The latest trend in labour funds
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, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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