Browse Analysis of Managed and Structured Products

22.3.2 Disadvantages Of Labour-sponsored Funds

Explore the disadvantages of Labour-sponsored Venture Capital Corporations (LSVCCs), including high risk, complex redemption processes, and high administrative costs, making them suitable only for high-risk-tolerant investors.

Labour-sponsored Venture Capital Corporations (LSVCCs) are designed to energize the economy by investing in small and mid-sized businesses. However, they come with significant disadvantages that make them suitable only for investors with a high risk tolerance. In this overview, we’ll delve into the key drawbacks of labour-sponsored funds.

High-Risk Nature

Due to the nature of the companies in which they invest, LSVCCs are considered a high-risk, speculative investment suitable only for investors with a high risk tolerance. These corporations invest largely in new or small enterprises, which inherently carry a higher risk of failure.

Did You Know?

It is estimated that 80% of all new companies dissolve within five years of start-up.

Complicated Redemption Process

Redemption of LSVCC shares is generally more complicated than that of conventional mutual fund shares. Various rules govern LSVCC redemptions, differing not only among provinces but also between provincial and federal regulations.

Federal Requirement

Under the Income Tax Act, shares must be held for at least eight years to avoid the recapture of federal tax credits. Redeeming the shares before this period necessitates repaying the tax credits received on the LSVCC when the fund was purchased.

Example:

If Pierre decides to redeem his LSVCC shares after only five years, he will have to repay the $750 federal tax credit and the $750 provincial tax credit he received.

Provincial Variations

Some provinces allow immediate redemption after purchase, while others enforce a mandatory holding period before redemption. Certain provinces even prohibit redemptions altogether until specific conditions are met.

High Administrative Costs

Another significant downside of LSVCCs is higher administrative costs. Venture capital investing is more labour-intensive compared to investments in liquid stocks. Consequently, the costs associated with administering these funds tend to be higher than those for conventional equity funds.

Management Expense Ratio (MER)

The elevated administrative costs are reflected in the higher MER (Management Expense Ratio). Additionally, LSVCCs must maintain a larger cash reserve to finance redemptions, which can negatively impact fund performance in rising markets.

Key Takeaways

  • High Risk: LSVCCs invest mainly in small and new companies, making them high-risk and suitable only for high-risk-tolerant investors.
  • Complicated Redemption: The redemption process is complex and varies by province, with a federal requirement of holding shares for at least eight years to avoid tax credit recapture.
  • High Administrative Costs: The costs of administering LSVCCs are higher compared to conventional equity funds, leading to a higher MER.

Frequently Asked Questions (FAQs)

What are LSVCCs?

Labour-sponsored Venture Capital Corporations (LSVCCs) are investment funds that provide venture capital to small and medium-sized businesses, often in exchange for tax credits for their investors.

What makes LSVCCs a high-risk investment?

LSVCCs are considered high-risk because they invest primarily in startups and small businesses, which have a high likelihood of failure.

What are the federal requirements for redeeming LSVCC shares?

The Income Tax Act requires that LSVCC shares be held for at least eight years to avoid the recapture of federal tax credits. If redeemed before this period, the investor must repay the tax credits received.

How do redemption policies differ among provinces?

Provincial redemption policies vary, with some allowing immediate redemption after purchase, while others enforce mandatory holding periods or prohibit redemptions until specific conditions are met.

What is the impact of high administrative costs on LSVCC performance?

High administrative costs, reflected in the MER, and the requirement to maintain a large cash reserve can drag down the performance of LSVCCs, especially in rising markets.

Glossary

  • LSVCC: Labour-sponsored Venture Capital Corporation, an investment fund providing venture capital to startups and small businesses.
  • MER: Management Expense Ratio, a measure of the total cost of managing and operating an investment fund.
  • Income Tax Act: Federal legislation that governs income tax in Canada, including provisions related to LSVCCs.

Chart: Impact of High Administrative Costs on MER

    graph TD;
	    A[LSVCC] -->|Higher Administrative Costs| B[Higher MER]
	    B -->|Reduced Performance| C[Investor Returns]

By understanding these disadvantages, investors can make more informed decisions regarding their involvement in Labour-sponsored funds.


CSC® Exams Practice Questions

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Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

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## What is the primary risk factor associated with Labour-Sponsored Venture Capital Corporations (LSVCCs)? - [ ] Low liquidity - [ ] High transaction costs - [x] High-risk, speculative investment nature - [ ] Long-term growth potential > **Explanation:** LSVCCs invest in early-stage companies, which are inherently high-risk and speculative. These investments are only suitable for investors with a high risk tolerance. ## According to estimates, what percentage of new companies dissolve within five years of start-up? - [ ] 50% - [ ] 60% - [ ] 70% - [x] 80% > **Explanation:** It is estimated that 80% of all new companies dissolve within five years of start-up, indicating the high-risk nature of investments made by LSVCCs. ## How long must LSVCC shares be held according to the Income Tax Act to avoid repayment of federal tax credits? - [ ] 5 years - [x] 8 years - [ ] 10 years - [ ] 3 years > **Explanation:** The Income Tax Act requires that LSVCC shares be held for eight years to avoid the recapture of federal tax credits received at the time of purchase. ## What happens if an investor redeems LSVCC shares before the minimum holding period? - [ ] The investor must pay a penalty - [ ] The investor loses future dividends - [x] The investor must repay received tax credits - [ ] The investor receives lower returns > **Explanation:** If an investor redeems LSVCC shares before the minimum holding period, they must repay the federal and provincial tax credits received when they originally bought the shares. ## What makes the redemption process of LSVCC shares complicated? - [ ] High redemption fees - [x] Varying rules between provinces and the federal government - [ ] Lengthy paperwork - [ ] Limited redemption windows > **Explanation:** Redemption rules for LSVCC shares differ from province to province and between provinces and the federal government, making the process more complicated. ## In the provided example, how much federal and provincial tax credit will Pierre have to repay if he redeems his LSVCC shares after five years? - [ ] $500 - [ ] $1000 - [x] $1500 - [ ] $2000 > **Explanation:** Pierre will have to repay $750 federal and $750 provincial tax credits, totaling $1500, if he redeems his LSVCC shares before the required holding period of eight years. ## Which factor contributes to the higher cost of LSVCCs compared to conventional equity funds? - [ ] Lower liquidity - [ ] High dividend payouts - [ ] Long-term investment strategies - [x] Labour-intensive venture capital investing > **Explanation:** Venture capital investing is more labour-intensive, thus increasing the costs of administering LSVCCs relative to conventional equity funds. ## How do higher costs of LSVCCs affect their MER (Management Expense Ratio)? - [ ] It lowers the MER - [ ] It has no effect on the MER - [x] It increases the MER - [ ] It stabilizes the MER > **Explanation:** The extra cost of administering LSVCCs due to labour-intensive venture capital investing is reflected in a higher MER compared to conventional equity funds. ## Why must LSVCCs maintain a large cash reserve? - [ ] To invest in more start-ups - [ ] To distribute dividends - [ ] To pay management fees - [x] To finance redemptions > **Explanation:** LSVCCs need to maintain a large cash reserve to finance redemptions, which can negatively impact fund performance in rising markets. ## What impact does maintaining a large cash reserve have on LSVCCs during rising markets? - [ ] It enhances performance - [ ] It has no impact - [ ] It stabilizes performance - [x] It drags down performance > **Explanation:** Maintaining a large cash reserve to finance redemptions can drag down fund performance in rising markets as it reduces the amount of capital available for investing in growth opportunities.

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Sunday, July 21, 2024