $2.7 billion for Quebec alone. Although investing in these funds may initially seem attractive for individuals receiving tax credits, they have low returns, high operating costs and negative effects on the supply of venture capital.
In an Economic Note published by the Montreal Economic Institute, Jean-Marc Suret, a professor at Université Laval’s School of Accounting, provides a synthesis of studies on this type of program in Canada. He explains that these funds “are derived from an obsolete model of intervention, since venture capital requirements have changed.” The study’s main conclusions are based on Canadian labour funds as a whole.
Unsufficient returns, high costs to the public treasury
The cumulative cost of labour-sponsored venture capital corporations programs in Canada reached $5.4 billion in 2003, with half of this, $2.7 billion, emanating from Quebec. These subsidized funds have shown abnormally low returns: from 1992 to 2002, the average return was 2.5% a year, less than Treasury bills. This may be explained in part by the fact that the companies financed under this program are, for the most part, inefficient in creating value and innovation.
Eligible investments in labour-sponsored funds include categories for which government assistance is hard to justify: real estate, investments in publicly traded or foreign firms, companies with assets of up to $350 million. The portion of capital devoted to sectors truly in need of financing is diminished, going instead to more remunerative, less risky investments. The favoured funds merely displace private capital rather than increasing the available financing.
The management fees of these labour-sponsored corporations are abnormally high. They run from 4.2% to more than 4.5%, compared to 2.6% for other small-cap funds. The fixed amounts paid to executives represent more than 3.1% of assets, indicating that management fees are not indexed to returns, contrary to the rule in the industry.
An outdated approach
Changes in public equity markets and the supply of venture capital challenge the usefulness of tax expenditures in this area. New rules and practices on the stock market make it easier for growing companies to get listed and to obtain financing, at an early stage, even before they produce income.
Moreover, venture capital is already quite abundant in Canada. Labour-sponsored venture capital corporations collect about $1 billion a year in Quebec, 10 times the province’s total needs in start-up capital. This large excess of venture capital may explain in part the industry’s low returns. The law allows these corporations little time to invest the amounts they collect, often leading them to finance unprofitable projects.
In addition, the unions appoint a majority of the board members of these corporations without actually investing in them. Executives’ management mandates are thus not even negotiated with shareholder representatives. This organizational structure generates high agency costs. Weak governance is aggravated by the fact that shareholders, in Quebec, cannot withdraw the money they have invested if they are unhappy. The managers therefore do not have to face an assessment of their results.
The Economic Note titled Labour-sponsored venture capital funds: time for a reassessment, was prepared by Jean-Marc Suret, professor at the School of Accounting at Université Laval, and CIRANO fellow. He also holds a Ph. D. in finance from Université Laval.
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Information and interview requests: André Valiquette, Director of Communications, Montreal Economic Institute, Tel.: 514 273-0969 ext. 2225 / Cell: 514 574-0969 / E-mail: avaliquette (@iedm.org)