US embassy cable - 05TORONTO2638

The Canadian Financial Services Sector: Playing Catch-Up on the Venture Capital Front

Identifier: 05TORONTO2638
Wikileaks: View 05TORONTO2638 at
Origin: Consulate Toronto
Created: 2005-10-12 15:52:00
Redacted: This cable was not redacted by Wikileaks.
This record is a partial extract of the original cable. The full text of the original cable is not available.

121552Z Oct 05
E.O. 12958: N/A 
SUBJECT: The Canadian Financial Services Sector: 
Playing Catch-Up on the Venture Capital Front 
Ref: (A) Toronto 1633   (B) Toronto 1728 
Sensitive But Unclassified - Protect accordingly. 
1.  (U) This message is one in a series reviewing the 
Canadian financial services sector from a cross-border, 
North American integration perspective.  In September 
2005 the Toronto Financial Services Alliance sponsored 
roundtables for ConGen Toronto with industry sector 
experts in venture capital, banking (septel), 
securities (septel), and insurance (septel). 
2.  (SBU) SUMMARY AND COMMENT: Canada's venture capital 
and private equity public policy association, the 
Canadian Venture Capital Association (CVCA), advised 
ConGen Toronto during a September 13 roundtable that it 
has mounted a campaign to increase the supply of risk 
capital available to Canadian entrepreneurs.  One goal 
is to ensure that funds are properly channeled to 
support new enterprises that are commercializing 
technology coming from Canada's leading university and 
research institutions.  CVCA is concerned that Canada's 
undersized venture capital industry and current 
regulatory framework stifle growth opportunities for 
Canada (and North America) and fail to take advantage 
of Canada's positive economic performance.  CVCA cites, 
among other things, eight structural impediments to 
investment in Canadian venture capital that the federal 
government imposes on the industry via the Canada 
Income Tax Act.  The CVCA expressed frustration that 
Canada's strength in publicly-funded university 
research is often commercialized in the U.S. due to a 
dearth of venture capital in Canada.  To address these 
issues, the industry hopes to raise its profile in 
Canada and the U.S. to attract large institutional and 
pension fund investors to Canadian private equity funds 
and interest in several emerging homeland security-type 
technologies.  The Security and Prosperity Partnership 
(SPP) Financial Services Sector Working Group may wish 
to factor these concerns into its work plan review. 
Boom and Bust - Context of Venture Capital in Canada 
--------------------------------------------- ------- 
3.  (U) At a September 13 Canadian Venture Capital 
Association (CVCA) roundtable for ConGen Toronto, 
representatives of the private equity industry 
explained that the Canadian venture capital industry 
was a late starter compared with the U.S.  Tracing its 
origins to the mid-1970s when the fledgling industry 
established the CVCA, the market only attained "take 
off" velocity during the 1990s with the technology 
bubble.  Over 50 percent of Canada's venture capital 
industry is concentrated in Ontario.  Major components 
of the industry focus on software and the life sciences 
in Toronto, telecom and Internet technology in Ottawa, 
and biotech and information technology in the "Golden 
Horseshoe technology triangle" around Kitchener, 
Waterloo, and Guelph.  Quebec is the second largest 
market due in part to the province's dirigiste 
policies, which mandate that venture capital generated 
in Quebec must be invested locally.  Western Canada's 
focus on resources, oil, and gas had not been conducive 
to the development of a venture capital industry, 
according to the CVCA; however, a small venture capital 
industry is developing in Vancouver, closely connected 
to the venture capital industry in Seattle. 
4.  (U) In the 1990's, growth was rapid, the CVCA told 
us, but when the high-tech bubble burst in late 2000 
and early 2001 the descent was equally rapid.  Capital 
was drained from the industry as venture capitalists 
fled the overwhelmingly tech-based venture industry. 
Currently, the 1,000 members of the CVCA manage some 
C$50 billion in assets.  This is about 1/20 of the size 
of the U.S. industry and, in relation to population and 
GDP, half the size of the U.S. venture capital market. 
Cross-Border Integration 
5.  (SBU) The CVCA has in recent years observed a trend 
towards cross-border integration of the venture capital 
industries in the U.S. and Canada.  U.S. companies find 
certain aspects of the Canadian market attractive - 
competition is not as fierce, making returns 
significantly higher, and Canada's publicly funded 
universities are good incubators of intriguing 
technologies.  U.S. companies that have recently come 
to Canada include KKR, the Carlisle Group, several 
Boston-based groups, and some funds from Washington and 
New York.  Also, Canadian-based venture capitalists 
have recently succeeded in raising funds from U.S. 
firms.  Most prominently, Celtic House, an Ottawa based 
group, sourced 50 percent of its funding from the U.S., 
which the industry here saw as a real breakthrough. 
Ventures West, a Vancouver-based group, and Jefferson 
Capital, based in Toronto, have in recent months 
recorded similar successes.  The CVCA believes that the 
venture capital industry is in the process of becoming 
truly continental, with several smaller regional 
centers of gravity outside the main Toronto hub. 
Digging out from the Tech Collapse 
6.  (SBU) CVCA described the big picture challenge as 
digging out from the tech collapse.  This has been a 
slow and arduous task, according to the CVCA.  In the 
best of times, Canadian venture capitalists have 
suffered in comparison to their U.S. counterparts from 
the relatively small pool of venture capital and the 
fact that Canadians tend to be more risk averse than 
Americans.  The CVCA pointed to the following factors 
as slowing the recovery: 
--Increased regulatory burden: according to the CVCA, 
the ultimate goal of any venture capitalist is to take 
fledgling private companies public and to cash in at 
the initial public offering (IPO).  Following enactment 
in the U.S. of the Sarbanes-Oxley legislation and 
Canada's coordination with U.S. law  (ref (A)), the 
costs to companies of complying with beefed-up 
disclosure provisions are dissuading small and micro 
cap companies from going public (i.e. issuing an IPO). 
The CVCA said the industry has, ironically, benefited 
to some degree in recent years from taking public 
companies private again; 
--Loss of Canadian subsidies: The CVCA deplored the 
decision of the Ontario government to phase out a 30 
percent tax credit previously given to Ontario 
residents who invest up to C$5,000 in designated pools 
of venture capital; 
--Proximity and relative strength of the U.S. market: 
the CVCA confirmed that of Canada's best ideas migrate 
to the U.S. where venture funding is more readily 
available.  As a result, Canada faces the "perverse" 
situation that its publicly funded university system 
acts as a great incubator for innovative ideas that are 
then developed commercially south of the border (ref 
(B)).  A good example is the University of Waterloo, a 
leading Canadian math and high-tech engineering 
university, which supplies over 50 percent of its 
graduating classes to Microsoft Corp.  (NOTE:  Bill 
Gates has taken a personal interest in this university, 
often slipping in quietly to meet with Waterloo 
students, as he did on October 7.  END NOTE) 
Canadian Tax Act Impedes Venture Capital Industry 
--------------------------------------------- ---- 
7.  (SBU) The CVCA reserved its harshest criticism for 
the federal government and has identified in a paper 
submitted to the federal Department of Finance eight 
structural barriers to investment in Canadian venture 
capital and private equity funds under the Canadian 
Income Tax Act.  These problem areas include: 
--Impediments to the use of Qualified Limited 
Partnerships (QLP), especially with regard to Canadian 
content restrictions, as a vehicle for venture capital 
and private funds. 
--Passive investment as a limited foreign partner in a 
Canadian fund being subject to Canadian tax. 
Department of Finance letters of exclusion are not, the 
CVCA says, a reliable instrument to the general venture 
capital investor; 
--Lack of tax treaty relief for U.S. LLC ("Limited 
Liability Company") partners under the Canada-U.S. 
Income Tax Convention, which often prevents a U.S. fund 
from investing in Canada.  (NOTE: an LLC is a type of 
legal entity that combines the benefits of liability 
protection for the owners of the business with the 
potentially favorable tax benefits of flow through 
taxation.  END NOTE); 
--Cumbersome use of "parallel funds" to protect 
Canadian investors from Canadian withholding tax rather 
than a look-through mechanism that would require 
withholding of taxes only to the proportionate extent 
of the non-Canadian interest in the partnership; 
--Delay in the issuance of Section 116 certificates 
following the completion of a corporate sale 
transaction, which has forced U.S. investors to delay 
the sale of their resulting shares in public markets. 
This has led to a growing perception that Canadian 
regulatory requirements do not accommodate market 
--The Non-resident tax return requirement even when no 
tax is payable and the transaction has been reported to 
the Canada Revenue Agency (CRA); 
--Limits posed on "Associated Companies" eligibility 
for Scientific Research and Experimental Development 
(SR&ED) tax credits under current definitions that do 
not recognize genuinely independent associated 
companies; and 
--Cross border merger provisions that deny a roll-over 
for shareholders of Canadian companies that receive 
shares of U.S. companies as a result of a merger 
transaction (NOTE:  This single issue CVCA claims leads 
many experienced Canadian entrepreneurs to establish 
their new businesses as U.S. incorporated companies, 
even though the business is initially being formed in 
Canada.  END NOTE). 
8.  (SBU) The CVCA emphasized that resolution of all 
eight impediments would not/not have any material 
fiscal impact on the Government of Canada.  In each 
case, the identified structural barriers do not 
represent requests for lower tax rates or increases in 
other tax benefits.  The CVCA argued that many of these 
impediments take the form of misguided nationalistic 
rules, such as "Canadian content" provisions, which 
scare away foreign investors.  The CVCA also claimed 
that many of these eight structural impediments have 
been previously discussed with the federal Finance 
Ministry but, so far, have at best been only partially 
addressed in legislative amendments. The CVCA hoped the 
federal government would eventually remove these eight 
impediments to investment in Canadian venture capital 
(NOTE: The CVCA Paper "Summary of Tax Issues for 
Discussion with the Department of Finance" has been 
sent to WHA/CAN and Embassy Ottawa.  END NOTE). 
Planned Remedies 
9.  (SBU) The CVCA believes that its overarching goal 
must be to grow the pool of venture capital in Canada. 
To do so, the CVCA plans several measures, including: 
--Campaigns to market itself better in Canada.  Many 
small investors, the CVCA believes, are not aware or 
have a poor understanding of private equity funds. 
Roynat Capital, a venture company that hosted this 
roundtable discussion, is currently running full-page 
ads in the "Financial Post" (the business section of 
the National Post), featuring several venture capital 
success stories. 
--The CVCA hopes to prod large pension funds of large 
institutional investors in the NAFTA area to take a new 
look at venture capital and invest more money in the 
industry.  Among the targets is the Ontario Teacher's 
Pension Fund, Canada's largest pension fund.  The CVCA 
mentioned the federal elimination of the 30% foreign 
property ceiling on Canadian pension funds in February 
2005, as a recent positive development for the 
increasingly continental venture capital industry.  In 
particular, pension funds have found it difficult to 
invest in venture capital pools, in which the domestic- 
to-foreign content ratio can fluctuate significantly. 
--The CVCA believes that Canada is currently incubating 
several technologies with homeland security 
applications that would be of interest to both the 
Canadian and U.S. governments.  They noted that U.S. 
Department of Defense contract awards to Canadian 
companies are almost twice as large as the defense 
contracts going to U.K. companies. 
--The CVCA points to two favorable market trends that 
could lift the Canadian venture capital market.  First, 
recent quarterly data - which are notoriously volatile 
- show a 50% jump in investment in Canadian venture 
capital pools, with 35% coming from outside of Canada 
(mostly from the U.S.). This investment from foreign 
sources was at its highest level in two years.  Second, 
the federal government's September decision to all but 
freeze "income trust conversion" (a highly popular 
investment vehicle) is already increasing the flow of 
capital to the traditional IPO market. 
Positive Government Initiatives 
10.  (SBU) In addition to these CVCA efforts, the 
industry hopes provincial and federal government 
initiatives will help the industry recover.  For 
example, Ontario is supporting Centers of Excellence, 
which provide seed money to encourage commercialization 
of home-grown technologies in the areas of Energy, 
Communications & Information Technology, Public 
Infrastructure, Materials and Manufacturing, and 
Photonics Research.  Also, the federal and provincial 
governments have partnered in establishing a Medical 
And Related Sciences (MARs) hub in Toronto, an attempt 
to turn medical research into commercially viable 
hospital applications.  And on October 7 the Toronto 
Region Research Alliance (TRRA) was launched to 
implement a focused strategy to commercialize R&D in 
the Greater Toronto Area.  Using San Diego as one model 
that has attracted a large number of venture capital 
firms, this new alliance has brought together the 
formidable talents of its founders Dr John Evans, 
president of MARs, former president of the University 
of Toronto and now Chair of the Board of Directors of 
the Canada Foundation for Innovation (CFI); Gordon 
Nixon President and CEO of RBC Financial Group, 
Canada's largest bank; David Pecaut, Managing Director 
of the Boston Consulting Group of Canada; and Ross 
McGregor, Chairman Emeritus of Ketchum Canada, Canada's 
leading fund development consultancy.  This group hopes 
to bring the U.S.-based Battelle Institute to partner 
with the University of Toronto to create a world-class 
bio-tech commercialization facility and to establish a 
National Research Council presence in southern Ontario. 
List of Attendees 
11.  (U) The venture capital industry was represented 
Dr. Robin Louis, President of CVCA and President of 
Ventures West Management; Richard Remillard, the CVCA's 
Executive Director; Bob Roy, Managing Director, Roynat 
Capital; Rick Nathan, Managing Director, Goodmans 
Venture Capital; Mark MacDonald, Buyout Specialist, 
OTPP Private Equity; and Arlene O'Neil, M&A Lawyer, 
Gardiner Roberts LLP.  The Toronto Financial Services 
Alliance was represented by its President, Janet Ecker 
(former Ontario Minister Finance); and Susan Viegas, 
Economic Development, City of Toronto.  The U.S. was 
represented by CG Jessica LeCroy; Consul for 
Economic/Political Affair Sherri Holliday; and Economic 
Specialist Colin White. 
Background: the CVCA and the TFSA 
12.  (U) The CVCA - Canada's Venture Capital & Private 
Equity Association - was founded in 1974 to represent 
Canada's venture capital and private equity industry. 
Its over 1,000 members are firms and organizations that 
manage the majority of Canada's pools of capital 
designated to be committed to venture capital and 
private equity investments.  The CVCA fosters 
professional development, networking, communication, 
research and education within the venture capital and 
private equity sector and represents the industry in 
tax and regulatory matters. 
13.  (U) The Toronto Financial Services Alliance (TFSA) 
is a joint public-private partnership created in 2002 
by the City of Toronto's Economic Development Bureau 
and the Toronto-based financial services industry.  The 
TFSA works closely with industry, affiliate services, 
and government to enhance and promote the 
competitiveness of Toronto as a premier North American 
financial center. 

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