Guarantees
come at a price
What if I
told you there was an investment today that would guarantee your principal,
provide generous tax credits, and provide some potential to generate some
return on top of that? This investment does exist in the form of a labour
sponsored investment fund (LSIF). Interested?
In the
world of LSIFs, there is something known as pacing requirements. This time of
year, lots of money flows into LSIFs. The funds have a window of time during
which they must invest a certain percentage of their assets into “eligible”
(i.e. venture capital) investments.
If a fund
fails to keep pace with the legislated requirements, it could face penalties.
The idea here is that the government subsidizes individuals to invest in these
funds so they’d better make sure they put the money to its intended use. But
ample time is given so that funds need not rush money out to venture
investments.
At the end
of the day, LSIFs must invest at least 70 per cent of the money they bring in
from investors. However, they must also keep a minimum of 1/5th of
their total assets in cash (or something equally liquid).
For every
dollar that a LSIF invests in a community small business investment fund (or
CSBIF), it is given credit for investing two dollars as far as the pacing
requirements are concerned. A CSBIF is a special type of venture capital fund.
It’s a fund
investing in entities whose assets and employee salaries stay within specified
municipal boundaries. While certain LSIFs are restricted to investing in
specific provinces, CSBIFs are restricted to specific municipalities. Further,
they typically invest in entities with total assets of less than $1 million.
Suffice it
to say that as risky as LSIFs are, CSBIFs are a few notches above it on the
risk scale. Otherwise, the government would not offer added incentives to
invest in these funds.
The basic
proposition of guaranteed LSIFs is that they’ll set aside something like 40
cents out of every dollar in a government bond to make sure that investors at
least get their money back if the fund is held up to a certain date.
How can a
LSIF invest its required 70 per cent of funds raised and still set aside enough
to give investors their money back? You guessed it, by investing in CSBIFs.
With
ten-year government of Canada bonds yielding around 5 per cent annually, a LSIF
would have to set aside just about 40 cents of each dollar if capital is to be
repaid within ten years. (And that’s ignoring the fees attached to this
product, which would require a larger chunk of each dollar set aside.)
The problem
with a guaranteed LSIF, as I see it, is that its first priority seems to be to
guarantee capital – and it chooses to invest in these risky CSBIFs so that it
can set enough money aside to provide the guarantee.
Is it just
me or is there something wrong with this concept?
Sure,
people will buy into it because the whole idea plays on most investors’ fear of
investing in anything with a remote chance of losing money. But this isn’t my
vision of a true venture capital investment.
With such a
small amount actually going into venture investments, this is more like a
pricey GIC than a venture fund. Further, we talked about the evolution of
venture investments last week and that it takes the better part of ten years
for investments in established businesses to pay off. Investing in things like
tiny research facilities will require more time than most people are willing to
commit before any real return may be realized.
I often use
this test for new investment products:
Would I invest some of my own money (or that of family or friends) into
the product. In the case of guaranteed LSIFs, my answer is ‘absolutely not’.
I’ll be surprised if investors get anything beyond the promised capital
repayment.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.