Publication: C.D. Howe Institute Commentary
Publication Date: 15-FEB-07
Delivery: Immediate Online Access
Author: Hurwitz, Stephen A. ; Marett, Louis J.

Article Excerpt
Canada's private equity sector--in which individuals and institutions fund private equity firms that invest, in turn, in Canadian operating companies--is needlessly hampered by Canada's cross-border tax laws. Those laws discourage investment by US institutional investors in Canadian private equity firms and by US private equity firms in Canadian operating companies. In this respect, the Canadian tax scheme stands in sharp contrast to that of other countries, such as the United Kingdom and the United States, where no similar cross-border tax barriers exist to this kind of foreign capital.

In this Commentary, we identify and discuss existing Canadian tax barriers to the entry of foreign (mostly US) private equity from both buy-out and venture capital firms (1) and of foreign (again, mostly US) institutional capital, primarily in the form of pensions and university endowments. We examine the harm these barriers cause, and we propose ways of reducing them.

In addition to the economic benefits that typically travel with cross-border capital, investment in Canadian operating companies by US private equity firms is usually accompanied by human capital. This human capital involves deep knowledge of the US market and extensive networks of executive, sales and marketing personnel, and familiarity with potential customers, distribution channels, suppliers, and strategic partners in that market. In addition, Canadian private equity firms that invest alongside their US counterparts have the opportunity to develop relationships that enhance their investing skills, leading to further co-investment opportunities in both countries.

These are important issues, because there is a shortage of capital flowing to Canada's private equity firms. Given the size of Canada's gross domestic product (GDP) and population relative to those of the United States, Canadian venture capital firms should be receiving about 10 percent of the total funds invested in the two countries' venture capital firms. Their share, however, is far short of that amount and falling, as Table 1 shows. It is not surprising, then, that the share of investments in Canada by venture capital firms also falls far short of the amount one would expect (see Table 2).

In 2005, emerging Canadian venture-funded companies raised an average of C$3.1 million, while their US counterparts raised an average of C$10.4 million (Thomson Financial 2006). Yet these companies compete directly in the same North American market and ostensibly have the same need to be well capitalized. An especially serious shortage exists in Canada of so-called later-stage B, C, and D venture financing, relative to the abundance of such funds in the United States, which is critical to funding the market expansion of emerging companies. (2)

The investment performance of Canadian venture capital firms also significantly lags that of US firms. Over the 10-year period prior to the end of June 2006, Canadian venture firms had net horizon returns of 2.5 percent, while their US counterparts achieved 20.7 percent (Thomson Financial and CVCA 2006). We hypothesize that the underfunding of Canadian venture capital firms, demonstrated in Table 1, is a significant contributing cause to their underperformance. The less funding Canadian venture capital firms receive, the less they have to invest in emerging Canadian companies.

To continue this argument, the more poorly capitalized emerging Canadian companies are, the less competitive they will be in the North American marketplace against their better capitalized US counterparts. The more poorly these emerging Canadian companies perform, the worse is the resulting performance of the Canadian venture capital firms that fund them. The worse the performance of these Canadian venture capital firms, the greater their difficulty in securing funds from institutional and other investors. And so this debilitating cycle goes, reinforcing and causing underachievement for Canadian entrepreneurs and venture capitalists alike. (3) Thus, at each level of the Canadian venture capital sector, a significant shortage of capital exists relative to that available in the US counterpart, and the data reported in Tables 1 and 2 suggest that fundraising and investments by Canadian venture capital firms in 2006 will be at their lowest levels in four years.

Because Canadian and US private companies compete directly with each other in the same North American market, the lack of capital of Canadian venture-backed companies--on average, less than one-third of that of their US competitors--is a significant handicap. Further, the inability of Canadian operating companies to obtain sufficient capital to expand successfully in the North American market also contributes to their having to be sold early in their life cycles and long before they attain market leadership, frequently to large US companies and often at low prices. (4)

The result is that Canada is not deriving the full benefit of the billions of dollars of direct funding the federal government delivers for university and hospital research and development (R&D) or the indirect funding it affords Canadian businesses through Scientific Research and Experimental Development (SR&ED) tax credits (see Canada 2006). (5) Rather, this extensive federal government funding has become, in effect, a subsidy to US businesses that acquire Canadian companies cheaply, then reap the financial rewards when these companies...



NOTE: All illustrations and photos have been removed from this article.



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