22.3.2 Disadvantages Of Labour-sponsored Funds

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.