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Advisory Council of Economic Growth, chaired by McKinsey & Co.’s Dominic Barton, will call on Ottawa to take a number of measures to boost Canada's economy.

Paul Chiasson/THE CANADIAN PRESS

An expert panel advising Finance Minister Bill Morneau will recommend Monday that Ottawa increase funding to newer, fast-growing companies, ahead of a budget that is expected to reveal more details about the government's innovation agenda.

Mr. Morneau's Advisory Council on Economic Growth will call on Ottawa to take a number of big measures to boost Canada's sluggish economy. The Globe and Mail has learned that the council, chaired by Dominic Barton of McKinsey & Co., will recommend that the federal government:

  • Push for bilateral trade agreements with China, India and Japan, at a time when Canada’s economic relationship with the U.S. is in question because of the protectionist stance of President Donald Trump;
  • Develop industrial strategies to champion eight “world-class” sectors, including agri-food, advanced manufacturing and health and life sciences;
  • Increase the amount of goods and services it buys from innovative Canadian startups;
  • Address the low rate of work force participation by women, aboriginals, elderly Canadians and other underrepresented groups.

But it is the council's recommendations related to the financing of innovative Canadian companies that have already stirred opposition, even before they are made public.

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Sources say the government is keen to push for more growth-capital financing, believing there is a "market failure" that has left small- to medium-sized companies starved for funds to expand.

But in the process of addressing the problem, the council has exposed fault lines among key players in the startup sector over what role government should play to make Canada a bigger player in the global technology business. Sources say the council is pushing two financing ideas in particular. It will encourage the formation of a "growth fund," inspired by a similar model in Britain, which would be seeded and managed by Canadian banks and other financial institutions to finance growing small and medium-sized enterprises with long-term capital.

The idea has been championed by Bank of Canada Governor Stephen Poloz, Business Council of Canada chief executive officer John Manley and Canadian Imperial Bank of Commerce CEO Victor Dodig as a way to give emerging corporate stars a homegrown financing option. Talks are under way among Canadian banks, Manulife Financial Corp. and Finance ministry staff concerning the launch of what would initially be a $500-million fund; the council is calling for the fund to reach $1-billion in five years.

The Barton-led council is also calling for the government to create a "matching" fund that would provide debt financing directly to startups equal to amounts they raise in equity from qualified venture-capital financiers. The money would be repayable once the companies are sold, go public – or if they move their headquarters outside Canada. The idea was suggested by Canadian tech entrepreneur Dan Debow.

Both ideas face challenges and skeptics. But behind the scenes, the Barton council is already facing a backlash over a recommendation it will not be making.

For months, Canada's venture-capital industry, which finances higher-risk startups, has been heavily lobbying the council and government in hopes of securing a sequel to the so-called "venture-capital action plan" (VCAP), which was introduced by the previous Conservative government in 2012. The program, intended to revive the then-moribund Canadian VC industry, is regarded as a success. Venture funds that received $500-million from governments in Ottawa, Ontario and Quebec in turn raised another $900-million from private sources to invest in startups.

Buoyed by a new group of funds led by former operators and entrepreneurs, Canada's venture-capital sector has rebounded, leaving behind its past reputation as a poorly managed business that produced negative returns. Government data show that average trailing 10-year returns by Canadian venture-capital firms have sharply improved from less than zero to above 4 per cent, since 2013, though they are still less than half the average returns of American venture-capital firms.

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Flush with federal VCAP financing, venture capitalists have concluded the most active year for investing in Canadian startups since the dot-com bubble.

"We've created something that's working and we're planting the seeds of a sustainable ecosystem," said Jerome Nycz, executive vice-president of BDC Capital, an arm of Business Development Bank of Canada which administers VCAP.

But many venture capitalists say they need more government help in the form of another VCAP fund – and if they don't get it, funding and prospects for early-stage entrepreneurs could dry up, just as Canada's startup sector is gaining global acclaim.

"It takes approximately 10 to 20 years for a manager to become established" and show returns that can consistently attract private investors, Golden Venture Partners' founder Matt Golden, one of Canada's best-regarded early-stage venture capitalists, wrote to Mr. Morneau in December. "With a reignited venture-capital industry, it is critical that our new batch of fund managers are given the time needed to prove their mettle."

Innovation Minister Navdeep Bains, a fan of VCAP, has requested another $400-million for a follow-on venture-capital program and an another $100-million earmarked for clean-technology venture investors over five years in the budget, The Globe has learned. A spokeswoman for the minister declined comment. It is unclear whether the Finance Department will agree.

Mr. Morneau has thus far shown a strong predilection to act on the recommendations of his growth council. The government quickly followed up on the council's first three recommendations last fall with pledges to form an infrastructure bank, speed up immigration for skilled foreigners and to actively pursue foreign direct investment.

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However, unlike Mr. Bains, the council won't be supporting a VCAP sequel. Instead, sources say the council has lumped VCAP together with other innovation programs the government funds – at an annual cost of $3-billion-plus, dominated by research and development tax incentives – and is recommending Ottawa review how and why it spends all that money, with an eye toward winding down ineffective programs.

The council's silence on a VCAP 2.0 has many in the venture-capital business on edge. J.S. Cournoyer, general partner of Montreal's Real Ventures – one of Canada's busiest early-stage investors, said: "If it was not for VCAP … we wouldn't be able to raise another fund and I don't think any of the Canadian funds would either."

Sources say that some members of the council – notably former Canada Pension Plan Investment Board CEO Mark Wiseman – have little interest in reviving VCAP. They are concerned by what they believe are excessive costs associated with the program, after Auditor-General Michael Ferguson last year said management fees over the life of VCAP could reach $250-million, out of the $1.35-billion raised from the government and private investors. Mr. Wiseman declined an interview request.

Some council members also think it takes too long for VCAP money to end up in the hands of companies. "If you think we're spending our time worrying about VCAP, I can assure you we're not," said a source familiar with the growth council's deliberations. "[The council is] making recommendations that are going to change the course of the Canadian economy … Do you think that some VCAP program makes one [bit] of difference?"

VC industry advocates argue the program isn't a handout but an investment: Before fund managers who received VCAP money can earn performance fees, they must return all of the government's cash. "I can't think of a better bang for [the government's] buck," said Mike Woollatt, CEO of the Canadian Venture Capital and Private Equity Association.

They also argue the matching fund idea won't work, arguing the government would have to set up an automatic funding mechanism that would reward all applicants regardless of their merits, or require a complex, bureaucratic screening process that would leave the government in charge of picking winners. "It is unclear how any of this can be better than having a motivated and aligned investor" working with management to add value, said Peter van der Velden, managing general director of Toronto-based bioscience VC firm Lumira Capital.

It's understandable Canadian VCs feel threatened: Mr. Debow says in a white paper about the matching idea that Canada's proximity to Silicon Valley and New York "means that it doesn't need to" have a big VC industry.

Meanwhile, the bank-led growth fund is taking shape behind the scenes, with the active encouragement of Mr. Morneau, who spoke Friday with top bankers to discuss the plan. (A spokesman for the Minister said he wouldn't comment on the council's recommendations until they are released.) Leading Canadian financial institutions would contribute tens of millions of dollars each to a "patient-capital" vehicle that would buy minority equity stakes or subordinated debt from growing companies. As the companies use the capital to grow, the fund would remain a long-term, passive investor.

The government wants the initiative to be led and financed by the private sector, but it has helped clear the way. The federal bank regulator last fall introduced changes to capital-requirement rules that would make it easier for banks to participate in such a fund, and the minister called on senior Finance official Tim Duncanson, a former Onex Corp. managing director, to facilitate the fund's creation.

Knowledgeable sources say that while Mr. Dodig and Bank of Nova Scotia CEO Brian Porter – who have jointly drawn up proposed terms for the fund – are on side, their counterparts at the other big banks and Manulife have been more hesitant. But by Friday, sources say, the country's six largest banks and Manulife made a commitment to work out details on a $500-million fund they would jointly finance, with other financial institutions possibly seeding a second $500-million tranche.

"We've had some constructive conversations in the last couple of months, in particular getting greater clarity regarding capital treatment, business plans and profitability. While there are still some details to iron out ... broadly we're supportive of this initiative," said Dave McKay, CEO of the Royal Bank of Canada.

Some skeptics have said successful, expanding Canadian companies typically don't have the same problems accessing capital as their peers in Britain, where the British business-growth fund was created after a government task force found the British public blamed the banks for the 2008-09 financial crisis and for not helping enough with the economic recovery.

They also point to the fact the British fund, launched in 2011 with £2.5-billion ($4-billion Canadian) from the country's five largest banks, had invested in everything from juice bars to satellite-technology makers, crowding out existing private-sector investors. It lost money in its first four years. A recent CIBC study on a possible Canadian growth fund projected it would underperform traditional private-equity funds.

The debate about exactly how Ottawa should aid smaller-growth companies highlights two questions: does Canada even need a thriving homegrown venture-capital industry, and if so, should it receive years of further government backing?

VCAP was initially a hard sell, in large part because of the venture-capital industry's dismal returns, lack of skilled managers and the retreat of the sector's past financial backers. But if the program was intended to address a market failure, it's hard to argue that dire situation still exists.

Even without VCAP, the Canadian government would still be one of the top funders of Canadian venture capital through BDC, Export Development Canada and Sustainable Development Technologies Canada. Five provinces have committed hundreds of millions of dollars to venture investments in recent years. (To be fair, there is even more government-funded venture capital in the European Union and at the state and city level in the United States).

In addition, many prominent U.S. venture investors have piled into the Canadian market in recent years, including JMI Equity, Bessemer Venture Partners and Sequoia Capital. Canada's hot artificial-intelligence sector has drawn financing from Google and Microsoft; Intel, Amazon, TenCent Holdings and several top-tier pharma companies have also invested in Canadian startups.

Furthermore, Canadian investors are increasingly opening their wallets for venture capital. Banks, insurers, energy companies and endowments have been increasing their venture-funding commitments, while entrepreneurs who have made their fortunes in a range of sectors have done likewise.

There is evidence funds can get off the ground without VCAP, or government money altogether. John Ruffolo, who manages OMERS' venture portfolio, brought in two corporate investors – Bank of Montreal and Cisco – but no government money into the pension fund's $260-million second venture fund, and is believed to be raising another large fund without government backing.

Some suggest there is ample global capital to finance the best of Canada's successful tech startups in the absence of a Canadian venture-capital sector. But would they step up to fund the more than 55 per cent of early-stage venture deals in Canada last year that were financed exclusively by Canadian backers? Many Canadian venture capitalists aren't sure. "Ultimately VCAP will be successful when it's not required anymore," said Jeff Pentland, managing director with Northleaf Capital Partners, one of the four VCAP fund-of-fund managers. "I don't think we're at that stage now."

With files from Andrew Willis

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