LSIFs carry
big risks, with potential to match
Wilder
stock markets swings; the expectation of lower future returns; and plain old
desire for something different have all created a market for what’s known as
alternative investments. The term describes a class of investments that isn’t
mainstream, isn’t suited for everybody, but that offer attractive benefits.
Namely, these benefits are the potential for high rates of returns and
diversification. For the next two weeks, we’ll talk briefly about the pros and
cons of one kind of alternative investment - labour sponsored investment funds
(LSIFs). This week, we start with a discussion of risks.
LSIFs are
otherwise known as venture capital funds to describe the types of companies in
which they invest. Venture capital companies are usually very young
enterprises. They can range from fresh start-up firms that consider revenues of
any sort to be a luxury; to more established firms that have developed a market
for its product or service but need money to finance the next growth phase.
In most
cases, venture capital companies are private – i.e. most don’t trade on any
public stock exchange like the Toronto Stock Exchange (TSE) or the Canadian
Venture Exchange (CDNX). The private nature of most of these firms is at the
root of both the risks and rewards of this asset class.
Valuation
risk is perhaps the most significant and most misunderstood of LSIF risks and
is two-dimensional. When the LSIF manager decides to invest in a company, how
can s/he be sure that a fair price is paid? With publicly traded stocks, the
stock price at any one time reflects the aggregate opinion of thousands of
market participants that have reviewed and evaluated a company’s financial information.
With private companies, the LSIF manager may be one of just a handful of people
evaluating its worth. In other words, when deciding whether or not to invest,
the LSIF manager doesn’t have the public markets to use as a point of reference
– thereby making the job of assessing a fair value that much tougher.
The other
side of valuation risk refers to the ongoing valuation. Once an investment in a
venture is made, the company must be valued on an ongoing basis to ensure the
LSIF’s daily unit price fairly reflects the value of its underlying
investments. This is needed to ensure that both buyers and sellers are treated
fairly. Regular mutual funds, like Ivy Canadian, simply use the closing TSE and
NYSE market prices of its stock investments to calculate the fund’s unit price.
LSIFs, which all have substantial investments in private firms, must establish
internal policies to fairly value each of its venture investments to arrive at
a unit price for the LSIF.
It may
become quite obvious at this point that there is a ton of subjectivity involved
in the whole valuation process – from deciding what to pay for ownership in a
company to making sure each investment’s carrying value is reflective of
reality.
Despite the
subjectivity, investors should take some comfort in the fact that a fund’s
valuation is subject to review by an independent third party, usually a team of
business valuation experts. If these outside valuators disagree with the value
assessed by the LSIF, the fund may have to adjust its value (usually down).
However, there are potential conflicts of interest since a LSIF’s auditor often
acts at that independent third party to perform the annual fund valuation.
To draw an
analogy of how well they really check the value of each company, suffice it to
say that these independent valuators don’t reinvent the wheel, they just make
sure it’s still round.
Liquidity
refers to the ease with which an investment can be turned into cash – i.e.
liquidated. Since shares in private companies don’t trade on any organized
exchange, there is no facility to liquidate an investment in such firms. Hence,
a large part of a LSIF’s success hinges on its ability to “bring” liquidity to
its investment.
That can
mean:
Ÿ
helping
a company “go public” (i.e. help it get its shares traded on a stock exchange);
Ÿ
selling
its stake in the company to another firm; or
Ÿ
the
more unusual case of the LSIF actually selling its stake back to the company’s
management.
Whatever
the means, exiting investments in private companies at a very handsome profit
is the ultimate goal of the LSIF manager.
The final
major risk of investing in any company, particularly private ones, is that of
business risk. Key to a company’s success is its ability to execute its
business plan, which requires strong management. Another major factor is the
overall health of the industry in which a company resides. The list of “what
can go wrong” is long, but many factors can contribute to a company’s success,
or lack thereof. It is this set of critical factors that must be thoroughly
researched by the LSIF management team and taken into consideration when
assessing a company’s value.
This week’s
discussion really just scratches the surface of the bigger risks relating to
LSIFs. Next week, we’ll look at the brighter side of venture capital investing,
tax implications, and some suggestions on how to incorporate LSIFs into your
portfolio.
Dan Hallett, B.Comm., CFP, CFA is 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, and Manitoba.