Labour fund revolutionary beats a tactical retreat

(September 8, 2004) The firm that tried the reshape the labour sponsored investment fund (LSIF) industry is calling on its investors to back out now, while they still have some of their cash.

Terra Firma Funds trumpeted its own launch as a revolution in the labour fund space, calling its closed-end investment structure a bold step forward in investor protection. The company launched three funds, Terra Firma Income Fund 2004, Terra Firma Equity Fund 2004 and Terra Firma Emerging Companies Fund 2004. Unfortunately, the family of three funds only attracted $1.2 million in investments.

“In order to protect the existing net asset value and to avoid eroding this value with on-going expenses, we believe it is in the best interest of all shareholders to redeem their shares now,” said Julie Makepeace, president and CEO of Terra Firma Funds and Managing Director of IPM Funds. “Redeeming all Class A shares of the Funds, while disappointing, is the right thing to do.”

“The funds are very small and unable to carry their own operating costs without an extremely high MER,” Makepeace adds. “So IPM Funds, the management company has made arrangements to control those costs.”

IPM terminated contracts with their venture capital consultants, their back-office administrator and waived its own management fee, along with the directors’ fees.

“We’ve done everything we can to control costs but there are some basic expenses — audit, custodian, liquid portfolio manager and so on — that as basic services still need to be maintained to operate funds. Even these costs will be relatively high on such small funds.”

She says the company has been focused on raising capital to support IPM as the fund manager and carry the funds through another RRSP season. But that effort failed.

“We think that it’s important that the shareholders redeem now, rather than incur more costs going forward,” Makepeace says. “Without a well-capitalized management company it is not possible to execute the original mandate of the funds and make venture capital investments.”

Special meetings of the shareholders of the funds will be held on September 30, 2004 to vote on the resolutions to redeem all outstanding Class A shares of the funds. If shareholders approve, all issued and outstanding Class A shares of the funds will be redeemed on October 19, 2004.

“This is a reminder that brand new LSIFs carry a unique risk; that is, the risk that the fund won’t raise enough cash — open end or closed end,” says fund analyst Dan Hallett, CFA, CFP and President of Dan Hallett & Associates. “Even if Terra Firma had set up without the ‘closed’ angle, having raised $1.2 million in their first year would have had to make them think if they should bother with future fund raising.

“You have so many Ontario funds vying for what has been a shrinking pool of new money that it’s inevitable that some new firms will have no choice but to fold.”

Makepeace did cause a bit of a splash with the launch of Terra Firma at the beginning of the year, though. She was highly critical of the LSIF industry, saying the traditional open-ended fund structure left early investors exposed to all the risks of venture capital financing, while allowing late investors to swoop in as the fund matured and reap the rewards. Terra Firma funds were set up as closed-end products, eliminating the dilution of early investors’ stake in the funds.

Makepeace also criticized traditional LSIF managers as being too concerned with attracting new capital, rather than managing the cash they had already attracted.

“As a category, LSIFs have been very focused on raising capital, but have been unable to deliver good returns to shareholders,” she said earlier this year.

Such criticism did not go unnoticed.

“The LSIF industry makes a significant contribution to Canada and it is regrettable that a new entrant has decided to make such broad and critical generalizations, ultimately for their own gain,” said Dale Patterson, executive director of the Association of Labour-Sponsored Investment Funds (ALSIF).

But Makepeace is adamant that Terra Firma’s failure to attract investors was not a reflection of the new approach.

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“It’s definitely a superior model and I think we’ve really shaken up the labour fund industry and drawn people’s attention to it,” she says. “This model is better for the shareholders. These products need to have a maturity date that is coincident with when the shareholders would be logically looking to redeem at the end of their term.

“If they do mature at that point, then the venture capital managers can be moving the portfolio to peak performance at that point, so you’re not constantly diluting the returns with the inflows of capital. It’s the only model used in the private equity funds, because those are discerning investors who wouldn’t tolerate it.”

So if the product itself was superior, what went wrong?

“We should have mounted a bigger, more aggressive marketing campaign and we were a little bit late,” Makepeace admits. “We launched the funds in the middle of January and it’s very difficult for the financial advisor to entertain a new labour sponsored fund in the middle of January — their RSP season is in full swing by then. We needed to be out there talking to them in September and October.”

Makepeace says it is difficult to attract enough capital in a single season to fully fund the management company, but hopes to re-launch the funds this fall for the 2004-2005 RRSP season.

But Hallett says launching the very same funds a year later doesn’t sound like it has a high probability of success, given the apparent narrow interest the first time around. “Then there’s the Ontario moratorium on new LSIFs. I suppose the only way around the moratorium is if Terra Firma returns unitholders’ money but doesn’t actually fold the funds — hence allowing them to ‘re-market’ them next year.”

Investors who received the LSIF tax credit in the spring will see this amount deducted from their redemption as a withholding tax, as there is no provision in the relevant tax acts to allow for a transfer to another firm. Makepeace points out that this “nets out” in the end, but investors may still fell burned.

“The shareholders don’t lose anything, but they don’t benefit from that tax credit,” She says. “It’s unfortunate that we have not been able to raise the capital in the management company to finance the ongoing operation of the Terra Firma funds, because I really believe they are a superior product.”

“Investor confidence won’t be shaken as a result of Terra Firma’s proposed liquidation but I hope it makes investors and advisors think twice about new LSIFs,” says Hallett. “It doesn’t mean you avoid them altogether, but you’ve got to have more than a good story. Advisors have to look further down the road to the fund’s ability to raise a sufficient amount of money.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(09/08/04)