The Changing Latitude: Labor‐Sponsored Venture Capital Corporations in Canada

• Author: Sofia Johan,Feng Zhan,Denis Schweizer
• Date: 01 March 2014
• DOI: http://doi.org/10.1111/corg.12057
• Published date: 01 March 2014

The Changing Latitude: Labor-Sponsored

Venture Capital Corporations in Canada

Sof‌ia Johan*, Denis Schweizer, and Feng Zhan

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paperseeks to understand the role corporate governance and governmentpolicy plays in the

portfolio choices of the labor-sponsored venture capital corporations (LSVCCs) in Canada. We investigate whether or not

the change in tax policy announced in Ontario (2005) had an impact on the investment behavior of Ontario LSVCCs and

whether the unique corporate governance structure of LSVCCs enables them to focus on their investment mandate

subsequent to this announcement.

Research Findings/Insights: Our f‌indings suggest that LSVCCs in Ontario are more likely to include public companies in

their fund portfolios after the announcement of the change in tax policy. We f‌ind that after 2005, LSVCCs have increased

their number of investments in public companies by 59.13 percent and in turn decreased their number of investments in

private companies by 13.17 percent. On the other hand, we f‌ind no signif‌icant changes in investment behavior for LSVCCs

in other provinces. In terms of the percentage of total investment in public companies, we f‌ind that the LSVCCs in Ontario

are more likely to increase their total investment in public companies by 50 percent and to decrease their investment in the

short term by 46.43 percent. LSVCCs in other provinces, however, are reducing their percentage of investment in public

companies by 58.33 percent and increasing their total investment in private entrepreneurial f‌irms by 38.33 percent in the

same period.

Theoretical/Academic Implications: With a hand-collected proprietary dataset, we are able to augment existing studies on

the unique structure of LSVCCs in Canada with empirical evidence on the style drift due to the changes in government tax

policy. We compare and contrast the investment behavior of LSVCCs before and after the tax policy change in Ontario as

well as the investment behavior of LSVCCs in other provinces. We hypothesize that as a result of the elimination of the tax

credits, the removal of certain investment restrictions, and weaker corporate governance, LSVCCs have drifted from their

original mandate to invest in high-risk venture companies to investing in less risky public companies. Such style drift may

be a result of LSVCCs preparing for potential wealth transfer or liquidation by retail investors. More importantly, we f‌ind

the unique corporate governance structure of LSVCCs may facilitate this drift from their original purpose of providing

venture capital to small and medium-sized entrepreneurial (SME) f‌irms.

Practitioner/Policy Implications: We highlight that the style drift of LSVCCs in Ontario may result in such funds behaving

more like other types of mutual funds and the deviationfrom their original mandate to provide venture capital may not only

prove detrimental to entrepreneurial investee f‌irms seeking such capital, but also negate any diversif‌ication benef‌its sought

by fund investors. Also, such deviation may not necessarily justify the higher management expense ratio charged by

LSVCCs.

Keywords: Corporate Governance, Venture Capital, LSVCC, Tax Policy, Investments

INTRODUCTION

The economic benef‌its of venture capital have been well

established by numerous academic studies. Research

has established that in addition to bridging the capitalgap in

the f‌inancing of entrepreneurial f‌irms, venture capital fund

managers play a signif‌icant role in enhancing the value of

their entrepreneurial investments as they provide consider-

able administrative, marketing, and strategic advice to

entrepreneurial f‌irms, as well as facilitating a network of

support for an entrepreneurial f‌irm with access to accoun-

tants, lawyers, and investment bankers (Cumming & Johan,

2012a; Gompers & Lerner, 1999; Leleux & Surlemount, 2003;

*Address for correspondence: Sof‌ia Johan , York University – Schulich School of

Business, 4700 Keele Street,Toronto, ON, Canada. Tel:1-647-449-3410; E-mail: sjohan@

schulich.yorku.ca

145

Corporate Governance: An International Review, 2014, 22(2): 145–161

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12057

Manigart, Korsgaard, Folger, Sapienza, & Baeyens, 2002;

Manigart et al., 2002; Sahlman, 1990; Sapienza, Manigart, &

Vermeir, 1996; Wright & Lockett, 2003). To encourage

venture capital investment in Canada, Canadian labor-

sponsored venture capital corporations (LSVCCs, also

known as labor-sponsored investment funds (LSIFs)) were

created with the objective of providing venture capital to

small- and medium-sized entrepreneurial (SME) f‌irms to

facilitate economic development and growth. Unlike other

more traditional venture capital funds, the LSVCCs were

created and structured to raise capital from the large retail

investor pool and not institutional investors, and to facilitate

this objective, both the federal and provincial governments

provide tax credits for individual investors who invest in

these funds. The tax credits are also provided to incentivize

investments in such funds as, while they are seen to be

potentially particularly benef‌icial to the economy in terms of

increasing innovation and other benef‌its, they are also

deemed to be more risky than mutual funds. It is interesting,

however, that several studies (Cumming, 2007; Cumming &

MacIntosh, 2006, 2007; Sandler, 2004) have found that not

only do LSVCCs provide retail investors with lower returns

but the performance of LSVCCs are also far behind many

other indices, such as small cap fund indices as well as the

lowest risk Treasury bills. These f‌indings cast doubt on the

success of the government-sponsored program and question

the ability of these LSVCCs to provide long-term economic

growth. More importantly, research suggests that LSVCCs

have a negative impact on the overall capital available to the

entrepreneurial f‌irms as the tax credits awarded and the

fund management mandates or constraints are structured

such that the access to cheaper capital and the necessity for

such capital to be invested within a tight time frame may

have resulted in a “crowding out” of other types of venture

capital investors (Cumming & Johan, 2012a; Cumming &

MacIntosh, 2006). This not only directly undermines the

initial purpose of creating the LSVCCs but may also exacer-

bate direct losses in government tax revenue.

As a result, the provincial government of Ontario

announced on September 30, 2005, that it would gradually

eliminate the tax credit for individual investors investing in

LSVCCs. It also lifted the restriction on the investment in

publicly listed companies by LSVCCs. Eliminating the tax

credit would undoubtedly reduce the attractiveness of the

venture capital funds to retail investors therefore impacting

the inf‌low of fund capital into LSVCCs in Ontario. In this

paper, we seek to understandthe roles corporate governance

structure and tax policy in Ontario played in the portfolio

choices of the LSVCCs. We investigate whether or not the

announcement of the elimination of the tax credit in Ontario

changed the investment behavior of Ontario LSVCCs and

whether the unique corporate governance structure encour-

ages LSVCCs to maintain their original function of provid-

ing venture capital to private entrepreneurial f‌irms.

The elimination of tax credits to investors in Ontario will

have an impact on LSVCC fund inf‌low. Studies have shown

that investors are incentivized to invest in LSVCCs with the

promise of tax credits due to the cheaper actual cost of initial

investment. More importantly, the same investors are less

concerned about the long-term after-tax return due to the

up-front benef‌its (Barclay, Pearson, & Weisbach, 1998;

Bergstresser & Poterba, 2002; Cumming & Johan, 2012a;

Cumming & MacIntosh, 2003a, 2003b). LSVCCs in Ontario

therefore will become less attractive to retail investors after

the change in tax policy and there will in turn be added

pressure for higher returns from existing investors as they

get closer to their allowed redemption dates or when their

statutory lock-up periods expire. LSVCCs have been found

to be underperforming even risk-free 30-day Treasury Bills

(Cumming & Johan, 2012a; Cumming & MacIntosh, 2006,

2007) and, as a result, fund managers in Ontario are

incentivized to alter their investment behavior to counter or

mitigate the potential effect of the change in investor senti-

ment pursuant to the removal of the tax credit, and the

potential redemptions as the lock-up periods expire. The

fund managers may alter portfolio risk, measured by vola-

tility, by drifting away from the less volatile investments in

private entrepreneurial f‌irms toward more volatile public

companies, or the fund manager could continue to provide

venture capital to risky f‌irms with high potential upside

returns (positively skewed returns distribution) as their

initial investment mandate required. Recall that LCVCC

fund managers have distinct skill sets for providing venture

capital and value added to entrepreneurial f‌irms and there-

fore they may not be as skilled in investing in publicly listed

companies as mutual fund managers or hedge fund

managers. Also, in terms of market risk, volatility is higher

for public equity compared to private investments (see

Cumming, Hass, & Schweizer, 2013).

Our f‌indings suggest that pursuant to the announcement,

LSVCCs in Ontario are increasingly reallocating their assets

from private f‌irms toward public companies. We f‌ind that

after 2005, LSVCCs increased the number of public compa-

nies in their portfolios by 59.13 percent and decreased

(and/or omissions of reinvestments from exited private

companies) the number of private companies by 13.17

percent. These results are statistically signif‌icant at the 10

percent and 1 percent levels, respectively. On the other hand,

we f‌ind no evidence to suggest the same shift in terms of the

fund portfolios for LSVCCs in other provinces within the

same period. In terms of percentage of total investment in

public companies, we f‌ind that while the LSVCCs in Ontario

are more likely to increase their investments in public com-

panies by 50 percent, the LSVCCs in other provinces have

decreased their holdings in public companies by 58.33

percent since 2005, when compared with the overallaverage.

Our results also indicate that LSVCCs in provinces other

than Ontario are likely to increase their total investment

in private entrepreneurial f‌irms by 38.33 percent while

LSVCCs in Ontario are more likely to decrease their total

investment in the short term by 46.43 percent compared

with the overall level of average investment in short term.

Venturecapital funds are known to style drift, for example

from the riskier early stage to the latter stages of investment

such as mezzanine and buy-out stages, and they are also

known to invest in public versus privately held f‌irms

(Chaplinsky & Haushalter, 2010; Cumming, Fleming, &

Schwienbacher, 2008; Cumming & Johan, 2012a). Our

research augments such academic work as our results indi-

cate that after the changes in tax policy in 2005, there is a

trend for LSVCCs in Ontario to drift away from investing in

private entrepreneurial f‌irms and increasingly investing in

146 CORPORATE GOVERNANCE

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