Proceedings of the Standing Senate Committee on
National Finance
Issue 2 - Evidence - November 26, 2013 (afternoon meeting)
OTTAWA, Tuesday, November 26, 2013
The Standing Senate Committee on National Finance met this day at 2 p.m. to examine the subject matter of Bill C- 4, A second Act to implement certain provisions of the budget tabled in Parliament on March 21, 2013 and other measures. (Topic: federal Labour-Sponsored Venture Capital Corporations Tax Credit.)
Senator Joseph A. Day (Chair) in the chair.
[English]
The Chair: Welcome to this meeting of the Standing Senate Committee on National Finance.
[Translation]
Honourable senators, this afternoon we will continue our study of the subject matter of Bill C-4, A second Act to implement certain provisions of the budget tabled in Parliament on March 21, 2013 and other measures.
[English]
This is our eighth meeting on the subject matter of Bill C-4. This afternoon we will be discussing the proposed phasing-out of the Labour-Sponsored Venture Capital Corporations Tax Credit, which is contained in Part 1 of the bill, clauses 59, 73, 80, 81 and 113. If you'd like to make note of those various numbers, perhaps our witnesses may, in talking about specific clauses or aspects, refer to one of those clauses: 59, 80, 81 and 113. I also have 73 in here.
We are pleased to welcome Mr. Peter van der Velden, President of the Canadian Venture Capital Association, I believe based here in Ottawa?
Peter van der Velden, President, Canadian Venture Capital Association: That is correct.
The Chair: Thank you. He is here by videoconference; our monitors are up and working.
We also welcome Léopold Beaulieu, President and Chief Executive Officer of Fondaction CSN; and Geneviève Morin, Chief Investment Officer.
I understand that Mr. van der Velden will give his opening remarks first, to be followed by Mr. Beaulieu and Ms. Morin.
Mr. van der Velden, you have the floor, sir.
Mr. van der Velden: Good afternoon, ladies and gentlemen, and thank you very much for the opportunity to speak to the committee.
I've spent my entire career working in Canada's innovation sector either as an entrepreneur, manager or investor. In addition to my role as President of the Canadian Venture Capital Association, I'm also General Partner at a firm called Lumira Capital. We are the largest Canadian-domiciled VC firm focused on investments in the life sciences and med- tech area. We currently manage three funds, two of which are new, and we are the first fund in Canada to close on capital from the Venture Capital Action Plan. We did so last month.
Let me start by saying that the CVCA is highly supportive of the Venture Capital Action Plan and believe it is a very important initiative. At the same time, the CVCA believes that now is not the right time to put one of the pillars of an improving but still fragile venture capital ecosystem at risk, and that a strong domestic — and I emphasize that word ``domestic'' — VC ecosystem is vitally important for creating a next-generation economy, supporting and building on domestic innovation, enhancing job growth, accelerating the growth of entrepreneurial companies, and creating wealth for Canadians.
Let me start with why I say ``improving.'' Venture capital returns have, in fact, improved in each of the last three years. Venture capital investment in 2012 was $1.5 billion, a five-year high. Year-to-date investment in venture capital is $1.4 billion, so we will certainly hit another five-year high. In 2013, this year, a Canadian-based company raised the largest amount of venture capital ever raised by a Canadian company: $170 million in a single financing round.
Senators, 2012 was a banner year for new fund formation with $1.8 billion of capital raised, for the first time in many years almost on par with our U.S. peers — a one-in-ten ratio. The federal government has announced it is now implementing its Venture Capital Action Plan — all positives.
Why ``fragile''? Despite improving investment returns, a winnowing of weak managers and a clear lack of capital, which I'll speak more to later, traditional VC funds investors in Canada, primarily pension plans, save for one or two exceptions, are more or less out of the ecosystem. This creates significant problems for private managers. The ability to get re-ups or recommitments is almost non-existent, and when you go to raise capital on the international market, the first question is: Where is your domestic market support?
Despite 2013 being a banner year for new investments, 40 per cent of that capital came from foreign or U.S. investors. If nothing else, it highlights the fact that there is a significant domestic funding gap and demonstrates that arguments around crowding out, if in fact they ever existed, certainly do not exist anymore.
In addition, we've seen a significant restart in the venture ecosystem as a function of the action of a number of provincial ``fund of funds.'' Unfortunately, most of those funds have now deployed 100 per cent of their capital, so a billion dollars of capital that has been deployed over the last four years is now out of the ecosystem.
Finally, in terms of fund formation, after a banner year in 2012, the reported fund formation for this year to date, including all private independents and retail funds, is only $780 million, or 40 per cent less than last year. At that level of funding, we're about at 50 per cent of that replacement number of $1.5 billion that I alluded to earlier. What's really worrisome is that of that $780 million, $361 million comes from the labour-sponsored funds — the very funds we're talking about changing now, so almost half of that capital.
Let me specifically talk about the labour-sponsored funds. Quebec-based labour-sponsored funds in 2007 and 2008 were among the very first funds in the country to recognize and be able to act to do something about the VC funding gap. They did so by instituting new ``fund of funds`` called Teralys Capital. They were anchor investors to that fund. That model was followed in many other provinces: Ontario, Alberta, Nova Scotia and B.C.
Quebec-based LSIFs were and continue to be one of the few reliable re-ups or recommitments, even for successful firms like my own. When we went out to fundraise, of the dozens of LPs we had in our funds, our two LSIFs were the only two investors who were still engaged in the venture capital ecosystem. Every other pension fund investor in our funds was no longer making venture capital commitments. We could not have gotten to the endgame of raising $170 million, which we did, without a very strong lead order from Fonds de solidarité FTQ.
Quebec-based LSIFs, both directly and indirectly via ``fund of funds,'' also have been important, not only as lead investors in the market as a whole, but also in enabling private independent funds. In fact, they have invested in funds not just in Quebec but across the country — funds like Vantage, Celtic House Venture Partners and ourselves, which are all domiciled outside of Quebec.
In smaller secondary markets such as Saskatchewan and Nova Scotia, LSIFs remain significant parts of the local ecosystem, and their loss would undoubtedly have an impact on venture capital deployment in those markets.
Finally, our concern at the CVCA is that we are at risk right now of losing $400 million from the venture capital ecosystem at a time when it cannot afford to do so.
The Chair: Thank you very much.
Mr. Beaulieu.
[Translation]
Léopold Beaulieu, President and Chief Executive Officer, Fondaction CSN: Thank you. I am here with Geneviève Morin. She and I will try to answer committee members' questions during the question period. Thank you for inviting us.
Fondaction has more than $1 billion in assets under management and more than 120,000 shareholders, most of whom are small and medium savers. Their average income is $48,000 a year.
Fondaction is the first financial institution in Quebec to be given an A+ grade, based on its sustainable development report, for its implementation of the Global Reporting Initiative. That rating is also indicative of Fondaction's governance and operations.
We believe that the void left by labour-sponsored funds could well do more to deter private capital than stimulate it, particularly at a time when the consensus is that demand for capital is greater than supply.
We at the Fonds de travailleurs du Québec reviewed the situation and submitted a reasonable proposal to the Department of Finance, the main points of which were made public on October 23. In it, we suggested that, in view of the situation, we should join the federal program and that tax expenditures should be reduced by one-third over a 10- year period by limiting rather than eliminating cash contributions.
The Institut de recherche en économie contemporaine has conducted a study showing that the federal tax credit resulted in a tax cost of $25.5 million in respect of Fondaction shareholders in 2012-13 and that the government received $27.7 million in tax revenues from Fondaction's investment operations in that same year.
As of May 31, 2013, 43.7 per cent of Fondaction's investments were venture-capital-based. This is a significant effort, far greater than that of the pension plans and other institutional investors receiving pension-related tax benefits.
In that regard, our direct investments in businesses and, as just mentioned, the amounts that we invest in private venture capital funds are not being given sufficient consideration. As of May 31, 2013, we had invested more than $117 million in 22 venture capital technology funds. That helps strengthen the venture capital ecosystem, in which everyone cooperates in supporting the development of innovative businesses through specialized private funds, labour- sponsored funds, Crown corporations, university research commercialization corporations and even angel investors.
The official statistics unfortunately understate that contribution since they merely focus on the significant indirect activity of our investments in private venture capital funds.
Now I would like to point out that the labour-sponsored funds in Quebec do not constitute a barrier to private venture capital funds.
The studies are conclusive on this point. They include those by Deloitte, KPMG-Secor, IREC and even the work of Gilles Duruflé, an expert known to the federal government and Quebec. Fondaction's shareholders, Quebec's National Assembly and hundreds of businesses and business leaders are not used to intervening publicly on issues such as this and have asked that this matter be reviewed.
What I would like to discuss with you is the ecosystem, access to financing, problems in the regions and also small transactions because 76 per cent of Fondaction's direct business investments are valued at less than $1 million.
Why then not combine efforts in various ways rather than dismantle something that works?
[English]
Senator Buth: Thank you very much to our witnesses for being here today.
I'll start with Mr. van der Velden and then perhaps, Mr. Beaulieu, you can also answer. You've thrown a lot of numbers around. I couldn't write fast enough, actually.
Mr. van der Velden: My apologies.
Senator Buth: I think I heard you say that there's quite a bit of demand for venture capital —
Mr. van der Velden: Correct.
Senator Buth: — and that we've done a good job of providing venture capital, but the supply of funds is limited. Can you tell me what percentage of venture capital funding comes from these labour-sponsored venture capital funds?
Mr. van der Velden: I can give you a rough estimate. If you look at fundraising year to date, of the $780 million of new capital raised, 361 is from the retail side, the labour-sponsored side. The balance is private independent funds. Of the $1.8 billion from last year, roughly $1.2 billion was private independent funds and the balance would have been other funds, including the retail funds. That number was probably about $400 million last year.
Senator Buth: One of the things we're concerned about is how these funds are being used, and if they are truly being used for venture capital projects. Are we seeing the innovation essentially coming through to commercialization? How do you measure the success of these funds?
Mr. van der Velden: I can't answer that specifically because I'm not someone in the business of measuring the success of these funds, but what I can say is this: It is clear that we've gone through a big change. There's been a very cathartic change where we've gone through a consolidation period and funds that weren't performing have gone. We've lost venerable firms. VenGrowth and Ventures West are no longer in the ecosystem. The firms left today are best in class. We've seen a significant improvement in returns because these firms are in fact doing a good job. There are layers of venture capital. There are venture capitals that do seed capital, high risk, binary outcomes, ones that do a step above that, and venture capitals that do later stage. You can't measure in any one way across all funds, but what we know today is the relationship between all the funds in the ecosystem today is highly symbiotic. A labour-sponsored fund like Fondaction, the other witness here today, is doing both direct investment and investing in funds like mine.
I'm investing in innovation outside Quebec that they can't touch and wouldn't go to because of the way they're restricted. We're investing in health and life sciences companies. They don't have internal teams who have the depth and skill set. My team is MDs and PhDs and guys who live and breathe this sector. They're using their tools to help us do our job better.
It's a highly symbiotic ecosystem and not one layer doing one thing. You can see real performance improving; the funds still in existence have better returns than those that have gone out of business, and I think we have a system that is truly symbiotic.
When I mentioned that 40 per cent of our capital comes from outside sources, it's clear, if you read data from C.D. Howe, that U.S. capital does not foster innovation. It's an important part of the ecosystem. I would not say we shouldn't have it, because that would be wrong. We need the capital to build the kind of companies we are talking about. Of the $170 million in capital raised by the company I talked about, the Canadian content was $20 million because we don't have funds that have the capacity to write those kinds of cheques.
When you talk about things like innovation it's clear that domestic, on-the-ground venture capitalists are the ones who generate the innovation and we're the ones who fund that kind of innovation; that's not coming from external investors.
Senator Buth: Would people continue to invest in these funds because they're doing well even if there wasn't the tax credit?
Mr. van der Velden: I can't answer that question. I don't know. We do know that when the credit got removed, the Ontario system collapsed. I don't know the answer to your question.
Senator Buth: Were there other mechanisms that picked up what Ontario lost?
Mr. van der Velden: No, because Quebec and the Quebec funds have been very proactive in trying to rebuild the ecosystem. If you look at capital over the last few years, it is clear that the Quebec ecosystem is stronger today than other parts and that's what has been so important in Quebec's action to invest outside. They're using their strength to help the rest of the country come up at a time when there hasn't been a clear replacement. We were out fundraising for our new fund. We had good returns.
The number one question is: Where are your domestic pension plans in terms of investing? It had nothing to do with returns. It's a more complex question.
The good thing about labour-sponsored funds is they were the orders out of our fund that immediately re-upped, supported us. When new LPs and our corporate partner called, they were there for us as an LP who had a long-term relationship with us, knew how we worked, managed capital and were highly supportive of our fundraising initiatives. We could not have raised capital without those LPs in our fund.
The Chair: I'll ask you to take a step back, Mr. van der Velden. What makes them labour-sponsored and how does organized labour get involved?
Mr. van der Velden: I would encourage you to ask the other witness. Historically when these programs were set up, there was a structure that said they had to be affiliated with a labour organization — basically workers in the economy. They raised their money principally from those groups as the initial starting point.
[Translation]
Mr. Beaulieu: With your permission, I would like to answer that question. Fondaction came into existence as a result of union demand. Fondaction is authorized by legislation to take in savings and to make available up to 60 per cent of its assets to finance Quebec SMEs and obviously to invest in private venture capital funds.
These are retirement savings, but they are not the unions' money. Labour-sponsored funds, as they are called, do not belong to the unions, but rather to the people who invest, to the shareholders who hold an interest in a labour- sponsored fund. Most of the people involved in Fondaction's governance are outside people who sit on its board of directors.
Fondaction takes in retirement savings, and a portion of those savings is invested either in specialized funds or directly in businesses. Fondaction allocates smaller amounts in individual investments where the investment is direct and larger amounts to a number of specialized funds, venture capital funds, as mentioned earlier.
The capital invested may be divided into three types: venture capital as such, which is allocated to new technologies, innovation and the health sciences and to businesses with negative cash flow. These are businesses that will develop their markets over time, complete their commercialization, start up operations and try to achieve global status.
Then there are the businesses in which we invest development capital, growth capital, and it is this combination that enables savers to invest in a diversified fund, with a portion also invested in the financial markets. This is where we have an interest in knowing how to raise money in a diversified fund, a portion of which is invested directly in venture capital or in specialized funds. It is important to understand that the supply of financing from labour-sponsored funds serves two specific purposes in the chain or ecosystem: it meets local needs not otherwise met and is allocated to specialized funds that advise and assist businesses.
To develop an Olympic champion, one that is highly profitable, first you have to know how to advise and assist it. You have to go through several stages in order to attain that level. Then there are a number of talented young businesses that must be advised and assisted, and if you can manage to get one Olympic champion out of that group, that is very good, but it would be a mistake to focus solely on that business thinking that all venture capital should go to it alone.
Senator Bellemare: I have a few questions for Mr. Beaulieu in particular, but I would also like to get Mr. van der Velden's reaction.
Mr. Beaulieu, you cited two figures in your remarks. First, you said that the 15 per cent federal tax credit represented a tax cost of $25.5 million in the 2012-13 fiscal year, but that it generated tax revenue of $27.7 million in that same year. Based on your figures, then, it is cost-effective for governments to invest in Fondaction. I would like you to explain those calculations to me.
In addition to that financial question, I would also like you to cite a specific example to illustrate your statement that 43.7 per cent of the investments made by Fondaction may be characterized as venture capital investments. Could you give us a simple, specific example of a Fondaction investment in a business as part of a specific project?
Then I have an important question on the impact of the proposals that are on the table regarding workers and savers who put money into that, based on Ontario's experience.
Go ahead and answer the first question, please.
Mr. Beaulieu: I may ask my colleague Geneviève to respond with respect to the tax benefit, tax cost and tax revenues. In fact, for every dollar the federal government spends on investors, on savers, it takes in $1.09 in tax revenues for the same year.
How is that calculated? I am not an economist. IREQ does that job, but I can tell you the common theme running through this. First, there is the econometric model that the Government of Quebec developed at the Crown corporation Investissement Québec to calculate the impact of tax costs. Obviously, based on the IRÉQ study, the data can be used to determine which businesses could have obtained financing without us. We do not count them.
The businesses that receive venture capital that they would not be able to obtain otherwise — and those businesses are always able to attest to that; they are counted — and the businesses that receive development capital, growth capital, and that are of the desired size, the size of SMEs, count for half of our investments. The econometric calculation in then made.
This is the result it produces. That is why we think this is a serious problem because the result, which we will discuss in a moment, is that we are forced to reposition ourselves differently and to get out of venture capital.
Senator Bellemare: May I speak to that question? If you could forward us the Investissement Québec study or the other study, that would help us very much in our subsequent efforts to understand this matter.
The Chair: Can you do that, Mr. Beaulieu?
Mr. Beaulieu: Willingly.
Senator Bellemare: What are the venture capital examples?
Mr. Beaulieu: Geneviève Morin will tell you about that.
Geneviève Morin, Chief Investment Officer, Fondaction CSN: When we talk about venture capital investment, we say that the idea is to meet the definition. We are talking about investing in businesses that, when we invest in them, are still losing money, are still investing for the future and not making immediate profits. We may be talking about software businesses or businesses that develop robots for the aeronautics industry.
Allow me to cite an example that illustrates quite clearly how we work. The business is called Enerkem. We immediately positioned ourselves alongside industry stakeholders and also made it known that we were interested in innovation and sustainable development.
Enerkem will process waste to make ethanol, renewable energy. Consequently, it is involved in sustainable development. We were able to advise and assist the company in its early stages through funds in which we had invested, specialized funds. Rho, a fund that has major American sponsors, then came into the picture to add additional financial capacity.
Fondaction also made a direct investment when the business started growing again. Nearly $100 million has now been invested in the business, which is currently building its first commercial plant in the Edmonton area, and the business is not yet profitable. You have to know how to take risks, but you understand that this type of investment cannot be made by a single fund. It must be made in a healthy ecosystem with people who know each other, who assist each other and who let each other pursue their own speciality.
Senator Bellemare: Could I get a response to my brief reaction on the impact —
The Chair: Later. I will put you down for the second round. We are short of time.
Senator Chaput: Thank you, Mr. Chair. My question is for Mr. Beaulieu.
When you talked earlier about venture capital and venture capital companies, I believe I heard you say that most shareholders earn an average of $40,000 a year.
Senator Bellemare: Forty-eight thousand dollars.
Mr. Beaulieu: The workers and citizens who invest their savings in Fondaction earn an average of $48,000. That means the federal government grants them a tax credit of $439 to encourage them to invest in their retirement, but a portion also goes to development capital, to venture capital and to maintain and develop employment.
Senator Chaput: I believe you also mentioned that you made a proposal to the federal government when the highlights of this bill were made public. Could you tell me about that proposal and how it was received?
Mr. Beaulieu: We developed a proposal under which we would invest less than we previously did but would nevertheless still be able to invest in venture capital and to join the planned federal program. What we proposed for the next 10 years was to invest two dollars in venture capital for every dollar of tax credits granted to the shareholders of Fondaction and of labour-sponsored funds.
That means Quebec's two funds will have access to: $550 million in private funds in Quebec, which are able to invest across Canada, plus $400 million invested in private funds outside Quebec, including $120 million in the two national funds, which are provided for in the federal government's action plan, plus, as Ms. Morin explained, more than $1 billion invested directly in businesses with the intervention of those funds over the next 10 years. And all that would happen while reducing the tax cost by approximately $300 million over 10 years by, for example, limiting cash inflows to labour-sponsored funds by setting a ceiling rather than abolishing them.
We thought that was a reasonable proposal that would make it possible to continue taking in savings, because the financial institutions, as you know, are built on the fact that people trust in their continued existence, and the announcement that a tax credit will be terminated, even gradually, causes concern among savers and may, sooner rather than later, have a deterrent effect on contributions to those funds.
That is why, in closing, I wondered why not combine efforts, since the consensus is that supply is not meeting demand? Why not add and combine measures rather than dismantle what works?
[English]
Senator Callbeck: Thank you to all the witnesses. I have two or three questions and I'd like to hear from each witness.
One is on sponsored venture capital. You sometimes hear that one of the problems is the separation between control and ownership. It creates poor governance and as a result the returns are not that good. I think the returns are much lower in the United States. I'd like to hear each of you comment on this.
Mr. van der Velden: For clarification, you're talking about control versus ownership in terms of a labour-sponsored fund?
Senator Callbeck: Yes.
Mr. van der Velden: From the CVCA's perspective, the private independent partnerships are not really an issue. They control on their own. For the labour-sponsored funds it is different, but we have not seen it to be an issue. We have gone through an evolution where there were issues, and I can't say they didn't exist. We have seen firms where, if they existed, the governance issues that you refer to have worked themselves out because they do not exist anymore. The funds that exist today have found the appropriate structures for managing their governance appropriately.
Senator Callbeck: Can I hear from the other witnesses?
[Translation]
Ms. Morin: As regards the governance of labour-sponsored funds, I repeat that most of the members of Fondaction's board are independent unions, but there is a union presence and a connection with the unions that it is very useful and important in attracting money from labour sources. These people do it on a volunteer basis. They do not receive commissions, and that is what makes it possible for us to raise that money at a reasonable cost.
Furthermore, there is no involvement in decisions that are made based on their best interests. There was a time in the early 2000s when labour-sponsored funds were criticized. Government funds were criticized as well, and that all came to a head Quebec in a commission called the Brunet commission. Following the commission's proceedings, the decision was made to organize the venture capital structure to make it as efficient as possible by having the labour- sponsored funds that attracted savings, pooled those savings and then selected the best private fund managers of technology capital for small businesses. The funds now provide support through co-investments and are able to supply development capital to address other problems, such as investments in regions where there are no private venture capital funds. Generally speaking, you do not see many of them outside the major centres.
These funds make much less of an effort for small transactions, those of less than $1 million. As you said earlier, 76 per cent of our transactions are valued at less than $1 million. Labour-sponsored funds are responsible for 52 per cent of start-up investments in Quebec. So when people say we do not take enough risks, that is not true. Our mission is both to maintain that balance between return and safety for our shareholders and to promote economic development.
[English]
The Chair: Mr. van der Velden, you talked earlier about Ontario cancelling its provincial parallel program. We're discussing here the 15 per cent credit against federal income tax.
Mr. van der Velden: Correct.
The Chair: Is there any province in Canada that has continued a program parallel to this 15 per cent against provincial taxes?
Mr. van der Velden: Yes, a number of programs still have it. I believe British Columbia, Saskatchewan and Nova Scotia still have these kinds of provincial matching programs.
The Chair: So when you said Ontario collapsed — the whole industry collapsed — because the provincial portion of the program was cancelled, do you think most of these are dependent on a provincial contribution as well?
Mr. van der Velden: In Ontario, the total combined tax credit was 30 per cent. It was significant. When the 15 per cent was removed and timed out, it led to the collapse. I think it was certainly one of the strong incentives for retail investors in Ontario to participate in the fund.
[Translation]
The Chair: Mr. Beaulieu, what is going on in Quebec right now?
Mr. Beaulieu: Mr. Chair, allow me to cite four figures. In 2008, $340 million was raised in private funds in Quebec and $386 million in Ontario. In 2012, the figures were $924 million in Quebec and $581 million in Ontario. So the growing gap is apparent. Given what Mr. van der Velden, President of CVCA, just mentioned, you can also see that this is an illustration.
The Chair: Now is it possible in Quebec to claim a tax credit payable to Quebec? Is it 15 per cent?
Mr. Beaulieu: Yes. A tax credit is currently granted for contributions to labour-sponsored funds in Quebec. It is 15 per cent for the Fonds de solidarité and 25 per cent for Fondaction, because Fondaction is not yet big enough to operate with comparable and desirable administrative expenses. That is the desired objective, and whereas the federal government is eliminating the tax credit, I would say the Government of Quebec has temporarily set it at 25 per cent, based on Fondaction's development conditions and setting a ceiling on its annual growth.
This year, for example, Fondaction will be stopping in a few weeks because it will reach $200 million in contributions, and contributions are expected to reach $225 million next year. Shareholders in the Fonds de solidarité received the 15 per cent credit, but no ceiling is set for Fondaction.
Ms. Morin: It is important to understand this concept of controlling supply, which may be part of the problem that has arisen in Ontario, where many very small funds were created, whereas each fund in Quebec has its own incorporating act. You cannot just create a fund like that. The government ensures that funds have an opportunity to reach a critical size that results in reasonable management fees and a desired intermediation effect.
The Chair: Thank you.
Senator Hervieux-Payette: Thank you. Welcome to both witnesses. I am very interested in this subject. I was wondering whether you had partnerships with the Business Development Bank. I thought it had a modest shareholding program. Has it been involved in projects with your fund?
Ms. Morin: Yes, if I may respond for Fondaction, we have several co-investments with the Business Development Bank of Canada, which is involved with us in certain files. It is also involved in some private investment funds in which we have also invested.
Senator Hervieux-Payette: So we could get a good evaluation by a federal organization that could tell us whether it is helpful to have a labour-sponsored fund in Quebec because it knows the Quebec scene, particularly since one of Quebec's characteristics is that it is a province where there are a lot of SMEs.
Ms. Morin: You touch on an excellent point. It seems no recent evaluation was done before the decision was made. Reference is frequently made to studies by Cumming and MacIntosh, which date back to the early 2000s, to 2005, 2006 and do not really reflect the new realities. Other studies have been conducted. Deloitte came to see how the labour- sponsored funds and tax-advantaged funds were conducting themselves in Quebec. It confirmed the value that was being created and the gaps in the market that are filled by labour-sponsored funds.
Gilles Duruflé, an expert the Conservative government itself retained for its committee, conducted a study to evaluate performance. He notes that all the criticism on performance is based on a study that dates back to 2002, which is less relevant today and which is also more descriptive of the reality of venture capital as a whole at the time than what it has become.
On the contrary, some tax-advantaged funds won the CVCA Deal of the Year Award. When you compare the outflows, the values of the businesses when they are sold, you see that labour-sponsored funds also perform very well. In fact, a study should be conducted before any action as radical as abolishing the tax credit is taken.
Mr. Beaulieu: I would also add KPMG, the company that conducted an exhaustive study that was submitted to the Department of Finance and that did something very important on the impact of labour-sponsored funds.
Senator Hervieux-Payette: I asked the minister to expand that study, but I have not received a response. You could check the minutes of our meeting yesterday. Out of curiosity, I would like to know the number of shareholders and the number of businesses you are involved in.
Mr. Beaulieu: Fondaction is directly invested in 149 businesses, including Filaction, which is a fund that makes smaller investments but that was set up entirely with Fondaction money. So we are directly invested in 149 businesses.
If I include businesses that are financed by private venture capital funds in which we have investments, the number rises to 850. Those 149 businesses alone do a total business volume of $2.299 million. That represents nearly 30,000 direct and indirect jobs that have been created or maintained as a result of our investments. And these are not duplicate investments; this is money invested in proportion to our investments in those businesses.
This is something that deserves consideration. I submit to you that your question is extremely important because, as we say back home, ``You can cut off the branch you're sitting on, but, please, not on the trunk side.''
Senator Hervieux-Payette: Very good idea.
[English]
Can I ask a short question of Mr. van der Velden?
The Chair: We have another video conference coming on the same subject, but we have different witnesses. I have three names left on my list here for a second round. If you have a question that's particular to Mr. van der Velden, could you pose that?
Senator Hervieux-Payette: Do you see any other way we could diminish the damages for this measure? I suppose there is competition in the venture capital world, and I suppose that the people who are investing are ordinary workers, not specialists. What would be the way for private venture capital to reach that clientele so they continue to invest in the economy?
Mr. van der Velden: I actually think you have a terrific structure in the form of the labour-sponsored funds that are domiciled in Quebec. What people don't understand is that venture capital is a learning business. It's very difficult. You've heard other witnesses talk about the fact that returns are much higher in the U.S. That's a bit of a fallacy. The reality is that 75 per cent of funds don't make money. It's a 20-year learning curve to be good at what we do. What we're seeing in Canada today is the maturation of our industry and you're seeing managers, like Fondaction, who have matured through the cycle. They've learned from investing in hundreds of businesses what the right behaviours are. That's true on the private side as well. That's why we're seeing returns improving.
We've just released a study with Industry Canada, Statistics Canada and Thompson Reuters, government stakeholders. It talks about the fact that venture capital helps companies. This was completely pure match, company versus company of those who got venture capital and those that did not. Venture capital-backed companies grow faster, generate more jobs, generate higher paying jobs, grow their assets more quickly, grow their revenue more quickly and not by little amounts; by significant amounts. Cutting off one leg, the LSIF part, and then funding the independent part is not the solution.
We need more capital and strong managers in Canada. I think we have a system today that is working, that has evolved through 20 years. We've gone through the evolution of winnowing out of people who didn't know how to do this.
There was a great study 25 years ago that an average guy like me, when he starts in the industry, loses $20 million of capital. That's a scary number, but there is a learning curve. I think to not leverage the learning curve that we've now established over 20 or 25 years of these funds, learning how to do it right, hiring sophisticated people, building investment teams that understand the business is a mistake and we would be cutting off our nose to spite our face.
[Translation]
Senator Bellemare: My question is for Mr. van der Velden. We have heard several presentations on the budget. We have been told that the purpose of these cuts is to make the tax system more neutral, to encourage neutrality with regard to the various funds. What is your reaction to that argument?
[English]
Mr. van der Velden: That's a legacy argument. Today we have a system that works. We have two different kinds of venture capitalists in the country. They are highly symbiotic. I manage money for Fondaction and, as was alluded to, we have made five investments out of the funds in which they're an investor. Three of those investments are in jurisdictions other than Quebec, so that's highly symbiotic. We are a co-investor with Fonds de solidarité FTQ in one of those three deals.
The reality is that today I don't think we have this competitive pressure issue. There was an argument that people made 12 or 13 years ago that one kind of capital was crowding out the other kind of capital. I'm going to come back to what I said earlier. Forty per cent of our capital came from foreign sources.
[Translation]
The Chair: Mr. Beaulieu, do you have a few more words to conclude with?
Mr. Beaulieu: I wanted to clarify my answer to the question that was asked earlier. The business turnover of the 149 businesses in which we are invested is $2.3 billion, the total payroll is $852.7 million and profits from those businesses amount to $729.8 million. These are effects on the neutrality of the tax system. I believe it was noted that this is indeed an interesting combination because there is room in the fund of funds, the federal program, for that money to come from labour-sponsored funds, from Crown corporations, like the $400 million planned, from commercialization companies and from private capital from various sources, and these are the objectives of the specialized funds that count and that will operate.
I would also like to cite four figures with regard to neutrality. In 2011, the federal government granted credits in respect of labour-sponsored funds in Canada to 316,390 people. The average tax credit was $439.71. The cost of the tax credit that year was $139.1 million.
There is no a comparison. Here is another figure is we are talking about putting public finances in order. Capital gains exemptions are granted not to 316,390 people, but rather to 10,330 individuals, 10,330 Canadians who received $2.21 billion, that is to say $214,803. It seems to me that, yes, we do have something to discuss regarding neutrality and calibration.
The Chair: Could you send us those figures because we do not have time to discuss them properly now? Ms. Morin and Mr. Beaulieu, thank you very much for attending our meeting and for providing us with information on Fondaction.
[English]
Mr. van der Velden, thank you very much. I'm sorry, but the time has run away from us and we have another team waiting for another conference call. Thank you very much for being here.
Honourable senators, this is our second session this afternoon and we will continue our discussion on the proposal to phase out the Labour-Sponsored Venture Capital Corporations Tax Credit, which is contained in Part 1 of the bill. Honourable senators will know that that is at the present time a 15 per cent tax credit. Both of our witnesses are appearing on video conference during this session.
Mr. Finn Poschmann is Vice President of Research with C.D. Howe Institute, and Dr. Mintz is Director and Palmer Chair in Public Policy at the University of Calgary School of Public Policy.
Mr. Poschmann, we will begin with your opening statement. You have the floor, sir.
Finn Poschmann, Vice President, Research, C.D. Howe Institute: Mr. Chair, members of the committee, thank you for your invitation to this meeting. It's a delight to see the committee again, and greetings to the new members here. Good afternoon, everyone, and to you, too, Dr. Mintz.
We were asked to address Part 1 of this bill, but in particular the Labour-Sponsored Venture Capital Corporations Tax Credit, so that is what I will do. That will allow me to be concise and pointed. My point is very simple: It will be good to see an end to the federal LSVCC credit.
The credit, of course, is intended to increase the flow of funding to venture capital enterprises. It does so by subsidizing, through the tax system, returns to retailers who choose to invest in this particular corporate form. The corporate form that the LSVCC legislation specifies includes a governance arrangement that demands representation for organized labour. It is aimed at directing new capital flows to the needs and interests of Canadian workers.
It also prescribes the general classes of investments that LSVCCs might choose, as well as a timeline for doing so. It requires that investors lock in their money for a fixed period to derive the full benefit of the credit. And the federal credit in the past has been bolstered by similar provincial credits, most of which have been withdrawn or are in the process of being withdrawn, except for in Quebec. That's where we stand now.
My prior is that venture capital investment is a perfectly important part of the economy, and let's not make any mistake about that. It provides funding for new ideas, for innovation, and for the entrepreneurship that is the lifeblood of a healthy, growing and innovative economy. Venture capital funding is positive for R&D levels and R&D spending growth. Venture capital-supported firms are more likely to file for patents and to obtain them.
Evidence from Australia suggests that VC funding boosts those same results, boosts asset and sales growth, shortens the time to an initial public offering, and boosts employment. These outcomes are good things, with tremendous spillover benefits that go beyond the companies and their investors.
Those are good things, and the LSVCC model is remarkably unsuited to deliver those good outcomes. The legislation specifies constraints on the corporate government's form, and there's no evidence that this particular corporate form delivers better results than unsubsidized corporate or private equity forms.
The tax credit, in particular with provincial augmentation, provides a positive return to investors, even if the projects the fund managers choose are negligibly or negatively profitable — or unprofitable. On a first-principles basis, the message that comment delivers is that the program distorts capital markets or funds allocation in an unhelpful way.
The markets say the same thing. LSVCC returns are low. Retail investors, absent the credit, historically would have done much better investing in a broad market index and not exercising any diligence or making choices themselves. The funds themselves have occasionally had trouble investing the cash that the credit's availability has caused to arrive at their doorsteps. At any particular time, the LSVCCs are invested in not particularly productive or innovative assets.
There's no good evidence that the LSVCC credit increases net investment in venture capital projects. The research we've published suggests that in Ontario, the credit has crowded out or displaced ordinary VC investment that the market might have generated. Evidence on this front is powerful in Quebec, too.
The generosity of the combined federal and provincial credits seems to have created a situation in Quebec where the program has reduced the net private flow of funds to venture enterprises to less than it would be in the absence of the credit. It's the combination of the federal and provincial credits that makes the program so attractive to participants. Eliminating the federal credit, on this view, would increase or at least could increase the net flow of VC funding in Quebec.
Finally, this is not a narrowly held view that I'm describing. I'm unaware of any public finance economists or tax policy specialists who believe that the LSVCC model is well suited to the aim of stimulating VC funding — none. Neither, to my knowledge or in my experience, does the VC community, outside of the LSVCC world, support the program.
For these reasons, I support an end to LSVCC credit. I look forward to it, and to our discussion today.
The Chair: Mr. Poschmann, thank you very much. Before I go to Dr. Mintz, did I hear you say that B.C. was no longer involved in a provincial scheme? We heard earlier that Ontario had withdrawn its provincial credit that paralleled the federal credit. What other provinces are still involved?
Mr. Poschmann: Ontario is phasing out its credit. The form still exists, but the credit is disappearing. The credit itself is only a significant factor in Quebec.
The Chair: Okay. Thank you.
Dr. Mintz, you have the floor.
Jack Mintz, Director and Palmer Chair in Public Policy, University of Calgary School of Public Policy: Thank you very much. It's a pleasure to meet your committee again. We'll probably echo some of the things that Finn Poschmann said — my colleague Finn Poschmann from the past.
Let me take a somewhat first theoretical argument that I think is important in understanding why the Labour- Sponsored Venture Capital Corporations Tax Credit has actually been a failure in achieving the results that it wants to achieve. We have to go back to the overall question: Is there a market failure when it comes to venture capital? We have strong financial markets in the country. It's not entirely clear why one particular sector would need special consideration for government policy as opposed to other sectors when talking about financing businesses.
An argument is sometimes made, and it has to do with start-up businesses, that lots of people have different ideas. And some people argue there's a venture financing gap, but frankly there's no evidence of it. Just simply because people want to get some money that other people may not be willing to lend is not a sign of a gap. There may be very good reasons that some people don't get funding; they may have bad projects. A lender who is sophisticated enough knows these are not good projects to fund.
However, a potential market failure arises due to what's called adverse selection in markets. That is when there are good projects and bad projects. When lenders don't know the good ones from the bad ones, they may not be willing to lend money at a price that the good ones would be willing to invest in because they may not make enough money. The bad ones may be the only ones willing to take the loan and end up failing because the lender ends up picking up the cost in the end as a result of the failure.
This was actually an argument made by Nobel Prize winner George Akerlof a number of years ago, but when you do have this problem of adverse selection in markets, you could get a market breakdown where there's not sufficient money to be funding the good projects in the market that are being hurt by the existence of these bad projects at the same time.
How do you get around that? There are arguments of how markets try to sort these things out, and the way they do is by using what they call signals. One, for example, is how much of the internal resources is an entrepreneur willing to put up to invest in the project. The share of their investment or their willingness to commit to the investment is a sign that they think they have a good project. The market will use that as the signal of sorting out good projects from bad projects.
This is where something like the Labour-Sponsored Venture Capital Corporations Tax Credit fails. It's a subsidy toward people looking for investment from the outside. It includes firms that do not have strong resources because they don't have a very good record from the past and have been able to accumulate funding from friends and others willing to invest in their project.
What happens is that you end up subsidizing through the credit of 15 per cent. In Quebec it's 30 per cent. I think a few other provinces still have the credits but the major ones do not. But when you do have funding available to subsidize people going to outside investors, you actually end up distorting the market and you have too many bad firms coming into the market who end up squeezing out the good firms in terms of returns. You end up getting a worse situation.
What tax policy experts have found over the years is that you're better off having a research and development tax credit that goes to the firm. The good firms will get it equally as well as the bad firms. That is a better way of trying to encourage innovation than the use of a venture capital equity credit, which is not very good.
So that's what the theory would say.
What has been the practice in Canada? In some of the work I did in the decade from 2001 to 2011, the average rate of return on venture capital investments in Canada, which are dominated by labour-sponsored venture capital credit corporations, has been only 3 per cent compared to the United States where it's 20 per cent.
If you look at why pension funds in Canada invest in venture capital in the United States and not in Canada, you can see why. They can't use the LSVCC credit, but they certainly are not going to invest in 3 per cent when they can go elsewhere and get 20 per cent instead. Three per cent is not much better than Treasury bills even though they're much riskier and should have a higher rate of return over time.
Solidarité in Quebec, which is a large venture capital firm, has had a poor return. The paper we published by Jeffrey MacIntosh called Tantalous Unbound, which I encourage you to read, is a scathing treatment of Solidarité. In a 20-year period, it has had a rate of return that is one-half that of treasury bills, but of the $8.8 billion invested in 2011, maybe 20 per cent of the assets are in actual venture capital and some are in bonds and not equity. There is not a lot of risk sharing. I'm not sure how venture capital statistics are kept, but if one says all of that money is venture capital, it is simply not true. A large portion of the money is invested in things like public corporate shares, government bonds, et cetera. In fact, over $4 billion of that $8.8 billion is invested in other things that are in the market and have nothing to do with venture capital.
The basic point in the end is that the program has been a failure. There has been a crowding out of private sector equity investment as pointed out in the literature. There is a separation of control and ownership which leads to poor governance, and the very large tax benefits provided to investors do not let them focus on the rate of economic return because they get significant investment tax benefits. They might get a good after-tax return when you include RSP deductions and the actual credit, but the economic returns are very bad. This is not a good way of trying to run the railway and not a good way of trying to get an appropriate boost to our innovation in this country. Therefore, I echo Mr. Poschmann's point that it is quite appropriate to cancel this credit.
The Chair: Thank you very much Dr. Mintz.
I still don't have a handle on how many provinces are still participating. You say it's not a major factor. That implies they are there, but the percentage is lower so you don't factor it in.
Mr. Mintz: I could always try to Google it. I have not checked it recently. I know Alberta doesn't have it. Ontario has phased it out, or is phasing it out. Quebec has it but they have a lot of other R&D-type policies that have some impact. I believe some of the smaller provinces might have it, but Mr. Poschmann may be better versed on that. I think New Brunswick has an equity credit, but I'm not sure if they have a labour-sponsored venture capital credit.
The Chair: British Columbia?
Mr. Poschmann: British Columbia certainly had one, but it is changing as well. The corporations themselves still exist, but they are no longer supported by provincial credits outside of Quebec, to my knowledge. If other provinces still maintain partial credits, I am unaware of it. As Mr. Mintz said, Ontario had one until recently and it is in the phase-out process now.
The Chair: The reason I ask is that we were told that Ontario collapsed as a result of one of two programs disappearing, and I was looking to see what impact this proposal might have in other areas. You are telling us that if it has any impact, it will be in Quebec only?
Mr. Mintz: No. Actually, Nova Scotia has one. I'm checking them right now.
The Chair: I appreciate you letting me know that. In the meantime, we will go on with our list.
Senator Eaton: I sit on the Agriculture Committee and very often we hear professors from the University of Guelph, Université Laval, other professors who talk about the death valley of innovation and research. They will get a product or something to a point and then they have no investment, can take it no further and very often find investors outside of Canada.
I appreciate everything you've said, but if not a tax credit — and I didn't get to ask the other two gentlemen about the risk factor for this tax credit because I think they should go hand in hand a bit — how else would you encourage innovation coming out of places like universities?
Mr. Mintz: Several years ago when I first came here to Alberta I ran a commission on savings and investment policy for the Alberta government. We got into this very issue of venture capital and how best to help develop more innovation in the country with respect to financing startups.
Our overall conclusion was that, as a major difference between Canada and the United States, the United States has a much bigger scale involved in venture capital funds. That allows them to hire and have more experts involved in evaluating various projects. They get more positive hits associated with their investments, which is why they are getting 20 per cent return in the United States as opposed to 3 per cent in Canada.
We came to the view that scale was very important and you need much bigger venture capital funds to be more successful. Of course if we want to have more financing in this area, the thinking is how to build better and bigger venture capital funds that could have more expertise that would be available for financing venture capital in Canada.
In fact, labour-sponsored venture capital firms are very small. There are a couple of large ones, but as mentioned with Solidarité, they do not do much venture capital themselves. Even though they are $8.8 billion, a lot of that money has been funded in other things besides venture capital. We need a better approach. The federal government and the provinces are trying to develop a ``fund of funds'' approach, which is to try and build bigger venture capital and get more scale involved. Whether that will succeed, we will have to see down the road, but it is a different approach and maybe one that makes more sense.
Senator Eaton: The provinces themselves would underwrite a fund or put some money into a fund?
Mr. Mintz: I guess they took our recommendations seriously because that's what happened in Alberta. They have put some money into ``fund of funds,'' but it's not a lot of money. I am not sure it is going to succeed because I'm not sure that you can get the scale that you want. It might be better, for example, to look at policies that encourage more U.S. venture capital funds to come into Canada. We have been doing some of that by reducing the tax barriers involved with venture capital funding, but the federal government has a new program that they are developing to try to create more ``fund of funds.'' We will have to see whether that's going to work.
Senator Eaton: One last question, to which I'm sure you'll say yes or no: If labour-sponsored venture capital funds were to solely invest in risk or R&D, would you be in favour of giving them a tax credit if they could not invest those funds in bonds or other established instruments?
Mr. Mintz: The answer is no because it's the wrong instrument. In fact, that's really the point of the research I did with the Belgians over a decade ago. We showed that when you subsidize something like firms selling equity to the outside market, you're encouraging too many bad projects to come into the market, and it squeezes out the good firms trying to get financing.
A better approach is something like the encouragement of research and development itself. In fact, you would have a very difficult time trying to limit an equity credit to only R&D projects because a firm may be doing some other things with the financing dollars that it needs. Even then, it's still better to give money to the firm to invest in something like research and development, if that's what we're trying to encourage for innovation, than to indirectly do it through an equity credit that distorts financing signals in the market.
The Chair: Mr. Poschmann, did you have any comment to make?
Mr. Poschmann: Thank you and absolutely. I agree with Mr. Mintz, perhaps unsurprisingly. Let me emphasize a point, if I may.
The credit is very good at steering funds to the LSVCCs. The evidence shows, however, that it is not nearly so good at delivering funding to innovative ventures or ventures that are likely to be successful. When it comes to funding ventures, it is not clear what the blockage is to investment in new and innovative projects. As Mr. Mintz suggested, we shouldn't be afraid of investment coming from abroad or elsewhere because the point is to steer investment to likely successful ventures, and there is no particular reason why we should subsidize, through the tax system, the retail investor to provide that funding.
As to other ways of stimulating similar outcomes: One, one could, as Mr. Mintz said, reduce barriers to outside investment; two, lower the capital gains tax rate; three, otherwise lower the tax rate on the returns to innovative R&D projects; and four, adopt and implement the means to improve commercialization of technology. There are a number of ways that one could go about improving the technology transfer, say, from university laboratories and facilities to the commercial sector, but that is a slightly different discussion. You certainly would not need to build a tax credit to do it.
Senator Hervieux-Payette: First, I doubt some projects, personally. I must say that you certainly can recognize that, even in the United States, the rule is usually that one out of ten projects is a success. We have to know that this is the rule and that the Fonds de solidarité would, let us say, average it by making sure that they don't go that route because, of course, they might lose the funds that belong to the workers.
My question is: How many $48,000-a-year people buy shares through a broker when they have to pay for the commission and when, to have a portfolio, they need to be more in the average of $100,000 and more? We're dealing with a very specialized group of workers. I was there at the beginning when we started that in Quebec. The idea was to protect jobs, to create jobs and eventually to have new companies. They go to innovation, and they have split the funds into three functions.
My question is: What is the alternative to keep the jobs? I saw one project where $20 million was invested by different funds in Canada. The U.S. funds came in, bought all of them, transferred all of the research and products to the United States, and they closed down the shop. If we're going to invest and give or not give tax credits, where will the money come from? These companies would never have existed without Fonds de solidarité. They put $20 million into one project.
The Chair: Which person did you direct your question to?
Senator Hervieux-Payette: Anyone who has the answer because we know its high risk when we are talking about the pure venture. This is a model from Quebec. Maybe, as academics, you can criticize what Quebec has done, but as far as I'm concerned, it was tailor-made for Quebec workers.
The Chair: Mr. Poschmann, are you able to help us there?
Mr. Poschmann: That's a great question.
First, on the retail side, that's one of the things about life. Small investors don't tend to be very good investors or pickers and choosers of projects, and that's why you would encourage people to save their money in relatively low cost, low risk funds if that's their choice and that suits their tastes. It is not such a good idea to have small investors choosing risky projects. That, in a way, is what we ask them to do when we market LSVCCs through stock exchanges. There are other tools available that exist without the credit. There's a product available on the major Canadian exchange that creates a shell into which investors can pool funds, and it does aggregate funds and invest in R&D projects. That's a model that will likely grow over time as the market evolves. However, if your goal is to create localized employment, there are much more direct pools than a credit to the investors, or one in which the structure of the credit shelters investors and fund managers from the risks that they're meant to take on.
Senator Hervieux-Payette: You qualified that as a total failure, and you bring in zero possibility of making some modification to mimic exactly the normal venture capital funding. I think it's one that has the name but has a different feature, so I'm just asking you: How would we get the $9 billion that the FTQ has and $1.3 billion from the Fondaction because these amounts of money would never get to the market and to the companies if these vehicles did not exist? Taxpayers are paying a very small amount of money to get this money invested in our economy in Quebec.
Mr. Mintz: Can I just quote to you some numbers on the FTQ? This is from May 29. Of $8.8 billion — close to the $9 billion you refer to — $4.2 billion is invested in what are called ``other investments.'' This is almost half, and this is $1.5 billion shares of public companies, which is not venture capital. Hedge fund units are $216 million, which is not venture capital; bonds, $2.3 billion, which is not venture capital; and money market instruments, $154 million, which is not venture capital either.
The other part of the money, development capital assets, does have a chance to be in venture capital, but it's in various unlisted shares and may not be venture capital at all. It's estimated that maybe 25 per cent of total funds at most are invested in venture capital.
Now you might get some successful hits with that, like the one you mentioned, but if you're only getting a very small rate of return, that means you have a lot of bad hits as well. If you're trying to grow the economy with successful firms, not with unsuccessful firms, this is not the way to do it. Therefore the labour-sponsored venture capital credit has been a failure in public policy. In fact there's some evidence to show that it squeezed out funding for venture capital because too many bad investments are getting funded, so we do need a better approach.
[Translation]
Senator Bellemare: The least we can say is that your comments have raised a lot of questions. You also cited some figures that are quite impressive. Canadian funds have rates of return of 3 per cent, compared to 20 per cent for American funds. I would very much like to have a breakdown of the investments of the American funds because, in my book, that is impossible if the American funds are only involved in venture capital. Venture capital can, by definition, achieve very high returns, but the likelihood of doing so, on the other hand, is low. Not all venture capital projects are good, and you do not know that at the outset. I would really like to get the information on American performance.
I also have a very specific question. I would like to hear what you both have to say about how you reconcile the situation with the idea of crowding out. This often comes up: if money in the financial markets is invested in instruments such as those we are talking about — labour-sponsored funds — that prevents other projects from obtaining financing and draws off funding for other initiatives, whereas, at the same time, the former Governor of the Bank of Canada, Mr. Carney, told us for some time that businesses had surplus cash and that he wanted them to invest it. However, we know that businesses are not going to invest in a small, very high-risk local SME because they want to hang on to their cash flows.
How do you reconcile all that, this crowding out argument, when the Governor of the Bank of Canada tells us that and we also know that, internationally, the argument is quite the contrary and that, with all those financial flows and a very active quantitative monetary policy, we are afraid of winding up with too much cash?
[English]
Mr. Poschmann: Senator, it's a great question. I'll do crowding out first and then the returns.
The crowding out is very straightforward. If you consider the availability of the credit this particular report put forward, it is attracting or soaking up investments that retail investors might have pursued that would have slowed elsewhere. As Jack pointed out, in Quebec — and you see very similar numbers in Ontario — a large share of the funds aggregated through the LSVCC or through Fonds de solidarité are not going to venture investments but are going to bonds, money market funds — publicly traded companies. If the investment being aggregated through these funds is not going to venture capital but instead going to bond instruments to publicly traded shares and money market funds, then you can have a net reduction in the flow of venture capital markets.
As to returns in Canada versus the U.S., yes, there is an element of risk. One of the things that investors certainly hope is that high returns travel with well selected projects as well as a certain amount of risk.
For LSVCCs in Canada the empirical evidence is suggesting that, one, the credit insulates this project, project managers, as well as the retail investors from the risk; two, the governance structure as well as the investment restraints on LSVCCs does not steer the capital to likely successful projects. On this point it's difficult to be strong enough. This is not really a value judgment. This is what the empirical evidence is telling us.
The Chair: Dr. Mintz, are you able to comment on that?
Mr. Mintz: First, as I mentioned earlier, one of the reasons for success in the venture capital field in the United States is in part due to scale and the fact that strong professionals are running the projects because of their skill, including scientific experts and others who can evaluate the projects. I understand that's one of the reasons for the better performance.
Second, we have to remember you would expect rates of return on venture capital, once you've observed them, to be relatively high because they are very risky. You can get a lot of failures, but there are just some that do a better job picking the good ones from the bad ones. As Mr. Poschmann pointed out, when you have tax incentives, that gets money from the market, from small investors who are not paying attention to the returns because of the tax benefits they get. It's not just a labour-sponsored venture capital credit of 30 per cent in Quebec but also a deduction under their RRSP, so the government ends up picking up close to 75 per cent of the cost of the investment, so they're not going to pay that much attention to how the returns are doing. That's really part of the problem.
One other quick point is on crowding out. There is another type of crowding out that goes on and that's true any time in tax policy. If you're trying to raise a certain amount of revenue to fund public goods and services, if you're giving a tax break for something like labour-sponsored venture capital credits, then you have to raise taxes elsewhere. You end up crowding out some of the investments or business or activity that's going on elsewhere in the economy because you have to make up for that tax credit. It's one thing if the tax credit really does a great job, but if it's doing a lousy job that hurts the economy as well.
[Translation]
Senator Bellemare: Have you examined the studies conducted in Quebec on the positive impact that labour- sponsored funds can have on tax revenues, which we discussed earlier, and employment? You share Quebec's view. It is true that size is an important factor. Mr. Beaulieu talked about that, as did Mr. van der Velden, but they told us that tax measures would compromise the ability of businesses to reach an ideal size for a number of specific small funds.
In short, have you read the studies conducted in Quebec that indicate that money invested generates greater revenue for the federal government, that every dollar invested creates $1.09 in federal tax revenue, for example?
[English]
The Chair: Have either of you gentlemen had an opportunity to study that work in Quebec?
Mr. Mintz: There was a study by Deloitte, I understand, but I haven't seen the study, so I can't evaluate it.
But I have to admit that many studies done by every industry about why they should get, let's say, accelerated depreciation or a special tax credit often talk about these multiplier effects. It's actually based on rather poor economics, because there's an assumption that if you increase activity in one sector, it just spills over to all the other sectors, creating more jobs. But that just can't be true in a fully employed economy, and in fact you're going to end up using resources from elsewhere in the economy.
I have a quip that if we add up every industry's employment multiplier in Canada, Canada would be the same size as the United States, and that's because everyone likes to justify their special handout on that basis. But the studies that have been done by economists on labour-sponsored venture capital credits are that this has been a failure of a policy. It's actually directing money to low rates of return. Once adjusting for risk, it's very poor. Therefore, you're actually not creating more jobs; you're probably directing money to parts of the market that it shouldn't be directed to and instead should go elsewhere.
Although Quebec has very good venture capital financing compared to some of the other provinces, as some people have pointed out — and I'm not quite sure how they calculate the numbers, because Fonds de solidarité doesn't put that much money in venture capital; they're putting it into a lot of other things. So I don't know if they're just taking the 8.8 billion or whether they adjust for that properly.
Quebec, even if it does have more venture capital financing, its productivity hasn't been all that good. So with all the micromanagement that goes on in the economy with special credits and special deductions and everything else, it has not exactly been a great example of achieving a much stronger economy, because it hasn't worked that well.
Senator Mockler: Bill C-4, which I support, supports the venture capital industry by removing ineffective taxes — and I agree with that — plus the fact that the OECD recommends the phase-out of precisely what is the subject matter: tax credits to labour-sponsored venture capital.
We also understand that with Bill C-4, Canada's long-term economic competitiveness will be driven by innovative businesses. In our Budget 2012, we did announce a $400 million Venture Capital Action Plan.
With your experience across Canada, can you apprise us as to how you think that particular initiative will help benefit provinces, including Quebec, across Canada?
Mr. Poschmann: First, in a way this dovetails with the previous question. The scale is important. Size is important to bringing down the cost of investment, but you have to choose the right projects. You have to have a governance mechanism and incentives that encourage the choice of the right projects. I mentioned earlier on some other incentive- based mechanisms for steering funding, such as capital gains tax treatment or the treatment of investments in innovative research and development, and the fruits thereof.
But on the question of government venture capital funding, this is a story yet to be told. We do have a federal fund in creation, or in process. Ontario is launching its own, and this is echoed elsewhere. There are other countries, such as Australia, and some in Southeast Asia, that have generated their own fund-of-funds partnership models with the private sector. Not clear yet what the characteristics are that lead to success. Early evidence says the governance model matters a lot. Pari passu, or side-by-side investments, is not a bad model. We don't know if that's definitive of success. The other observation is that bringing in professional managers is important and ensuring that you have the expertise that's available to choose projects.
This is what we know so far. Whether these are sufficient to generate success or success that goes beyond what the market would otherwise generate is not at all clear.
Senator Mockler: I was, a week ago this past Monday, in a forum and we were talking about — and Senator Eaton did relate a bit to funds being made available in agriculture, and we see it also in forestry and in other domains.
With your experience — I have to, Mr. Chair, ask this question.
The Chair: Will this question help us assess whether or not this initiative is a good one?
Senator Mockler: I think so.
With the EU trade agreement that we have, will this enable Canadian projects to have access to additional venture capital funding?
Mr. Poschmann: Is the question specific with reference to the federal fund, the federal venture capital program?
Senator Mockler: Yes.
Mr. Poschmann: The program, no question, will increase the flow of funding to the projects that its managers choose, so by itself that's a good thing. The proof will be in the outcomes, and whether there's an interrelationship with trade with the EU depends on the competitiveness in the marketplace, again the choice of projects, the likelihood that Canadian managers will choose projects that will increase trade with the EU. There are a lot of variables there.
There's nothing to say that it will or won't increase opportunities on this front. The big question is whether steering funding through a federal venture capital program will improve net availability of funding and not displace others. From a first principles point of view, which is where Mr. Mintz began, it's unclear that it will; but handled well, it will certainly do better than the LSVCC program has.
The Chair: Thank you. The final question is for Senator Chaput, from Manitoba.
Senator Chaput: It's a very brief question. It's a yes or a no, I guess.
Is there enough venture capital in Canada? Would you say there is enough?
Mr. Mintz: A very quick, brief yes or no: I really don't know, to be honest.
Senator Chaput: Fair enough.
Mr. Mintz: You hear the stories, and there may be some argument at start-up, but we don't know how to measure the venture capital gap. As far as I know, there's been no evidence to show that there's inadequate funding.
Mr. Poschmann: My answer would be similar. First principles, this is one of the axioms of utility theory: more is better. It's easy to say more funding would be better, but whether we have the right amount, too little, too much, absolutely unknown. Don't forget that, economy-wide, Canada is about the same size as California; similar population, not quite so rich, not so dense in innovative capacity. It's not surprising at all that the Canadian venture capital market looks smaller on a percentage basis than the market in the U.S.
The Chair: Thank you very much Mr. Poschmann, from the C.D. Howe Institute, and Dr. Mintz, from the University of Calgary School of Public Policy. We're trying to decide whether we need more or less evidence or information to assess this government initiative and what the impacts will be. I think your contribution has been very helpful, and we thank you for that.
Thank you, colleagues. That is all of the evidence we intended to hear on this particular aspect of Bill C-4. We'll go on to other matters tomorrow afternoon.
(The committee adjourned.)