Demise of venture capital market 'a real crisis' in Canada

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If Canada's venture capital market is ever to come back, the federal government will have to buck up and support it, argue some of the industry's most respected investors.

Their call is being made out of frustration. Since the tech bubble burst, the private sector has stubbornly refused to give venture capital a second chance. Without its support, the market has floundered. In 2000, $5.9-billion was invested in 1007 Canadian startups, according to Thomson Reuters. Last year, just $1.1-billion was raised by 357 Canadian firms.

The demise has hurt Canadian companies. Venture capital investors are the few institutions and individuals who are willing to invest in small startups with no proven track record. The cash they offer up is desperately needed in fields like biotech and technology where experimental research and development is vital.

Venture capital is also crucial to the wider Canadian economy. The federal government is staking the country's future on building a skilled economy that can compete globally, but Canada's skilled workers will have no where to work if their startups fizzle out. Tech industry darlings such as Research in Motion and OpenText would have never gotten off the ground without their early financial backers.

Because he believes venture capital is so systemically important, David Rogers at Caledon Capital Management argues the Canadian government should take a lead role in supporting it. Specifically, he advocates using moral suasion to get the country's biggest pension funds to allocate a portion of their capital – say 5 per cent – to invest in startups. That means the government shouldn't outright mandate the allocation, but rather strongly suggest that the funds support the industry.

"There's a real crisis right now: the big pension funds have abandoned the space, the small pension plans aren't capable of evaluating the venture capital opportunities and those that maybe participated in the early and late nineties didn't get great returns," Mr. Rogers said.

Because everyone is running scared, Mr. Rogers believes the government is the one stable force that can bring at least some money back to the table. He knows from experience. In 2006, the Ontario Liberals tasked him with creating the Ontario Venture Capital Fund. By putting up $90-million of the provincial government's money, he was able to convince institutions to throw another $115-million at venture capital. The big co-investors included Toronto-Dominion Bank, Manulife Financial and Royal Bank of Canada. The money is now invested in three different venture capital funds run by BlackBerry Partners, Georgian Partners and XPV.

But Mr. Rogers isn't naive. He knows that pension funds will argue it is harder to make money in venture capital because the investments are much riskier than bigger private equity investments, such as big stable infrastructure assets, but he has been in their shoes as head of OMERS Private Equity and his experience taught him that the plan is viable. South of the border, for instance, some U.S. state pension funds are mandated to pour money into local startups.

Furthermore, Canada used to be more generous. Historically, the country's biggest pension funds invested in venture capital. Then in 2001 the federal government changed its rules and allowed them to hold a greater percentage of foreign investments. "With Canada representing [close to]2 per cent of global GDP, there isn't a lot of room or interest for relatively early stage Canadian technology companies," said Ted Anderson, managing general partner of venture capital firm Ventures West.

Yet pension funds alone can't be blamed for the dearth of venture capital funding in this country. A decade ago, the industry was propped up by two main funding sources: a small group of institutional investors, which included pension funds, as well as retail investors, who put their money into provincially-supported labour sponsored investment funds. These investors were given tax breaks for putting money into venture capital, which meant they could break even on their investments even if they experienced something like a 25 per cent loss.

However, any progress made in the late nineties was promptly wiped out when the dot-com bubble burst. Both institutional and retail investors lost a lot of money, so the big funds pulled their cash and the Ontario government ultimately wound down its tax breaks.

Although some funds survived, they had few options for selling their investments. Typically, a venture capital fund will invest in startups in hopes of cashing in when the firm goes public. "A lot of us were just hamstrung with funds that just could not find decent exits," Mr. Anderson said.

Of course, some funds were able to get out, but the returns were only two or three times the amount they originally invested. "You really need a 10 [times]to make it work," Mr. Anderson said.

Mr. Rogers agrees. "There just simply haven't been enough really successful funds to really change the impression of how you make money in the Canadian market."

Still, some people think the situation isn't that dire because they argue U.S. funds will be there to support Canadian firms. Kirk Falconer, director of private equity research at Thomson Reuters Canada, strongly disagrees. Ninety-five per cent of all first-time venture capital financing comes from Canadian investors, he said, and U.S. funds usually invest only in later financing rounds. That ties the hands of startups. "If Canadian funds aren't there to give [money]to them, they probably can't go anywhere else," he said.

Even if the Americans do invest early, Mr. Rogers argued that it isn't healthy for the Canadian economy if funds south of the border "pluck away our best businesses."

Despite all of its problems, the men believe that Canada's situation can be fixed. For inspiration they recommend looking to Israel, which is now the second largest venture capital market in the world. The country's economy isn't huge, but the industry put its best minds together to hammer out a venture capital strategy. "Why can't Canada do that?" Mr. Rogers asked.

The U.S., too, had problems back in the seventies and eighties, and although Silicon Valley is thriving today, "there was a period when venture capital funds couldn't get a dime," Mr. Falconer said.

Now it's Canada's time, the men argue. "You can put as much money as you want toward science and technology," Mr. Falconer said. Without VCs, "it won't go anywhere." The following chart shows Canadian venture capital market activity from 1998 to 2010.

Source: Thomson Reuters Canada