Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 12 - Evidence - November 4, 2010
OTTAWA, Thursday, November 4, 2010
The Standing Senate Committee on Banking, Trade and Commerce met this day at 10:35 a.m. to undertake the 10- year statutory review of the Business Development Bank of Canada as required by the Business Development Bank of Canada Act.
Senator Michael A. Meighen (Chair) in the chair.
[English]
The Chair: Good morning and welcome to this meeting of the Standing Senate Committee on Banking, Trade and Commerce. My name is Michael Meighen. I am a senator from Ontario, and I have the honour to chair this committee.
To my right is the deputy chair of the committee, Senator Hervieux-Payette, from Quebec; to my left was Senator Ringuette, but she has left for a moment. She is from New Brunswick. Senator Moore is from Nova Scotia. Senator Massicotte, next to him, is from Quebec. Senator Kochhar is from Ontario. On my right, Senator Gerstein is from Ontario; Senator Mockler is from New Brunswick; Senator Ataullahjan is from Ontario; and Senator Marshall is from Newfoundland and Labrador. He is a guest today, substituting for another member. Welcome, Senator Marshall.
Colleagues, today we will resume our study of the Business Development Bank of Canada Act, or BDC Act.
[Translation]
This statutory review includes an examination of the BDC activities under the provisions of the act. The last review like this was in 2000 and it essentially looked at the trends and changes of financial markets for small and medium enterprises from 1995 to 2000 and at the BDC resources available to meet their needs.
[English]
In our first hour, via video conference, we welcome Douglas Cumming, from York University's Schulich School of Business. Welcome, Mr. Cumming. There is a slight delay in the transmission of our voice, I understand, so colleagues will have to endure that, as will you, Mr. Cumming.
Mr. Cumming's has an opening statement, and following that, we will have questions from members of the committee.
Douglas Cumming, Professor in Finance and Entrepreneurship, Ontario Research Chair in Economics and Cross- Cultural Studies, York University — Schulich School of Business: I will be brief in saying thank you for the opportunity to join you today to review the Business Development Bank of Canada, BDC. Since this is the first time I have appeared in front of the Senate committee, I can cover some of things I have been involved with in my professional life. I teach private equity and venture capital to M.B.A. students and Masters of Finance students at York University's Schulich School of Business. I have been here since 2007. Prior to that, I did similar work in the United States and Australia, and in Alberta much earlier than that.
I also occasionally do work in practice for private companies, as well as government bodies. For example, earlier this year I did some work for the Government of Ontario evaluating their venture capital programs. Similarly, I did some work a few years ago evaluating the government's venture capital programs in Australia for their department of industry, tourism and resources. The main focus in my professional work is as a professor doing teaching and research, primarily on areas around venture capital and private equity, entrepreneurship and, more generally, financial intermediation.
That is my background. In the work that I do, I am largely empirically based, so I work with large data sets or as much data as we can get our hands on because I strongly believe that things should be spoken about with reference to empirical data, insofar as those are available.
I have a PhD in economics and finance, and I have a law degree. I am a chartered financial analyst, and I have published over 60 papers and a few books, again most of those on private equity and venture capital.
I was invited to look at this issue roughly eight days ago. I am pleased to have the opportunity to comment on it. I know there are five suggestions with respect to the changes: first, to give small and medium-sized enterprises, SMEs, broader access to a range of different financial tools; second, to give the powers to provide a greater range of non- financial services; third, to give the powers to support SMEs to expand beyond their domestic markets; fourth, to remove the ceilings for paid-in capital; and fifth, to modernize the governance structure, which raises minor changes to update the BDC Act.
To differing degrees, some of the changes are not controversial and others are potentially controversial. Two of the changes are related to financial issues and three are more non-financial. The financial issues, I would suggest to you, are arguably more debatable than the non-financial issues. The financial issues are actually the first and fourth suggested changes. The first was broadening powers to give SMEs access to a broader range of financial tools. The fourth one is removing the ceiling for paid-in capital.
I should characterize some of the work I have done over the last 10 years with respect to public policy toward private equity and venture capital in Canada. I have written a number of papers on Canada's Labour-Sponsored Venture Capital Funds program, LSVCs. The views that I have expressed in that work have been that that particular program has not given rise to more venture capital in Canada but has actually displaced private investors and done so in a way that has been detrimental to the venture capital market in Canada.
If you look at the statistics, this is all data-based, so I am speaking from the data, not from opinion. The data strongly indicates that the growth and labour funds have expanded to such a degree that the labour funds accumulated so much capital that they were dominant. That means more than 50 per cent of capital undermanagement in venture capital funds in Canada was through labour funds, the dominant force in Canada. They have a governance structure in that particular program that was relatively inefficient in relation to the way private venture capital funds operate. In turn, that was to the detriment of the market and discouraged institutional investors such as pension funds and other types of institutional investors from making commitments to private funds in Canada.
The subsequent performance of investments through labour funds has been extremely weak. If you look at the performance of the labour funds since their inception, depending on the jurisdiction — say you took a dollar and put it into a labour fund and looked at the index back in roughly 1990 and then looked at the subsequent performance to date, you would observe rates of return that would be roughly zero. There has been no economic value generated through that particular government program.
This, of course, is not a review of the labour fund program, but I think it is an important context in which to understand public support for venture capital, private equity and entrepreneurship more generally in Canada. Relative to other countries, we have a pronounced presence of publicly supported initiatives to support entrepreneurs, such as through venture capital funds. That is extremely unusual.
In the last number of years, I have spent time living in many different countries around the world. I have spent time living in Germany, the U.K., Malaysia, China and Australia. I tell people about Canada's pronounced support for venture capital and entrepreneurship through public measures such as the labour-sponsored funds program, and they find it highly surprising the degree to which there are public initiatives to support entrepreneurship. The venture capital funds base, for example, is more than half of the market.
One thing that is changing is that in Ontario, they are phasing out the labour funds program. The phase-out will be finished at the end of 2011. That is being replaced with other initiatives in Ontario.
Returning to BDC, perhaps we can look at the fourth issue, removing the ceiling for paid-in capital. The context and timing under which the review is happening of course is right around the aftermath of the financial crisis, and the documents put out by BDC are strongly encouraging the need for greater flexibility in view of things such as financial crises. This may not be the most ideal time to think about legislative changes, but there is certainly a tendency to make big changes right after crises. In a more forward-looking context, that must be considered from the perspective of what one wants to have happen in the future.
Certainly in the recent crisis, we could look at it in two ways. BDC stepped up, if you will, with respect to loans it made to Canadian entrepreneurs during the recent financial crisis. On the flip side, in the venture capital space, the venture capital subsidiary of BDC drastically reduced its commitments during the crisis. There have definitely been differing effects.
I should stress that when we look at this from the basic rationale of why we would want a greater presence of government support and taxpayer dollars being put toward financing entrepreneurs, we would have to have strong evidence of a capital gap. That would mean that private investors are not doing their job in the sense that there is some sort of market failure for not providing capital to entrepreneurs that are in need of capital, and deservingly so. We like to have strong evidence of a capital gap before justifying a government intervention in this type of context, as well as other contexts.
That is the $20 question, you could say, needing evidence of a capital gap. I cannot say that I have seen tremendously convincing evidence of a capital gap that is empirically oriented. That is an issue that needs to be heavily weighted.
Going back to the first issue of expanding the range of financial tools, if you look closely at the way the legislation is set out in the BDC Act, starting with section 14, it is clear that BDC is supposed to provide loans, investment guarantees and other things. The proposed changes are phrased in a way that says they should be offered a broader range of financial tools, and examples are given to allow trusts and investments in not-for-profit organizations. The way those examples are phrased, I think is innocuous. It is difficult to say, ``Of course; why not? That sounds very good.''
At the same time, I am not sure if other things are envisioned alongside that, but they are certainly not stated in any other way. It is difficult to comment on the examples that are given and whether or not that would be limited in its scope to those additional types of financial tools or available more broadly.
In reference to the act, I find it puzzling that, through the venture capital division of BDC, it appears that it does things that already go beyond the way the act has specified with respect to loans and investment guarantees. That is certainly not venture capital.
I will talk briefly about the second, third, and fifth non-financial issues. On the second issue of non-financial services providing investment advice and various aspects, that is always a good thing. Entrepreneurs need training. Very often, in practice, people say that the advice given is more important than the capital. I would never argue with that. I think that is a useful thing.
The third issue is enhanced powers for exporting to expand beyond the domestic market. I wholeheartedly agree with the things that have been put in the BDC report with respect to entrepreneurs needing to be more global. We live in a global marketplace. One expression that people like these days, based on the popular book, is that the world is flat. We have seen statistics on this. Canadian entrepreneurs are less global than their counterparts in other countries, and it is good to be outward-looking. As a financial economist, I would never say that being global is a bad thing. That would be contrary to everything I have ever learned.
The only issue that it raises is the extent to which cooperation can be brought in with other partners, such as Export Development Canada, EDC, and Foreign Affairs and International Trade Canada, DFAIT. It appears, based on the material that I have seen put out by BDC, that they envision that cooperation will happen in a positive way. That is the one thing I would flag.
The fifth issue was modernizing BDC's governance structure. I cannot see any reason why that would not go forward.
I hope I have not taken too long. I have been accused of rambling on sometimes a little too long. Those are my initial thoughts based on what I have been provided, and I am happy to discuss any of these issues with you.
The Chair: Thank you, Professor Cumming. I can assure you that your comments were helpful. I must say, as a professor, you were, shall I say, remarkably succinct and to the point. You did not ramble at all.
For my edification, before we turn to my colleagues for their questions, on the first item of broader range of financial tools, I think I heard you mention the trusts, and I think you said that that does not seem to be a big deal and seems to be perfectly reasonable and so on. If that is so, does that comment apply also to securitization, indemnities and bonding services that were also mentioned as powers that BDC was looking for, and do you feel they are appropriate and within the same ambit as the trusts?
Mr. Cumming: Yes. Securitization is a tricky animal. Certainly, much has been written in the last few years in academic and practitioner outlets with respect to some problems with securitization, to put it bluntly. I would say that many people think that securitization has at least exacerbated issues in the financial crisis.
It is a tricky thing to comment on. Part of the reason I glossed over it in the opening remarks is that the difficulty I have is that the exact goals that BDC has with respect to securitization are not explicit in the material that I have been provided. I do not know how they envision using such securitized products. It is a little more difficult for me to comment on.
The typical thing I have seen with respect to securitization is that having some flexibility in being able to structure the securitized product is only a good thing. When private financial actors are able to do things in a way that meets their best interests, then that can only be helpful for the investor and the entrepreneur. At the same time, securitization breaks down when people lose skin in the game, so to speak. The ways in which the product might get sold off do not exactly have the ideal governance structure associated with it.
When I look at that suggestion that they want to get into securitization, I have mixed feelings. If it is set up properly, that is great, but I do not know exactly how they intend to set it up.
The Chair: Do you have a brief comment on indemnities or bonding services?
Mr. Cumming: That is less innocuous, I would say. My initial thought is that that could be potentially helpful, depending on the context. A priori, I do not see a need to restrict those types of things. As long as they are done with suitable governance structures and people know what they are getting into, they can be structured in a way to help entrepreneurs. As long as the appropriate governance is put into place, these types of things can work out.
Again, there is not a tremendous amount of detail in the material that has been given to me on that. Certainly the lengthier examples I have seen have been with respect to more popular things such as the trusts and the examples of the Canadian Youth Business Foundation and not-for-profits. That is perhaps an easier sell and less complicated for most people to think about, whereas securitization and indemnification are more complicated. I typically like to see much more detail than what I have seen. It is harder for me to comment on those.
The Chair: Thank you, professor.
Senator Hervieux-Payette: Thank you, professor, for joining us and sharing your knowledge. Have you published any studies about the comparison between BDC and other likely institutions in other countries? You seem to have travelled in many countries and have probably advised others. Have you published anything about this?
Mr. Cumming: I have not done direct comparisons between BDC and similar institutions in other countries. I have worked with, in many publications, data from the Canadian venture capital association, part of which comes from BDC. When I was asked to look at this particular issue eight days ago, the first thing I did, as I always do, was a literature search to see if anyone has actually done such a direct comparison between BDC and similar institutions in other countries. I found nothing, at least nothing in an academic way that looks at data in a hard manner — quantifiable data. That is not in existence. Maybe this suggests that, as academics, we need to step up to the plate and write such a paper.
I do know, in the BDC marketing materials that I was sent, comparisons have been made to other jurisdictions where they say in other countries that these are services available through the institution in their jurisdiction that is similar to BDC. I have certainly seen reference to that.
Senator Hervieux-Payette: Probably we would need that if we want to go further with this institution, for the simple reason that you mentioned, which is that we are falling behind other countries in terms of accompanying our entrepreneurs first in the global market. At the same time, if we do not have the institution to accompany our entrepreneurs, how will we help them to be more competitive in the global market?
This would be perhaps a recommendation to our minister to look at whether we have the right tools, whether BDC would be one of the tools that we would need to address this question. My own particular issue in this committee, which perhaps was a side issue, is the venture capital one.
You talked quite extensively about labour funds. I always refer to that as pension funds because it is mostly pension funds. The concern that I have is that Fonds de Solidarité and Caisse de dépôt et placement du Québec are both pension funds, but the Fonds de Solidarité receives very big tax credits from the government, so there is already money involved in that. The performance since 1990 has been zero rate of return, which means that we may have fallen behind. I do not know if you take inflation into account because this is 20 years ago.
In this case, if the market is very low in terms of venture capital, how would you see BDC playing a role to make more money available and have a better capital structure for the company — so they do not have just debt but they have equity — that will not put them in danger?
You mentioned in your presentation that the task performed by BDC, advising the entrepreneur, is very important. Should we increase that? Is it enough?
In looking at what is needed for the small and medium-sized business to grow in the future and to be competitive, how would you rank what is needed? Is it advice? Is it venture capital? Do we need other tools to fill the gap?
You said that to enter into helping the entrepreneur, you need strong evidence of a gap or a market failure. We have seen for quite some time that there is a market failure and quite a big gap. We need to address this question. How would you put that in light of the revision of the bill of BDC?
Mr. Cumming: There are a large number of issues there. If we start first with the context in Canada, over this past decade — roughly around 1998 or 1999 — labour funds comprised more than half of all venture capital in Canada. The funds grew very quickly in the 1990s, and the capital under management in Canada in venture capital has predominantly been with respect to labour-sponsored funds.
It is very difficult to address the issue of whether or not there is a capital gap in Canada, given this long history of a context of pronounced government intervention. The governance structure of a labour fund is much more inefficient than a typical private venture capital fund for a variety of reasons, largely to do with the legislation governing the fund. The funds are subject to statutory covenants with respect to how they do their due diligence and investments; they have to reinvest capital contributions within a certain period of time, which limits their due diligence timing.
They have grown in size so quickly over those years that the capital under management per fund manager is much larger than it should be. Therefore, the number of investments that a single fund manager makes is very large relative to a private venture capital fund.
In turn, the advice provided to the entrepreneurs, and the due diligence that they do before they make an investment, has been extremely compromised relative to private venture capital. They make a large number of investments; they do not have the time to do the proper value-added activities that they should with respect to their entrepreneurs, and the outcomes have been much worse relative to private venture capital.
With that context in mind with Canada's venture capital market and financing entrepreneurs, first, it is difficult to say that there has been a capital gap. Second, the data would strongly suggest that there has been crowding out of private investment due to the strong, dominating presence of the public sector support in the venture capital market.
That has been a tricky thing for investment in Canada. I cannot think of any other modernized country around the world that has more than 50 per cent of its venture capital market bought up by tax subsidies such as the labour- sponsored fund program. It is a very unusual context that we have with this dominating presence of public sector support through the labour funds.
I should say again that Ontario, in 2005, announced the phase-out of that program. That was initially scheduled for 2010. With lobbying and other things, it was pushed back to 2011. They have subsequently brought in other types of programs, where they have their own fund and act as a limited partner in private funds in another program.
They are replacing what they had with something else, which is arguably a better model. That is something that I worked on with the Government of Ontario, producing a report for them this past year.
You brought in many issues. Just to stay on topic here, in the venture capital context, how do we get that right amount of support for entrepreneurs in a way that will make them innovative, international, competitive on a world stage and competitive without the continual backing of the public sector? We want these entrepreneurs to not have to rely on government support for years and years at a time.
Again, the data on this is tricky. The hardest area is in the really nascent-stage companies, the very earliest of entrepreneurs. You could think of two people starting up a company in their garage, they need less than half a million dollars of support. Typically, the investment size is so small that the way private sector venture capital funds are set up, they do not have the time to make those kinds of investments. The rates of return in that area can be highly variable, so things could work out to be tremendously successful or tremendously bad. That is an area where many people think that if there is a capital gap, it is most likely to exist in that range.
In the larger investments space, where the private venture capitalists usually get involved, it is usually between half a million dollars and upwards of $10 million. If opportunities are available and there is a market without friction, such as undue tax burdens and those sorts of things, then things can work out very well.
Hopefully that answers most of the issues that you brought up. You certainly brought up many things that are tricky to answer in a short amount of time.
Senator Hervieux-Payette: Would you recommend a different provincial government to stop financing labour funds?
Mr. Cumming: Yes.
Senator Ringuette: You agree that BDC should finance foreign markets for Canadians through taxpayer money. I deduce from that, and your data suggests that Canadian chartered banks are not fulfilling their mandate through the Canadian SMEs that want to establish themselves in foreign markets.
Mr. Cumming: That is a trickier issue because, again, we would have to say that there is a market failure with respect to how our Canadian banks operate. We know generally that our Canadian banks are few in number, at least relative to other countries such as the U.S. They tend to be more conservative relative to other countries such as the U.S., which has worked out well in the last few years.
Whether or not they are doing their job with respect to helping entrepreneurs expand globally is something that is trickier to get at because, typically, the data that we like to see is not always available, especially for private companies. I cannot really speak to a data set that would say one thing either way.
The only thing that I could say is that if there is a program such as BDC that is encouraging entrepreneurs to use their services, then it would be unfortunate to have a restriction that says that they cannot do anything to help them with respect to internationalization.
For example, if I am a person who wants to start up a company and I approach BDC and I get help, then I subsequently ask, ``How will I make my company global?'' If they tell me long after the fact that I have established this relationship, that they cannot help me in that regard, I would be a little frustrated.
The Chair: That is the situation now, is it not? BDC cannot follow the customer abroad.
Mr. Cumming: Again, there are partnerships, as has been said, with DFAIT — Foreign Affairs and International Trade Canada — and EDC. There are other governmental institutions that can help with internationalization.
If those partnerships between BDC, EDC and DFAIT can be worked out, it does not seem to make sense to set up something such as the BDC and not allow them to offer advice with respect to internationalization. It just seems like the right thing to do.
Senator Ringuette: I was not talking about advice. I was talking about taking Canadian tax dollars to create jobs abroad, not in Canada, through the process.
Mr. Cumming: Yes. Likewise, I would say that the best way to phrase that type of restriction, if you will, is to say that if this is an organization that is being set up for the benefit of Canada, then it is inefficient to tell that organization, whether it be through advice or financing, that they are restricted to borders within Canada. Successful companies will not be ones that are restricted to operating within Canada.
You could think of it similar to a pie. The pie is really small if we restrict ourselves to Canada. Then if we think of this organization in a global marketplace, the pie all of a sudden becomes really big, and that financing will have much greater benefit to Canadians and the organization itself if it has opportunities to take advantage of the global marketplace.
Having a Canada-only restriction is something that might have worked a long time ago but not in the economy we are in today.
To give a quick example, think of an Internet company: What are their borders? I do not know what the borders are. I do not think there are any.
The Chair: Professor, we will not have time for all of the questions if we do not try to be shorter. I will thank you on that answer, thank Senator Ringuette for the question and move to Senator Gerstein.
Senator Gerstein: It is a particular pleasure for me to welcome Professor Cumming here, as my late father was the chair of the board of governors of York University for many years. Earlier in my political career, I had the privilege of chairing the election campaign of the founder of your school of administrative studies — now called the Schulich School of Business — Dr. James Gillies, who was a member of Parliament and served with distinction for many years, 1972 through 1979.
Professor, when the chartered banks extend credit, their main considerations are minimizing risk and maximizing returns. During periods of economic difficulty, such as the recent recession, to what extent, as a matter of public policy, do you feel BDC is obligated to step into the breach and extend credit to entrepreneurs for the good of the whole economy when the chartered banks may be reluctant to do so?
Mr. Cumming: That is a brilliant question. I think that for governments that have their government-funded institutions such as BDC, that is the time at which their role should be the strongest. In other words, public policy measures such as this are most effective when they are counter-cyclical is the way we would put it. If they were in tremendous difficulty and institutions are overly risk-averse in times of financial crises, then that can alleviate the difficult times that we face.
With respect to the loans that BDC has made, we know from the data put out by BDC over the last couple of years that they actually did just that. They were stepping up to the plate, as we understand it. At least that is what has been put out in the brochure that was part of the documents that I received from BDC.
On the flip side, it appears that exactly the opposite happened with the venture capital investment. Venture capital went down drastically over the last while. That is exactly the type of situation where BDC can step in, and they appear to have done a good job with their loans.
Senator Massicotte: Professor, if I were to summarize your thoughts, you made comments about the added powers BDC is looking at, but I understand your fundamental message is that you do not see why they exist because the data does not support a vacuum market failure, with the possible exception of the start-up venture capital arm. Is that a summary of what I think I heard?
Mr. Cumming: It is trickier. The fairest way to characterize it is that we do not have data that would conclusively say that there is a capital gap. That is probably the best way to phrase it.
With respect to the venture capital investments in particular, I would say, given the strong presence of the labour funds, that the intervention with respect to labour funds has made the quality of the market worse rather than better. That is probably the best way to characterize the environment for financing entrepreneurs.
Senator Massicotte: You said earlier that while the data was not conclusive, the data did point to the fact that there did not seem to be market failure.
On venture capital, you commented that there was an immense distortion in the marketplace given the political or tax nature of the labour funds. We have a presentation coming up by Canada's Venture Capital & Private Equity Association, CVCA. They will tell us there is an immense fall-off in raising funds and an immense fall-off in venture capital investment. There are all kinds of ills, and the solutions are less obvious.
While BDC has an immense role in venture capital, the numbers will show that there has actually been a decrease in their venture capital investment. A high proportion of BDC's capital investments is in plain vanilla deals, not in start- ups or in high risk, often pari passu with the banks, so not even satisfying the start-up venture capital role for which you saw a need. Would you agree with those observations?
Mr. Cumming: Yes, very much so. I definitely agree with the comments with respect to BDC's venture capital investments declining and not taking a lead in financing new companies, but they were more active, syndicated investors. They like investing with other people. They do not do the things that we might think that they would take a lead role in with the earlier-stage companies and initiating the investments.
With the shortage of venture capital in Canada, in the report that I did for the Government of Ontario back in July of this year, we showed, and I do not think this is that commonly known, that a majority of investments in Canada actually come from the U.S. We have a substantial amount of cross-border investment in Canada. A large number of American investors invest in Canada. The investment amounts they make tend to be larger. Often, when a foreign investor is involved, that has other potential benefits with the company with things such as internationalization and obtaining more capital and perhaps more expertise.
The main caveat, of course, is that entrepreneurs do better, all else being equal, when they have an investor that is very close and can provide hands-on advice on at least a weekly basis, sitting on the board of directors, et cetera. That international investment is not necessarily a great thing, but it is very unusual for a country such as Canada to have such a pronounced degree of international investment.
For various reasons, such as the dominating presence of labour funds, there have not been the greatest incentives for private investors to set up funds here in Canada. That has been a tricky thing.
Senator Massicotte: If we notice a shortfall in new capital raising in Canada, I do not know the answer. However, is it because the returns are inadequate for past investors, and they are being discouraged from investing in more ventures, probably influenced by the labour funds where the tax incentives are such that their return requirements are less, therefore their success is less dependent on the success of their investments? Would that be why?
Mr. Cumming: That is a perfect explanation, and I agree with that wholeheartedly. Labour funds do not have the institutional investors that have return requirements that private funds have. Labour funds can outbid private funds. They compete with private funds and deal with prices and lower returns. The returns in Canada for venture investing have been very low relative to other countries. As a general point, public policy works best when not in competition with private sector investment. Certainly in the labour fund case, the labour funds are in competition, for the most part, with the private funds, and that is exactly the opposite of what one would hope for. I agree with that wholeheartedly.
Senator Kochhar: You indicated that the function of BDC in advising SMEs is more important than providing the capital. You placed a lot of emphasis on that when giving your opening remarks. In view of that, do you think that we should increase the mandate of BDC to stick to giving more advice and concentrate less on giving capital or advising the other financial institutions about the application so that these people can go to the regular institutions and get the money they need? They would expand their advisory role manyfold.
Mr. Cumming: That is a great question. In the very short time that I have, I would say, for the nascent entrepreneurs, the advice can be as important if not more important. The role of providing advice and professionalization to entrepreneurs is great in connection with the prior question. It is great when the public sector institutions such as BDC can partner with the private sector in helping them achieve their main objective, which is a more active entrepreneurial market in Canada. To the extent that you believe that there is a capital gap for the really earliest-stage companies where our institutions in the private sector are not taking enough risk, then there is a role for financing to be provided by the public sector institutions.
Again, the empirical data on the degree to which there is a capital gap is hard to come by. However, if you will take us out in the dark, then you would say that our best guess is that, in the very earliest stages of investment, for these really nascent-stage entrepreneurs who have little in the way of collateral, that do not meet the typical requirements that a bank would like before they provide a loan, then that is where the public sector can step in and say that they will give them some money and that they think the end result will be a good thing. That is why, for most countries around the world, you do see institutions such as the BDC. Our best guess would be that at the super early stage, such as two people in a garage-type company, that will be where things are most problematic for entrepreneurs.
Senator Marshall: Mr. Cumming, to return to the comment where you are not convinced that there is a capital gap, you say that you have not seen the data to convince you of that. Can I make a leap and say that you would suggest we get that data before we start expanding the role of BDC?
Mr. Cumming: Yes, that is something with which one would always have the most comfort. The academic mindset would be to first gather all the available data, and then write a paper or report on it before making a conclusive decision with respect to a policy change. That is normally the way we would go about that process.
That has been the way that I have lived my professional life. With other contexts, for example, in doing a review for the Australian government with their programs and the way they approach things, and similarly in Ontario with the government venture capital program here, they were interested in the empirics before they went ahead and did other things. Again, I think that is a great idea, but that is the way I have been trained.
The Chair: On that note, I am afraid we will have to close this segment of our hearing today. Thank you very much, Professor Cumming, for your patience with us and for understanding that our time has been limited. I realize the questions do not lend themselves to a short answer, and it is not always easy to respond in a yes-or-no fashion.
We benefited greatly from your knowledge and your experience around the world, and we will be able to chew on what you have given us today when we are preparing our report. You may be surprised to see what appears in the report as a result of your interventions. Thank you so much.
Mr. Cumming: It is a privilege. Thank you.
The Chair: Colleagues, in the second hour of today's meeting, we are pleased to have with us Mr. Greg Smith and Mr. Richard Rémillard from Canada's Venture Capital & Private Equity Association, CVCA.
Canada's Venture Capital & Private Equity Association represents the majority of private equity companies in Canada. Its activities include advocacy, networking, information and professional development for venture capital and private equity professionals.
Mr. Smith is the president. He is also the managing partner of Brookfield Financial Corporation's global infrastructure advisory group in Toronto. Mr. Rémillard is CVCA's executive director.
Welcome to you both and thank you for your presence. I will ask you to proceed with your remarks and to accept our questions afterwards.
Greg Smith, President, Canada's Venture Capital & Private Equity Association: Thank you very much and good morning, senators. It is my pleasure to be here this morning. This is my first appearance before a Senate committee, so be gentle with me, please, as it goes.
As mentioned, I am the elected president of the Canada's Venture Capital & Private Equity Association and the managing partner with Brookfield Financial. As a background, I have been actively involved with the private capital business, initially in Western Canada and subsequently in Ontario, for approximately the past two decades. I am pleased to have with me Richard Rémillard, the executive director.
I would like to thank the committee for extending an invitation to CVCA to appear before the committee.
CVCA has been in existence since 1974, when it was founded by six venture capital funds. It now has over 130 member venture capital, mezzanine and buyout funds and more than 1,800 individual members. These funds collectively manage about $75 billion in capital.
CVCA represents the vast majority of venture capital, mezzanine and private equity funds in Canada. As such, CVCA is the sole voice across Canada of the private risk capital industry. I will say a few words about the venture capital part of the private capital industry and then move on to some thoughts about BDC.
Venture capital funds are 85 per cent to 90 per cent invested in what are considered high-technology industries. These include information and communication technologies, life sciences, agricultural technologies and water technologies, digital media and clean technology. These are mostly new companies in new sectors, many of which sectors did not exist 10 years ago.
These are high-potential industries of the future. These are the industries Canada must invest in, grow and develop if we are to compete in the global economy of the 21st century.
Our January 2009 research report, Why Venture Capital is Essential to the Canadian Economy, which was jointly funded by CVCA, BDC, Industry Canada and four provincial governments, reveals that there were 1,755 venture- capital-backed firms in Canada by 2008, with sales of approximately $18 billion, employing 150,000 Canadians. That research also shows that venture-capital-funded firms grow five times faster than non-venture-capital-backed companies and export 70 per cent of their sales. Quite clearly, funding these innovation companies is critical to Canada's ability to enhance its productivity and create a critical mass of high value-added jobs.
With respect to the state of the industry, I will not mince words. The venture capital industry is in crisis today. That crisis has several dimensions and several consequences.
Some of the dimensions are that very little capital is flowing into venture capital funds. We will shortly be releasing our third-quarter fundraising statistics that will show that the entire industry raised only $35 million in the third quarter of 2010. That is from the period of July to September. Most notably, there were no fund closings in the third quarter. This is a historic first for Canada.
Traditionally, capital providers are shying away from the asset class — institutional investors such as pension funds and insurance companies, along with some individual investors in retail funds. Corporate players are also largely absent. As you heard from previous witnesses, the banks in Canada have no appetite for the asset class, and there is little incoming foreign direct investment into venture capital funds.
As a result, many venture capital funds are smaller today than they otherwise would have been. On an industry basis, we are approximately one half the size proportionately to the U.S. venture capital industry, making Canada less able to support its entrepreneurs and growth companies.
Capital that recently found its way to the asset class, filling some of this gap, has come from government vehicles, either directly or indirectly. Examples include the Ontario Venture Capital Fund, the Teralys Capital Fund, Alberta Enterprise Corporation and the B.C. Renaissance Capital Fund Ltd. Provincial governments are understanding the importance of fuelling growth companies and creating clusters of innovation.
The industry's overall returns, while not stellar, are roughly comparable to those venture capital industries in other jurisdictions such as the United States and Europe, and have outperformed the NASDAQ and S&P 500 public market indices over the 10 years to December 31, 2009.
With venture capital in short supply due to the industry's own fundraising challenges, a smaller and smaller number of companies are being funded. The industry is funding two thirds of the number of companies annually compared to a few years ago. This means we are providing capital to about 400 companies per year, down from more than 600 several years ago. In fact, venture capital investment is at a 14-year low.
Less and less money is going into individual companies, particularly compared to the U.S., where portfolio companies get two and a half to four times the capital that a similar company in Canada would receive. This capital shortfall restricts the ability of Canadian companies to effectively compete or accelerate new technologies or ideas. Our industry's capital shortage is felt most acutely by life sciences and clean technology firms, which can have higher capital requirements.
The huge multi-billion dollar annual government investments in R&D risk being stranded as there is often no capital outlet for entrepreneurial companies that emerge from these investments. Consequently, we are increasingly losing companies to other jurisdictions, notably the United States, where the venture capital availability has been historically greater. We are not growing the next generations of Research In Motions, RIMs.
Set against this backdrop, we view BDC as a key player in the venture capital industry. With $735 million in direct and indirect commitments and $1.2 billion invested over the past decade, including $330 million in 23 venture capital funds, BDC has a prominent role in the industry. In fact, we were encouraged to read BDC's submission that commented that a strong and resilient venture capital industry is critical to the creation and growth of successful technology companies.
BDC is also a key syndicate partner in many venture capital deals, deals that might not otherwise have happened without the presence of BDC. This is reflected in BDC's own submission that refers to their survey of market participants in which respondents recognized the key role BDC plays in direct investing, especially as a reliable syndicate partner; and that the industry would face even greater challenges without BDC's intervention — a statement with which I agree.
BDC's venture capital authorized $85 million for the year ending March 31, 2010, and that $85 million was accompanied by $467 million from non-BDC sources of investment. It is worth noting that BDC has been a participant in five of the ten largest venture capital deals in the first half of 2010.
A shining example of this co-investment activity took place last year when BDC Venture Capital was the co-winner of CVCA's venture capital Deal of the Year Award, along with the Caisse de dépôt et placement du Québec and Fonds de Solidarité, for their investment in ViroChem Pharma Inc.
On BDC internationally, as noted in my remarks, research shows that venture-capital-backed companies, in addition to being significant job creators and R&D performers, are very international — much more so than the SME universe itself. Venture-capital-funded companies know that you cannot simply be the best in Canada, and you cannot sell only into the Canadian market. As a result, venture-capital-backed companies are likely to be the beneficiaries of an extension of BDC's capabilities into the international scene.
With respect to BDC's capital authorization, we consider it important that BDC's capacity to participate in venture capital not be hindered by the fact that its current capital ceiling has been reached. Thus, a removal or increase of this ceiling needs to be contemplated for BDC to be able to support the industry for the next 10 years.
Capital efficiency is key to BDC continuing to play its counter-cyclical role. As noted in BDC's submission document, when credit conditions force private sector lenders to retrench, BDC plays a counter-cyclical role, remaining steadfast in its support. The venture capital industry is currently weathering a perfect storm and needs BDC to continue its counter-cyclical role.
CVCA is a not-for-profit organization and has enjoyed a positive working relationship with BDC for many years. For instance, and as noted earlier in my presentation, BDC helped finance and participated in the writing of a seminal study of the economic impacts to venture capital that was released by CVCA almost two years ago.
CVCA would be open to exploring further opportunities for partnering with BDC. These partnerships could include joint research on improving the public knowledge of the asset class and monitoring and disseminating best practices in venture capital.
We are happy to take your questions.
The Chair: Before turning to our list of questioners, your presentation was succinct, clear and not ambiguous.
Mr. Smith: Thank you.
The Chair: You say that the venture capital industry is in crisis. Why is that?
Second, you say that as a result, venture-capital-backed companies are likely to be beneficiaries in the extension of BDC's capabilities onto the international scene.
Are you not concerned that if BDC is authorized to follow their client abroad, then that would mean that they would have less time and money available to partner in venture capital activities in Canada; or that jobs would be created abroad and thereby reduce the number of jobs created in Canada?
Mr. Smith: There are probably two parts to the question. Let me talk about the crisis first and where we sit in the industry. The whole capital system — what I will call the venture capital ecosystem — is dependent on what happens before and after it.
Look at how a company gets created or invented. We start from the investments in R & D and education. A founder, with typically their own money, or friends' and family money, will create an idea, a technology, and then incubate it. It then moves on toward the assistance of angel investors, who are then dependent on venture capitalists to exit and further grow, mentor, provide active management, international networks, and supply procurement, working with the entrepreneur, providing them access to the experience, wisdom and network that they cannot otherwise obtain on their own. Venture capitalists will then end up exiting to strategic players, private equity players or public markets, as the case may be.
If there is a break anywhere in the system, the other pieces of the environment will start to suffer. If angel investors cannot find good, solid exits or other venture capitalists to further capitalize the company to reach their milestones and commercialize their products, angel investors will stop investing in companies. It is important to see how the whole lifecycle works and comes together.
The biggest statistic you can look at, I think, would be that in Ontario alone, 10 years ago, over $3 billion was invested in companies backed by venture capital. In 2009, that number was less than $300 million. Across Canada, we are talking now about $1 billion invested from Atlantic Canada through to British Columbia, across all types of technologies — advance manufacturing, communication, digital media, clean technology, water technologies, agricultural technologies. If you take the breadth of our country and the number of different sub-sectors that have emerged in the new economy, that money does not go very far. We are at a state where we are at 14-year lows in investment-level activity in Canada. There is much more of an emergence into these new sectors that will be vital to how Canada competes in the next decade.
The Chair: Forgive me, but I still do not understand why we are at such a low. It cannot be high or low interest rates, can it? Why is there such a dearth of venture capital?
Mr. Smith: This could be a long discussion.
The Chair: Is there something that you think we should recommend that would help you?
Mr. Smith: We have done a number of studies on the impact of venture capital. I would encourage more work and more studies in the area of venture capital. The whole ecosystem needs work. What the provinces have done with some of their funds has been positive. What BDC is doing in the venture capital space is critical. BDC is a core pillar to what is happening to keep Canada competitive. The conditions would be worse in Canada if it were not for where BDC currently is doing both direct and indirect investment levels.
There are a number of macro external and internal factors. The regulatory regime on financial institutions that forces them to match assets and liabilities has a detrimental effect in growth and start-up company financing. A number of direct and indirect consequences are happening because of different regulatory frameworks, as well as macro factors in terms of expansion globally, to real assets and infrastructure, which puts capital away from emerging companies.
I do know, and believe strongly, that investment in the innovation economy is extremely critical for standard of living and our productivity. It is vital that Canada takes from its strong fiscal and regulatory framework. As it emerges from the global economic crisis, it has an opportunity to position itself in new emerging technologies such as agricultural technologies, water technologies and clean technology, taking advantage of some of our natural inherent strengths and capitalizing on that as we look toward competing globally. It is fundamentally important that we continue to look at this. It is a strong place to be.
The international following has been ancillary. It is not the core business of where BDC should be. Companies often find they need to react to customer orders or opportunities that exist abroad. Therefore, a mechanism is needed to react quickly to take advantage of some of those opportunities. There is always the example of having a manufacturing facility in Canada, where you have to have an assembly or a bonding warehouse in another jurisdiction, and you need the ability to set that up and capitalize it and move to create the jobs and opportunities in Canada. There is some ability where you are currently involved with a company, where international activities would be a direct benefit in terms of the speed and the methodology of how quickly you could react. The proper governance and investment criteria set around an international capability would greatly benefit Canadian companies.
Richard Rémillard, Executive Director, Canada's Venture Capital & Private Equity Association: If I could add to what Mr. Smith has said, think of the venture capital world as a barbell. On one side of the barbell, you have capital coming into the industry. On the other side, you have capital coming out. There are problems in both places.
With capital coming in, less than a handful of big corporates have venture capital subs or have investments in venture capital funds. In our membership, we have TELUS Communications Company, maybe Rogers Communications Inc., and you might consider BlackBerry Partners Fund, so that is three. In the United States, they have hundreds and hundreds. Big corporations are involved in the sector. There is even a separate corporate venture capital association. They have big pension funds and institutional investors. They are all doing it themselves. There are many reasons, some of which stem from the crisis of 2008. That is one end of the barbell.
At the other end of the barbell is the question of what is the exit like. How do you make money in this business? You make it by launching a company in a public exchange. We had one initial public offering, IPO, in 2008 and one IPO in 2009 — ouch. Not a heck of a lot. Look at the other main exit vehicle, which is mergers and acquisitions transactions, or M & A transactions. The number of transactions is way down. Where will they go? Who knows. Company evaluations per transaction are way down. At both ends of the barbell, there are challenges.
The Chair: We will turn now to our list of questioners.
Senator Hervieux-Payette: Do you think we have and train the right workforce to do these start-ups? We have many university researchers. They all see themselves as millionaires, if not billionaires, when they have the perfect intellectual property, discovery and so on. However, it does not go far. When it comes to actualizing that in a pure commercial operation, they do not seem to know how to get there. Do we have the proper means and mechanisms to articulate into commercial operation all the fabulous innovation funding in the university?
Mr. Smith: There are two ways to look at it. When we look at the whole private capital or the venture capital ecosystem, how we treat and a culture of innovation in entrepreneurism is important. There are centres, such as the Ontario Centres of Excellence and the MaRS Centre, that do excellent jobs of training and providing resources to entrepreneurs and to new companies to help commercialize their technology. Should we be doing more? I would encourage us to do more.
Quite often people will ask if it is the culture in Canada that prevents us from being successful entrepreneurs. I do not buy that at all. Canada has good examples, such as RIM, of successful entrepreneurs that have created successful companies. It is beholden on us all to ensure that we have the right infrastructure in place, and access to capital is a great example. I come from the investment side versus the academic side. When you have a company that receives 50 offers of financing from the U.S. and 2 offers of financing from Canada, it is hard to be competitive. We need to ensure that we have a robust network of capital such that they can see that the opportunities to create companies and clusters of companies in Canada are important.
We found from our study that successful entrepreneurs go on to breed more successful entrepreneurs; successful investors go on to breed more successful investors. A snowball effect happens within an industry once the impetus or momentum starts. Getting that started in a number of key sub-sectors within the venture capital industry will create some success in Canada.
Senator Hervieux-Payette: On what you said about the U.S., at what stage do the investors usually come? My experience is they do not come at the early stage; rather, they come once a company is close to going onto the market and commercializing the product. The company has done the development and the pilot project, and then it lack funds. A great saviour comes from the U.S., buys all the intellectual property and companies are moving out of this country, with $25 million or more being invested in a company over a number of years.
Where are we failing, and where would BDC be helpful? When you arrive at the fourth or fifth years of these companies, it is not seed money they need but a substantial amount of money to go to the commercial level. We need to know what quantity of dollars we are talking about that is needed at that stage.
Mr. Smith: From a BDC perspective, the collaborative partnering approach has been very much appreciated. They have an indirect strategy of investing in funds, which creates a talent of investors and active management that have precise industry knowledge within narrow sub-sectors of digital media or clean technology, et cetera. That is important to the ecosystem, as much as them doing the direct investments as well, where they form part of syndicates and partners.
From the early stage right through to the later stage of venture investing, I would encourage BDC to have an active role in the early rounds as well as the later rounds of financing within that ecosystem.
I think everyone agrees that we are in a crisis within the industry. We spend a lot of time in our resource industries, whether it is forestry or oil and gas, trying to get value-added activity to go on in Canada, rather than just exporting our raw materials. I look at education and research and development the same way. We need to develop that value- added activity and that commercialization activity in Canada without just exporting our raw talent. That is the interesting parallel on which we should focus.
Senator Hervieux-Payette: We had the IT crisis some years ago. How did we come out of that, and can we learn from that? People lost confidence in putting their money in shares and people became timid. We are moving, I think, into a much bigger financial crisis. How do we restore confidence? What role would you give to the labour funds? They will not disappear, but if they fail to produce some results, how can they still exist and act somewhat in conjunction with you and BDC? How can we partner? We are a small country. How do we put our energies together?
Mr. Smith: I have a couple of comments to set the stage. The return performance between private independent funds and labour-sponsored funds is almost exactly the same. The statistical difference between private independent funds and labour-sponsored funds over a 10-year period is not a material difference, namely, less than half a per cent. We look at it in that perspective. Enhancements can be made to the labour-sponsored rules that would make it easier to react and perform to match the market dynamics. That is probably a different topic.
I believe the government should be looking at various policy tools. You need to look at how you incentivize corporations, individuals and institutions, and what kind of role the government plays within that ecosystem. I do not think there is one silver bullet that will fix the venture capital industry, but everything must be complementary and work in concert.
That is why I look at BDC, in terms of an investment platform by the government, as one of those critical platforms, both the indirect and the direct investing. The government should look at other avenues. I believe strongly that we will be moving from an economy of infrastructure stimulus to one of innovation stimulus. That will be the critical piece. The focus is how we turn research into jobs. Venture capital, at its very essence, just turns research into jobs; that is all it does.
Mr. Rémillard: To your question on the foreign side, if you look at our statistics going back 10 to 12 years, foreign direct investment into Canadian companies generally ranges around 20 per cent to 25 per cent, year in and year out. There have been fluctuations. In 2007, if I am not mistaken, foreign direct investment was as high as 38 per cent, and it is 20 to 21 per cent now. When you look at the top 10 deals, the largest deals in Canada, they are overwhelmingly dominated by the U.S. funds.
With respect to the LSIF fund, it is worth noting that we put out on annual Deal of the Year Award for the best return. In two of the last three years, this award has been won by a labour-sponsored fund.
Senator Moore: Mr. Smith, I missed the numbers. How much was the investment in venture capital in Ontario 10 years ago?
Mr. Smith: It was $3 billion.
Mr. Rémillard: It was $257 million in 2009.
Senator Moore: It was $257 million?
Mr. Rémillard: That is right, so a decline of roughly 92 per cent.
Senator Moore: You represent the vast majority of venture capital and private equity funds in Canada. Does that include angel investors and the labour-sponsored funds?
Mr. Smith: Yes, it does include labour-sponsored and private independent funds. It ranges from family offices, which would be your sophisticated angel investors, right through to pension plans, which include the Canada Pension Plan Investment Board, CPPIB; Ontario Teachers' Pension Plan, OTPP; and OMERS, the Ontario Municipal Employees Retirement System, for example. It is quite a broad range of membership. We have a good cross-section of the private capital industry, from venture capital through to buyout.
Senator Moore: You have 1,800 individual members, so those would typically be angel investors, I expect.
Mr. Smith: That is individual members, which include the buyout venture capitalists, service providers and capital providers.
Mr. Rémillard: Those are the executives of member firms. The membership structure is by organization, such as a venture capital fund or a buyout fund, and then they can register a number of their executives as individual members. That is how we count them.
Senator Moore: Do they pay an annual fee?
Mr. Rémillard: Yes. It maxes out at $3,000 for an entity such as CPPIB, and it is geared off of capital under- management: zero to 50 million, 51 to 500 million, and 500 million and above. The maximum that anyone can pay is $3,500.
Senator Moore: With respect to BDC, I am interested in the capital authorization. I mentioned to other witnesses that I am not a fan of just having open-ended capitalization. I like people to come to Parliament when they are dealing with taxpayers' money and explain why they want the money, how much they want and what they will do with it.
Mr. Smith, you say that a removal or an increase of the ceiling is required for BDC to be able to support the industry for the next 10 years. If we were to consider recommending an increase, do you have a number in mind? It is now $3 billion.
Mr. Smith: I have not done enough research to understand exactly where that number should be. The general direction I would make to the committee is that I would not want to see a ceiling impact BDC's ability to react to a gap in the market conditions, as it affects the venture capital industry. I would look at what the needs are in the industry as you consider what the appropriate ceiling should be.
Senator Moore: In the downturn, the Government of Canada, the House of Commons and the Senate of Canada reacted within weeks to increase BDC's limit so that they could function and fill the needs that popped up when other financiers withdrew. Did you consider that? It is not as though we are sitting back for months or a year trying to increase the funding of BDC so that it can react. Did you consider that when you wrote that statement?
Mr. Smith: When you look at the industry, the timelines that it takes in terms of fund formation, from an indirect investment standpoint —
Senator Moore: Are you talking about the venture capital aspect?
Mr. Smith: Yes, I am referring to the timeline for fundraising of a new fund. Typically, it takes six to eighteen months. When you are looking at an investment horizon, sometimes that can get done in as quickly as two or three months, but often the due diligence and the research goes on over a few months. The predictability and transparency of the availability of capital to support your partnership commitments into the industry are important.
I am very pleased to see the government reacted quickly during the global economic crisis. Whatever the approach to determine what the ceiling would be, as long as it gives enough transparency and predictability to the market, that is what I would be looking for.
Senator Moore: In the November 2010 deck that you circulated, it says that the World Economic Forum, WEF, report on global competiveness ranked Canada ninth in overall competitiveness but eighteenth for venture capital ability and labelled this a competitive disadvantage.
Do you know if the World Economic Forum report included the venture capital activity of BDC, or is it strictly the private sector of venture capital?
Mr. Rémillard: It is a very macro report that looks at industries on a country-wide basis as opposed to going down to that really smaller level.
Senator Moore: Your answer is yes, BDC's activity in venture capital would be included?
Mr. Smith: I would assume it is included at a macro level.
Senator Moore: If we are eighteenth — maybe we can get this report — I would be interested to know who is ahead of us and what the numbers are. Could you give us a couple of examples of the top two or three countries?
Mr. Rémillard: It is probably Israel, the United States and Singapore, just offhand. I believe those are the top three or four. I have to check the report. It is not the one that came out before I did this deck. It is the one that came out in approximately September of 2009.
Senator Moore: Is there a 2010 report?
Mr. Rémillard: Yes.
Senator Moore: Maybe we could get a copy of that World Economic Forum report. Was there one done in September of 2010?
Mr. Smith: I would pull the 2009 and 2010 reports. The 2009 is more robust in terms of venture capital availability than the 2010 report.
Senator Massicotte: When I first heard you were from Brookfield Financial, I responded because I am always worried about a conflict of interest. However, the good news is that I used to be an investor in your company, although I am not anymore. I must admit I lost money, but I will not hold that against you.
Mr. Smith: I will let Mr. Rémillard answer your question.
Senator Massicotte: In answer to Senator Meighen's first question, why is the amount of funds going down? You have a couple of magazines, and I have read returns and talked to venture capital friends of mine. The answer I am getting is that fundamentally returns are inadequate. There are not enough good deals out there for them to invest in. Even traders have closed up their last fund. The more obvious question is why that is the case. Maybe there is an entrepreneurial problem in Canada. The simple answer to that question is the returns are inadequate. When you brag that the returns in the last 10 years have been adequate to the S&P 500, I hope so. You are talking about the 500 largest companies in the world, with high diversification, much lower risk and certainly not a reference point.
Would you agree that that is the main problem? The solution is not so obvious.
Mr. Smith: I would fully support the committee doing a formal study of the venture capital industry because the inter-dynamic relationships between the various pieces are complex. Unintended consequences of different regulatory changes have gone on globally and within Canada. When there are shifting demographics, it also has an impact on people's behaviour. If you look at human behaviour and look at what is happening with individual companies and institutions, as well as some of the regulatory impacts, it has had an impact across the board.
By its very nature, obviously, the strength of venture capital compared to the public market would suggest everyone should go into venture capital and not into public markets. There is a balance in how everything transpires. However, even with the new Basel banking rules on banks, in terms of matching assets and liabilities, we have moved in the late 1980s from insurance companies being supporters of private equity and venture capital, to the banks being in the asset class, to pension plans being in the asset class, and now there is sort of a larger gap. Insurance companies moved in and out of the industry; banks moved in and out of the industry; and pension plans have moved into the industry; and they have restricted the participation in the industry. There have been these macro swings over the past two decades in Canada as they applied to venture capital and private equity, which is why I suggest that the external and internal forces happening within these institutions are harder to ascertain.
Senator Massicotte: The market works quite well. Certainly in a capital market, which is very deep, if the returns were adequate, I suppose you would see retail funds and many more players.
Mr. Smith: It is also about size, scale and scope. Cutting a $1-million, $2-million, $3-million or even $10-million cheque is much different from cutting a $100-million or $500-million cheque. It is an active management approach. You have to look at it as a very aggressive approach to capital management versus the more passive approach of public equity, bonds or real asset management.
Senator Massicotte: What has been the return in the last 10 years of the venture capital industry in Canada?
Mr. Rémillard: It has been minus 1.4 per cent.
Senator Massicotte: I think that is the answer Senator Meighen was looking for.
Mr. Smith: I cannot argue that the returns are not very positive. Interestingly, Mr. Rémillard and I were at a global conference, the first annual global venture capital conference, and there were 22 people from 11 countries. The returns in Canada are comparable to the returns globally in venture capital.
Senator Massicotte: Are we smarter or less smart?
Mr. Smith: You need to look at what is happening in the industry. Let us break it down more. It is sometimes hard to defend poor numbers, but it is also about looking in the rear-view mirror. The industries in which we invested 10 years ago were information technology and communication. The industries that are being invested in today are life sciences, clean technology, agricultural technology and water technology. Should you judge the investment in water technology based on the 10-year average return on communication technology?
Senator Massicotte: You are talking about a macro policy, and I agree with you, it is important to Canada as an economy, as a market, to nurture and support new technology. I have no problem with that argument. In fact, when I look at your association's recommendations, basically you are saying that the solution to your problem of raising money is to let us have the taxpayers subsidize the industry to a greater degree by way of tax credits and so on.
I will make a passing comment. I am always surprised how many market people — and Brookfield Financial is a significant market player — believe strongly in a market unless it applies to them. Everyone wants subsidies; everyone wants someone else to pay for their mistakes or their investment.
Having made that comment, I agree with the importance of it, but I suspect a solution does not lie in subsidizing further another market participant. It is perhaps getting everyone on a level playing field. I am not surprised the returns are approximately equal to the labour funds because there would be something wrong there. It does confirm that their ability to select the winners and losers are equally as good as the private sector. However, maybe the whole problem is that we have manipulated and put the marketplace into such turmoil that nothing seems to work. I am not sure that trying to subsidize one more market player will eventually correct all the distortions of the marketplace.
Mr. Rémillard: I will take a stab at answering your question, senator. First, the numbers we have show that all venture capital in Canada returned minus 1.4 per cent, as was stated earlier; NASDAQ over the last 10 years, to December 31, 2009, is minus 5.6 per cent; S&P 500 is minus 2.7 per cent. The point here is that when we segregate out the top quartile performers at 5.1 per cent, which is way above any public market, way above the TSX, way above over the last 10 years, is it fantastic? You be the judge of that.
The challenge we have is that even our top quartile performers cannot get capital. What they are running up against is not just the return. To answer your question directly, it is returns plus. What is that plus? That plus is the chairman of the Royal Bank, last week in his speech, saying that we are a bank; we do not do venture capital. Even if I wanted to do venture capital I would have regulators on my back asking what I am doing in this asset class. Why are you there? We are trying to de-risk you.'' I am putting some words in his mouth, but that is essentially what he said.
Some of the senior executives from the leading public pension funds — I will not name them — say that because of the growth of our assets, in the multi-billion-dollar range, they cannot countenance looking at any investment less than $700 million. There is no venture capital fund — except for maybe the Fonds de Solidarité in Quebec — that is larger than $300 million or $400 million. There is a structural issue that is at play.
Senator Massicotte: There must be some mid-sized pension funds that do not have that problem of size. If you allocate 1 per cent or 2 per cent, eventually there must be.
Mr. Rémillard: We did some research several years ago with Industry Canada, but it is a bit out of date. We compared the proclivity of pension funds in Canada versus pension funds in the United States to have an allocation to the asset class. The largest pension fund is about the same, but when the pension fund size drops to $5 billion and below, our people are not there, and in the United States, they are there. That is the difference. Again, that is several years old.
The Chair: My information is, and correct me if I am wrong, that unlike in the term debt space, BDC right now is pulling back its investments in venture capital. I was given some statistics in that respect, but I do not know. I am asking you to comment on that. More precisely, do you think any of the five requests that BDC has made with respect to this review would assist BDC in being more active in the venture capital market?
Mr. Smith: Just to finish off on the other comment, we did a study in May 2010 that was conducted by Gilles Duruflé that talks about government involvement in the venture capital industry and international comparisons.
The Chair: Could we have a copy, please?
Mr. Smith: I would be happy to share it with the committee. It might help you understand some of the other dynamics happening globally within the venture capital industry.
I looked at the first half of 2010 and made note of BDC's $85 million of investment activity supporting another $400-plus million in syndicate partner investment levels. I am very encouraged to see BDC continue to play a complementary and collaborative role with an indirect and a direct investment strategy. They do need partners to come along with them. They cannot do it themselves. It is a market where co-investment and collaboration are essential. Even among private sector components, you do not typically make a venture capital investment on your own, unless of course it is in the very early stage. That kind of partnership environment is needed.
I looked at BDC's results. I would encourage them to continue to expand their role in venture capital, but they have to do it at a measured pace with the partners that exist in the industry. They have to look at how to encourage foreign and other domestic investors into the asset class, which is why the strong balance between indirect, obviously being an essential component to it, as well as the smaller direct component, is important.
The Chair: This is not a criticism, just a statement: you have no particular answer as to why their venture capital investment has dropped.
Mr. Smith: I do not have an answer. I would ask BDC to answer the question. I do not know exactly why.
Mr. Rémillard: It is very substantial. If you look at their own numbers, they generated, together with syndicate partners in 1999, $599 million worth of investments, and $552 million in 2010. That is not inconsiderable when you consider that the average investments for the Canadian venture capital industry in a year-over-year basis are around $1.2 billion, $1.3 billion, depending on the year. That is not inconsiderable.
One thing that might be worth looking at is the extent to which, and this is part of our challenge as an industry, there is a capital shortage in Canada. Venture capital funds being scrunched down like this means that when individual funds with capital look for syndicate partners, not many doors open. That is the challenge. If you ask how many active venture capital funds there are in Canada, you get a very short list because they do not have the money.
Senator Massicotte: On those numbers, here is what I read from BDC's numbers. I have two observations. Let me see if you agree with them. Yes, there has been a slight increase during the difficult times, I think of 2 per cent in the venture capital investment of money that they have put up; and also if you look at what they invested in, it is what I call plain vanilla — a lot of simple venture capital investment, not much of a start-up nature, which is probably more important from a government-subsidized entity. In spite of the fact that we went through difficult times and that capital markets had a shortfall in liquidity, the role of BDC at that point in time was to come up to par. They did that from a securitization, but relative to venture capital and relative to business lending, we did not see a very significant increase of their role.
Mr. Smith: Are you talking about the early-stage investments?
Senator Massicotte: In other words, if you look at a two-year difficult period, the data does not show them coming up to the altar very significantly with venture capital or start-up. In fact, with start-up, they still have a minor level of involvement.
Mr. Smith: I will agree with the general comment. I think the act of participation will be important. When you look at dollar statistics, from early stage to later stage, obviously there is a dollar impact. An early-stage company is getting financed at $250,000 to $500,000. Later-stage companies require larger rounds of financing, which would skew the dollar-value statistics. In Canada, unfortunately, it is about $3 million where it should be closer to $7 million, so with the number of companies versus the dollar value invested, there will be a difference. You do have to find the balance in the life cycle to ensure that you are following your early-stage investments throughout the life cycle. When capital becomes more constrained, you have an early investment in your portfolio. You need to ensure you are following those successful investments all the way through. I can see in an economic condition where you are looking at commercializing, keeping companies going, that you would balance yourselves in an economic difficult situation to more later-stage investments.
Returning to the earlier comments on overall return performance, I also think it is important, from BDC's standpoint, to help the industry by focusing their indirect strategy on the top quartile performers and supporting those companies and those funds, which will have a positive impact overall in the industry and gain momentum as it moves forward over the next five to ten years.
The Chair: Unless there are other comments or observations of a very short nature, since we are out of time, I will thank our witnesses. Thank you for your presence, your professionalism and your insights into what is not an uncomplicated industry. We take your point that it is vital to the future of this country. We wish you well and, once again, thank you for your presence.
(The committee continued in camera.)