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Labour Sponsored Funds
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.

Venture capital

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

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 Risk

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:

  • helping a company "go public" (i.e. help it get its shares traded on a stock exchange);
  • selling its stake in the company to another firm; or
  • 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.

    Business risk

    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, 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 dha@danhallett.com
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