Canadian Venture Capital Activity: An Analysis of Trends and Gaps (1996–2002)

Part II: 7. Venture Capital Investment Trends by Investor Type

As explained in Part I, the VC industry is a complex, interdependent market. This complexity arises from this market's composition and structure (e.g. number and type of players) and from its operation (e.g. fundraising versus investments, investment criteria, decision-making processes). These factors have shaped the evolution and performance of the VC industry in Canada.

The evolution of the VC industry in Canada has been influenced by the number and the changing nature of the suppliers of capital and VC investors who participate in the market.

1. Suppliers of capital are the sources of capital for VC funds. They are primarily individuals, corporations, private and public pension funds, endowments, life insurance companies, and mutual funds. These suppliers provide capital to Canadian VC funds based on expected risk-adjusted returns and predetermined investment criteria, but they do not invest directly in Canadian firms.
2. VC investors raise funds from the different suppliers of capital and then invest in Canadian and foreign high-growth-potential companies. In Canada, there are seven categories of VC funds.^{Footnote 78}
   
   
   • Labour-sponsored venture capital corporations (LSVCCs) are VC funds sponsored by labour unions and capitalized by individual shareholders who receive federal and/or provincial tax incentives in exchange for long-term capital commitments, usually exceeding eight years.
   • Private independent funds are structured as limited partnerships and related vehicles.
   • Institutional funds are VC funds within large institutions, such as pension funds, insurance companies or endowments. In Canada, some of these institutional funds have indirectly supplied capital. Others have been directly involved as VC investors.^{Footnote 79}
   • Corporate funds include subsidiaries of industrial or financial corporations.
   • Government funds include BDC, FCC Ventures and EDC VC funds, as well as provincial government funds (e.g. SGF, Innovatechs).
   • Foreign investors are non-resident private VC funds or corporations active in Canada.
   • Other investors include mutual funds and other institutional investors with interests in specific private equity deals but without a permanent market presence.

In the U.S. VC market, private independent investors dominate VC investment, providing 83 percent of capital under management in 2002, compared to the 23 percent provided in Canada by private independent funds. Fundraising and investment in the Canadian VC market is led by LSVCCs, which rely heavily on tax incentives. The significance of private independent investors changes the basis of comparison, since their mandates are different from those of some LSVCCs and private independent investors (see Subsection 7.3.1).

The principle sources of funds is another major difference between the Canadian and U.S. VC markets (which explains, in large part, the dominance of LSVCCs in Canada). In Canada, individual investors provide 56 percent of total commitment in 2002, compared to 9 percent in the U.S. In the U.S., institutional investors are the main sources of capital, providing more than 85 percent of total commitment in 2002 (pension funds provide 42 percent, endowments and foundations provide 21 percent, and financial and insurance provide 26 percent of total investments). In Canada, institutional investors provide only 18 percent, a low participation rate that has influenced the evolution and growth of the Canadian VC market. While private independent and institutional investors have not been major players in the history of the Canadian VC market, their potential contribution will be essential to the growth of the VC industry.

Another complicating feature of the VC market is the internationalization of the market through increased capital inflows (investments made by foreign investors in Canadian firms) and increased capital outflows (investments made by Canadian investors in foreign firms). See Section 8 for a detailed review of Canadian VC investments made abroad.

This two-way flow of investment, particularly with the U.S., has brought significant benefits to the Canadian market and to Canadian SMEs. Foreign investments enable Canadian VC firms to build stronger networks with experienced venture capitalists in other countries; to provide diversification opportunities for Canadian VC firms; and to earn potentially higher returns for their investors (by investing in the best opportunities regardless of location). As well, foreign participation in the Canadian VC market provides additional sources of capital, which increases funding in Canada and, thus, meets specific needs of Canadian SMEs. Moreover, this increased inflow and outflow of capital fosters competition in the Canadian and U.S. VC markets and provides improved networks and strategic partnerships with more experienced VC investors, which develops the Canadian VC market. Indeed, in recent years, more deals are being syndicated in Canada, partly because foreign investors have been investing alongside Canadian investors.

To better understand how these domestic and foreign participants have shaped the Canadian VC market, this section presents key trends and observations related to VC fundraising trends and VC investments trends by type of investor from 1996 to 2002.^{Footnote 80, Footnote 81} It also briefly reviews the relative importance of the different suppliers of capital to VC funds managers.

Overall, the analysis shows that, over the past seven years, LSVCCs, government funds and foreign investors have played major roles in fundraising and investment, while institutional and private independent investors have approached VC relatively cautiously. These trends raise important questions and concerns about these investors' impact on the growth of the VC industry — which we will discuss, along with foreign investment, throughout this section, in Section 9, and in Part IV.

7.1 Overview of 1996–2002 Venture Capital Fundraising Trends and Analysis

As explained previously, VC funds (usually the general partner in the case of a limited partnership investment vehicle) first raise new capital from different suppliers and then invest in high-growth-potential Canadian and foreign SMEs. VCs generally raise funds every two or three years, depending on their investment activities. In fact, strong fundraising throughout 2002 and 2003 indicates that VC investment activity should increase soon.

VC fundraising must be examined within the proper context. Accordingly, this section looks at fundraising trends (the amounts of new capital raised by each VC investor type); at the source of new capital raised (the origin of new capital); and at capital under management trends (the total capital being managed by each investor type).

Table 16: Summary of Venture Capital Funds Raised, Capital Under Management and Capital Available by Investor Type, 1996–2002

	Funds Raised ($ Millions) (percent)			Capital Under Management ($ Millions) (percent)			Capital Available for Investment ($ Millions) (percent)
	1996	2002	Total Growth	1996	2002	Total Growth	1996	2002	Total Growth
Source: Macdonald & Associates Limited, 2003 a. While institutional investors have not raised any capital in 2002, pension funds have made their largest contribution to private independent funds with $510 million. As a result, pension funds have increased their indirect contribution as a source of new capital raised (see Figure 42).
LSVCCs	1 221 (70)	1 754 (54)	43	3 061 (47)	8 199 (36)	167	1 264 (50)	1 847 (24)	46
Private Independent	221 (12)	1 126 (34)	409	1 445 (22)	5 315 (23)	267	535 (21)	2 165 (29)	304
Institutional	80 (4)	0a (0)	–	358 (5)	4 281 (19)	1 095	146 (5)	1 831 (24)	1 154
Corporate	208 (12)	53 (1)	-74	1 119 (17)	2 633 (11)	135	407 (16)	1 206 (16)	196
Government	0 (0)	315 (9)	–	461 (7)	2 041 (9)	342	167 (6)	391 (5)	134
Total	1 730 (100)	3 248 (100)	88	6 444 (100)	22 469 (100)	248	2 519 (100)	7 440 (100)	195

The data from 1996 to 2002 (see Table 16 and figures 42, 43 and 44) suggest the following conclusions.

Fundraising trends — labour-sponsored venture capital corporations dominate fundraising activities; private independent funds are increasing fundraising

From 1996 to 2002, LSVCCs have led fundraising activities (and VC investments) in Canada, raising an annual average share of 46 percent of total new funds (and 54 percent in 2002) (see Figure 42). However, private independent funds have gained market share in recent years, raising 34 percent of total funds in 2002, up from only 12 percent in 1996 (the highest increase among investor types, with a growth of 409 percent in capital raised since 1996). The performance of private independent funds in recent years is linked to pension funds' increasing contribution of new funds (see information under the "Source of new capital trends" heading that follows).

Government-owned funds, which raised no funds in 1996, raised $315 million in 2002, through several newly established government funds, mostly the BDC (e.g. BDC seed, specialized funds), as well as through funds in Quebec.

Corporate funds have been less active in 2002, raising only 1 percent of new capital, which was a 74-percent decline in fundraising activities, from $208 million in 1996 to $53 million in 2002.

Finally, institutional investors have shifted from direct to indirect participation in the VC market. Their fundraising activities declined from 4 percent of new funds raised in 1996 to 0 percent in 2002. However, institutional investors have not disappeared from the VC market, as their role as suppliers of capital has increased significantly in recent years (see information under the "Source of new capital trends" heading that follows).

Figure 42: Fund-Raising Trends by Investor Type, 1996–2002

Source of new capital trends — individuals are still the main source of new capital raised; pension funds are providing indirect funds to private independent funds

As shown in Figure 43, individuals were the main source of new capital from 1996 to 2002, raising 51 percent of total funds. In 2002, however, while individuals provided 56 percent of new capital, the balance shifted. Pension funds (in particular, the Canada Pension Plan Investment Board and Bimcor Inc.) have increased indirect contributions to private independent funds. While their overall share of total capital raised remained stable in 2002 (16 percent in 2002, compared to an average of 18 percent between 1996 and 2002), pension funds provided the largest amount of capital to private independent funds: their $510 million represented 45 percent of funds raised by private independent funds in 2002.

This is an important and positive development in the market, as pension funds have historically been reluctant to make indirect contributions to private independent funds. According to Macdonald & Associates Limited, other institutional investors, such as endowment funds and mutual funds, are also starting to increase their indirect contributions to the VC market.

In the first nine months of 2003, however, funds raised just $1.3 billion, suggesting that Canadian funds may not match the $3.2 billion raised in 2002. According to Macdonald & Associates Limited, several Canadian private limited partners are raising funds and are preparing to announce final closings. Among these are Royal Bank Technology Ventures Inc., Milestone Medica Corporation in partnership with Boston-based VIMAC Ventures LLC and BTG Ventures, and Primaxis Technology Ventures Inc. in partnership with Silicon Valley-based Draper Fisher Jurvetson. These strategic partnerships should attract institutional investors to the Canadian VC market.

Figure 43: New Capital Raised by Source, 1996–2002

Capital-under-management trends — labour-sponsored venture capital corporations and private independent funds are the largest investors in terms of capital under management; institutional investors have experienced the largest increase since 1996

LSVCCs and private independent funds have dominated the distribution of capital under management (see Figure 44), managing an average of 43 percent and 24 percent of total, respectively, from 1996 to 2002 (and 36 percent and 23 percent in 2002).

In terms of the growth of capital under management, however, institutional investors ranked first among investor types, with a steep increase of 1095 percent, from only $358 million in 1996 to $4.3 billion in 2002 (compared to the overall increase of 248 percent for all investor types). As a result, institutional investors' market share has grown from 0 percent in 1996 to 19 percent in 2002. This confirms that institutional investors were almost absent from the Canadian VC market before 2000.

Government funds' capital under management grew by 342 percent over the period, from $461 million to $2 billion. However, government funds' average share of capital under management from 1996 to 2002 amounted to 7 percent of the total.

Corporate funds experienced the lowest increase of capital under management, 135 percent over the period, growing from $1.2 million to $2.6 billion, resulting in a decline in market share to 11 percent in 2002. Nonetheless, they still lead government-owned funds in total capital under management.

While this increase of capital under management by the Canadian VC industry is positive, the Canadian VC market remains relatively small compared to U.S. and international markets. In fact, data since 1999 show an increasing size gap in capital under management as a percentage of GDP between Canada and the U.S. This gap may impair the relative performance and development of the Canadian VC industry.

Figure 44: Capital Under Management by Investor Type, 1996–2002

7.2 Overview of 1996–2002 Venture Capital Investment Trends and Analysis

Once VC funds have raised funds, they invest in Canadian and foreign firms, based on predetermined investment criteria and funding milestones. Each category of VC investor, through different legal frameworks, mandates, and investment criteria and practices, serves a specific segment of the VC market based on the size, sector, stage and regional characteristics of their investments.

While the distribution of fundraising activities has remained relatively constant across VC investor types, the distribution of VC investments by investors changes yearly, since market forces can affect the dynamics that determine investment patterns. The ebb and flow of VC investor types can lead one to confuse lasting trends with short-term aberrations. Bearing this in mind, the following information summarizes VC investment trends by type of investor from 1996 to 2002. Section 7.3 presents a more detailed statistical review of investor-type trends by deal size, sector, stage of development, and region. Figure 45 and Table 17 show the following:

• LSVCCs have been, and remain, the main players in Canadian VC investment, with the largest annual average share of total disbursement, at 27 percent from 1996 to 2002. However, their relative importance has been declining, from 40 percent of total investment in 1996 to 25 percent in 2002. While they remained the most active investor class, LSVCCs have not driven the growth of VC investment in Canada since 1996. Their investments increased by 53 percent over this period (from $410 million to $627 million), compared to 139 percent for VC investment as a whole in Canada (for all investor types).
• Foreign investors have become major players in the Canadian VC industry since 1999, averaging an annual share of 16 percent of total VC investments from 1996 to 2002. In fact, in 2000, 2001 and 2002, foreign investors were the most important players in the market, averaging 25 percent, 29 percent and 26 percent of total investments in Canada in these years, respectively. Foreign investors' average share of total VC grew 788 percent, from 3 percent in 1996 to 26 percent in 2002. This was the result of the 2021-percent growth of foreign VC investment, from $31 million in 1996 to $650 million in 2002, with a peak at $1.5 billion in 2000. It remains to be seen whether this influx of foreign capital is a lasting trend or an anomaly caused by recent market turmoil. Nonetheless, the drastic increase in foreign investment accounts for most of the Canadian VC industry's recent growth and vitality.
• Private independent funds have fallen to third place among Canadian VC investors, with an average annual market share of 17 percent over the period. This share dropped by 34 percent, from 19 percent in 1996 to 13 percent in 2002. However, market share fell because of the dramatic growth of foreign investments, not because private independent investment fell. Private independent funds have demonstrated some dynamism, today investing 58 percent more than seven years ago ($198 million compared to $313 million), an increase comparable to that of LSVCCs (53 percent).
• Institutional investors (mostly large public sector pension funds) have declined by 52 percent, from 15 percent of total investments in 1996 to 7 percent in 2002 (averaging 14 percent over the period), while most other investor types have gained market share. This decline occurred despite a 15-percent growth in amounts invested, from $159 million in 1996 to $183 million in 2002, and an 11 percent increase in financings, from 70 to 148.
• Corporate investors have contributed a small portion of total investment since 1996. While their investments rose 34 percent over the period, from $108 million to $144 million, corporate investors captured an average annual share of 9 percent. This represented a 44-percent decline in market share, from 10 percent in 1996 to 6 percent in 2002.
• Government investments grew by 433 percent, from $62 million in 1996 to $329 million in 2002. This was the second-largest increase among investor types since 1996, after foreign investments, which increased by 2021 percent. Government investments' market share increased by 123 percent, from 6 percent in 1996 to 13 percent in 2002, with a 7-percent annual average over the period. While government funds still represented a small share of total VC investments in 2002, their sharp increase in investments (along with the increase in foreign investment) contributed to the VC activity growth of 139 percent since 1996.
• Other investors increased disbursements by 231 percent (from $66 million in 1996 to $219 million in 2002), and increased the number of companies financed by 196 percent (from 52 in 1996 to 154 in 2002). From 1996 to 2002, this class of investor provided 10 percent of total VC.

Figure 45: Total Amounts Invested by Investor Type, 1996–2002

Table 17: Distribution of Venture Capital Investments for Each Type of Investor (Average Percentage), 1996–2002

	LSVCCs	Foreign	Private Independent	Corporate	Government	Institutional	Others
Source: Macdonald & Associates Limited, 2003
Average Share of Total:
VC Investments	27	16	17	9	7	14	10
Distribution of VC Investments by Investor Type by:
Sector	100	100	100	100	100	100	100
Information Technology	40	75	58	47	46	50	17
Life Sciences	21	15	20	19	35	18	49
Other Technology	4	8	3	6	5	5	5
Traditional	35	3	20	28	14	27	29
Stage of Firm	100	100	100	100	100	100	100
Early-stage	37	43	47	37	51	33	42
Later-stage	63	57	53	63	49	67	58
Deal Size	100	100	100	100	100	100	100
< $500k	4	1	5	2	7	3	2
$500–999k	5	1	7	4	9	4	3
$1000–4999k	39	7	34	32	32	28	26
> $5000k	51	91	55	62	52	64	69
Region	100	100	100	100	100	100	100
Ontario	52	56	51	45	12	32	48
Quebec	33	18	20	21	68	57	21
British Columbia	8	24	14	22	11	6	16
Prairies	6	2	13	9	7	2	12
- Alta.	1	2	8	5	2	2	4
- Sask.	1	0	1	1	5	0	3
- Man.	4	0	4	3	0	0	5
Atlantic Canada	1	0	1	2	2	3	2

7.3 Detailed Venture Capital Investment Trends by Investor Type — 1996–2002

This section complements the overall investor-types trends described, and provides a more detailed review and analysis of VC investment trends for each type of investor between 1996 and 2002 and in the first nine months of 2003.

7.3.1 Labour-Sponsored Venture Capital Corporations

As mentioned previously, LSVCCs have shaped the Canadian VC industry since their inception in the mid-1980s, when they were introduced to fill a void left by the retrenchment of pension plans and other institutional investors as sources of VC financing.

• In 2002, LSVCCs represented estimated tax expenditures of more than $500 million (about $320 million for the federal government, and $200 for the provincial governments of Quebec and Ontario).
• As the Canadian VC market evolved, some LSVCCs, like the Solidarity Fund, maintained a strong social mandate, which has limited their returns. Other LSVCCs have adopted strategies similar to private independent funds, which emphasize the highest returns for their suppliers of capital. The great diversity of LSVCCs' operations, structures and mandates makes it difficult to compare their returns performance. LSVCCs have also faced private sector criticism in recent years, since there is a perception that these investors can get lower-cost capital and crowd out private VC investment. See Section 9 for more details on policy issues related to LSVCCs.
• Nevertheless, LSVCCs continue to play a significant role in the Canadian VC market. In 2002, there were 21 LSVCCs across Canada, managing $8.2 billion and 36 percent of Canadian VC, making them first among investor types. Their investments amounted to $627 million in 319 companies, or 25 percent of total VC investment in Canada in 2002.
• In 2002, the most active LSVCCs, in terms of number of companies financed in 2002, were FTQ, GrowthWorks, FondAction, VenGrowth Capital Partners, Covington Capital Corporation, Fonds régional de solidarité FTQ, Skylon Capital Corp., Crocus Investment Fund, Fullarton Capital Corporation, and Lawrence & Company.

1996–2002 overall venture capital investment trends and analysis: despite labour-sponsored venture capital corporations continued lead, their relative importance is declining

From 1996 to 2002, LSVCCs were the most active investors in the Canadian VC market, averaging 27 percent of total amounts invested over the period. However, LSVCCs' investments grew at a much slower rate than the growth of VC investments overall, 53 percent (from $410 million in 1996 to $627 million in 2002) versus 139 percent. Consequently, LSVCCs' market share has declined as other investor types increased investments. LSVCCs' average annual share of total VC investments declined by 36 percent, from 40 percent in 1996 to 25 percent in 2002 (with a low of 14 percent in 2000).

LSVCCs concluded the largest number of financings over the period. In 2002, LSVCCs invested in 382 deals, a 64-percent increase from 233 deals in 1996 (with a peak of 522 in 2000).

Figure 46: Amounts Invested and Number of Financings by Labour-Sponsored Venture Capital Corporations, 1996–2002

Investment focus

• Average deal size — LSVCCs increasingly prefer large deals (above $5 million), which accounted for an average of 51 percent of total investments between 1996 and 2002, compared to 9 percent for deals below $1 million. This divide was even more pronounced in 2002, when 60 percent were large deals and only 5 percent were deals under $1 million. Despite the 160-percent increase in the amount invested in large deals, the larger number of LSVCC transactions means that the average deal size of LSVCC investments fell 7 percent over the period, to reach $1.5 million in 2002, which was well below the $2.7-million average in Canada.
• Stage of firms — The data for 1996–2002 show that LSVCCs shifted focus from later-stage firms in 1996 (75 percent of total investment, or $308 million) to early-stage firms in 2002 (51 percent, or $320 million). This shift is consistent with the overall trends toward early-stage deals observed since 2002 in Canada. However, despite this increasing importance of early-stage deals, nearly two thirds of LSVCC deals from 1996 to 2002 were still later-stage financings.
• Sectoral focus — From 1996 to 2002, LSVCCs invested 35 percent of their capital in traditional sectors (compared to 24 percent for all the other investors) and 40 percent in information technology (compared to 53 percent in Canada). However, since 1996, LSVCCs' sectoral preferences (along with those of other investors), have shifted from the traditional sector to information technology. In 1996, traditional-sector firms attracted $165 million, or 40 percent of LSVCCs' total investments. By 2002, this trend had reversed. Information technology attracted 48 percent of total investment, and life sciences captured 27 percent. In fact, when compared to the VC industry's overall distribution of investments by sector in 2002 (65 percent for information technology, 19 percent for life sciences, and 11 percent for the traditional sector), LSVCCs have been relatively more active in life sciences and traditional sectors than have other VC investors (27 percent for life sciences and 19 percent for traditional sectors).
  
  In terms of focus, LSVCCs have invested more in traditional-sector firms than have other investors (averaging 35 percent of total investments). However, the information technology boom increased LSVCCs' investments in information technology and life sciences firms, despite their strong focus on traditional sectors. The investment focus of LSVCCs is similar to that of most other investors. Their investments are mostly concentrated in deals above $1 million, in later-stage firms, and in Ontario and Quebec.
• Regional focus — Some LSVCCs were designed with a social mandate, such as creating or maintaining jobs, and a requirement to register, raise capital, and invest in their home province, typically Quebec or Ontario. There are no LSVCC tax credits in Alberta, and only one LSVCC in Atlantic Canada (in New Brunswick). As such, from 1996 to 2002, Quebec and Ontario received more than 85 percent of LSVCC investment (52 percent and 33 percent, respectively). B.C. and the Prairies attracted a relatively stable share, with about 8 percent and 7 percent, respectively, between 1996 and 2002, while Atlantic Canada accounted for less than 1 percent. Six LSVCCs in other regions of Canada are eligible for the federal and provincial tax credits but do not have offices in Atlantic Canada.

Recent situation: labour-sponsored venture capital corporations re-emerged as the leader of venture capital investments in 2002 and 2003

Despite LSVCCs' declining market share from 1996 to 2002, the market contraction in 2002 and the first nine months of 2003 has allowed LSVCCs to re-emerge among front-running industry players, behind only foreign investors, who have had the lead since 2000. In 2002, LSVCCs approached foreign investors in terms of dollars invested, with $627 million, compared to $650 million for foreign investors; and in terms of market share, with 25 percent, compared to 26 percent for foreign investors.

LSVCCs' recovery continued in the first nine months of 2003, when they led VC activities, with 28 percent of aggregate investments (or $262 million), 42 percent of financings (or 217 financings) and 43 percent of companies funded (or 208 firms).

This trend may be linked to LSVCCs' statutory requirements, such as investment pacing rules, which keep the fund active even when other investor groups reduce activity or withdraw from the market altogether.^{Footnote 82} Furthermore, LSVCCs raise funds mostly from individual investors through RRSPs, which may also have contributed to the relative strength of their VC activities.

In that context, LSVCCs have performed a strong countercyclical role. While these funds in many respects mirrored industry trends in 2001 and 2002, their number of transactions and disbursement streams declined less than those of several other cyclically sensitive investor types. In other words, LSVCCs brought some stability to both the supply and activity sides of the Canadian VC industry, an influence that has been most significant in Quebec and Ontario.

Despite LSVCCs' important role in the Canadian VC industry, they are unlikely to rally the industry's growth. LSVCCs' growth has levelled: the amount invested increased by 53 percent (compared to an increase of 139 percent in Canada), and the share of total investment declined by 36 percent, between 1996 and 2002. Moreover, it is highly unlikely governments will offer more fiscal incentives, given growing criticism that LSVCCs crowd out private investment. See Section 9 and Part IV for details on policy issues and research related to LSVCCs.

Consequently, institutional investors and private independent funds must participate for the Canadian VC industry to keep growing. Increased institutional funding (particularly from pension funds) would benefit Canadian private independent funds and increase available capital in the Canadian VC industry. See Section 9 for more details on policy issues related to institutional investors and private independent funds.

7.3.2 Private Independent Funds

Private independent funds are generally structured as limited partnerships or other related vehicles. In Canada, the most active private independent funds, in terms of number of companies funded in 2002, were Ventures West Management Inc. (B.C.), GrowthWorks (B.C.), T2C2 Capital (Quebec), Lawrence & Company (Ontario), MM Venture Partners (Ontario), Primaxis Technology Ventures Inc. (Ontario), GTI Capital (Quebec), VenGrowth Capital Partners (Ontario), Venture Coaches (Quebec), and TechnoCap Inc. (Quebec).

Following are the ke y investment trends for private independent funds from 1996 to 2002 and the first nine months of 2003.

1996–2002 overall venture capital investment trends and analysis: declining share of total investment for private independent funds

From 1996 to 2002, private independent funds were the second-most important players in the VC industry, averaging 17 percent of total investments (compared to 27 percent for LSVCCs and 16 percent for foreign investors). However, despite the 58-percent growth of private independent funds' investments, from $198 million in 1996 to $313 million in 2002, their market share declined by 34 percent, from 19 percent in 1996 to 13 percent in 2002.

Private independent funds' declining share of the market may be attributed to the steep increases among other investor types, such as foreign investors and government-owned funds (see the following information), and also to the 14-percent decrease in the number of financings, from 235 in 1996 to 202 in 2002.

Figure 47: Amounts Invested and Number of Financings by Private Independent Funds, 1996–2002

Investment focus

• Average deal size — Between 1996 and 2002, private independent funds focussed on investments above $5 million, which captured 66 percent of total investment in 2002, up from 26 percent in 1996. Smaller deals (less than $1 million) captured an average of 5 percent in 2002, down from 22 percent in 1996. This trend pushed the average deal size from $843 000 in 1996 to $1.5 million in 2002 (but back to $1 million in the first nine months of 2003), for an average of $1.4 million over the period. While the increasing average deal size is a positive trend, this average remains significantly lower than the national average of $2.7 million.
• Stage of firms — Along with government funds, private independent funds have driven the trend toward early-stage firms in recent years. In 1996, private independent funds directed 33 percent (or $65 million) of their investments to early-stage firms, compared to 61 percent (or $201 million) in 2002. As a result, early-stage firms attracted an average of 47 percent of the total amount invested by these investors, placing them second behind government funds (51 percent). However, while the importance of later-stage investment has declined over the period (from 67 percent in 1996 to 39 percent in 2002), private independent funds directed 53 percent of their investments to later-stage investments over the 1996–2002 period.
• Sectoral focus — While private independent funds were equally focussed on traditional (39 percent) and information technology firms (38 percent) in 1996, their preferences have shifted toward information technology over the past few years. In 2002, 78 percent (or $242 million) of private independent funds' investments went to information technology firms (an average of 58 percent over the period), compared to only 6 percent for traditional firms. Along with foreign investors, private independent funds have been the leading investors in information technology in Canada. Private independent funds' investments in life sciences remained relatively stable over the period, averaging 20 percent of total investments, similar to the national average of 19 percent.
• Regional focus — As with other investor types, private independent funds have invested mostly in Ontario firms. From 1996 to 2002, Ontario averaged more than 50 percent of private independent fund investments, compared to 20 percent for Quebec, 14 percent for B.C., and 8 percent for Alberta. The average distribution of investments remained relatively stable over the period, despite an increasing concentration in Ontario and B.C. and a diminishing focus on Quebec. Generally, these proportions coincide with the regional proportions of total VC activity, total economic activity and KBIs, as shown in Section 6.

Recent situation: despite the continued decline of venture capital investments, private independent funds have been relatively active

Private independent funds' ability to raise and invest capital was constrained by the difficult market environment since 2001. In 2002, private independent funds invested $313 million in 202 financings, for 13 percent of VC investments (down from $602 million in 310 financings in 2001). In terms of fundraising, however, private independent funds remained active; of the $3.2 billion in new capital commitments to the Canadian VC industry in 2002, 35 percent (or $1.2 billion) was raised by private independent funds. If Canadian private independent funds are able to sustain fundraising levels, they should achieve significant levels of VC activity.

In the first nine months of 2003, private independent funds invested $124 million (or 13 percent of total) in 112 companies, confirming the persistence of difficult investment conditions. Nonetheless, some major private institutional funds were able to raise capital and close their funds, which should soon result in new investments.

7.3.3 Institutional Investors

Institutional investors consist of private and public pension funds, insurance companies, and mutual funds or endowments managed by large institutions. In 2002, the most active institutional investors in Canada were CDP Capital, CDP Capital — Technology Ventures, CDP Capital — Communications, CDP Capital — Americas, Teachers' Merchant Bank, OMERS, Manulife Capital, the British Columbia Investment Management Corporation, the New Brunswick Investment Management Corporation, and the Columbia Basin Trust Venture Capital Corp.

Following is a detailed review of institutional investors' investment trends from 1996 to 2002 and in the first nine months of 2003.

1996–2002 overall venture capital investment trends and analysis — declining importance of institutional investors in terms of investments, but increase in number of financings

Through the late 1980s and the first half of the 1990s, pension funds avoided VC investments. Beginning in 1999, large, public sector pension plans began to include indirect and direct VC investments in Canadian SMEs as part of their overall investment activities. However, with the market decline since 2001, institutional investors have shifted from direct to indirect participation, which may explain their declining market share.

• From 1996 to 2002, institutional investors increased their indirect participation in the Canadian VC market. They led the supply of new capital in 2002, with 45 percent of capital raised (or $510 million), up from 5 percent (or $78 million) in 1996.
• Institutional investors have played a relatively small and declining direct role in the Canadian VC industry. Their investment levels grew by 15 percent, from $159 million in 1996 to $183 million in 2002 (peaking at $1.5 billion in 2000). This growth resulted in a 52-percent decline of their average share of total investments, from 15 percent in 1996 to 7 percent in 2002. Despite this decline, institutional investors still increased their number of deals by 111 percent, from 70 in 1996 to 148 in 2002 (peaking at 311 deals in 2000).

Figure 48: Amounts Invested and Number of Financings by Institutional Funds, 1996–2002

Investment focus

• Average deal size — Institutional investors directed 64 percent of their investments to deals above $5 million from 1996 to 2002 (compared to 91 percent for foreign investors). Deals between $1 million and $5 million attracted an average of 28 percent of their VC investments over the same period. Deals under $1 million averaged 7 percent of their VC investments over the period. Despite this trend toward larger deals, the significant increase in the number of deals (111 percent over the period) resulted in a 46-percent decline in the average deal size, from $2.3 million in 1996 to $2 million in 2002 (with an average of $2 million for the period). This was lower than the national average deal size of $2.7 million.
• Stage of firms — Contrary to the overall industry trend toward early-stage firms, institutional investors directed 67 percent of their investments to later-stage firms over the period (from 77 percent in 1996 to 74 percent in 2002), and 33 percent to early-stage financing. This is a significant difference from other investor types, who have focussed increasingly on early-stage financings.
• Sectoral focus — Institutional investors followed the overall VC industry trend towards information technology firms, which rose from making up 23 percent of their investments in 1996 to 77 percent in 2000. However, since the technology bust in 2001, institutional investors have adopted a more balanced approach, directing 45 percent of their investment to information technology firms in 2002, 29 percent to life sciences, and 24 percent to traditional sectors. While institutional investors' preference for traditional investments has declined significantly over the past seven years — from 38 percent of investments in 1996 to 22 percent in 2002 — they were more active in life sciences (29 percent) and traditional sectors (24 percent) than other investor types were in 2002.
• Regional focus — Institutional investors are, along with government funds, concentrated in Quebec, where they put, on average, 57 percent of their investment from1996 to 2002 (behind the 68 percent by government funds). Since 2001, however, this focus has been declining. In 2002, institutional investors directed less than half of their investment to Quebec (compared to 58 percent in 2001). This strong concentration in Quebec can be attributed to the presence of the CDP, which, through its subsidiaries (e.g. CDP Capital, CDP Capital — Technology Ventures, CDP Capital — Communications, and CDP Capital — Americas), plays a major role in Quebec's economy; these were the top five institutional investors in 2002. Ontario captured an average share of 32 percent of institutional investments, moving from 24 percent in 1996 to 67 percent in 2000 and back to 22 percent in 2002. This can probably be attributed to the relatively high level of activity by OMERS. These investors have been very active in Atlantic Canada, particularly in New Brunswick, through the New Brunswick Investment Management Corporation. In 2002, New Brunswick captured 6 percent of total institutional investments. In the Prairies only Alberta attracted institutional investments, attracting 2 percent of it from1996 to 2002, and 10 percent in 2002.

Recent situation: cautious institutional investors

Since 2001, institutional investors have adopted a more cautious and balanced approach. They reduced their investments from $289 million in 2001 to $183 million in 2002. However, they became the main supplier of new capital to private funds, providing $510 million (or 45 percent of new capital raised) in 2002. In the first nine months of 2003, institutional investors remained cautious, investing $96 million (or 11 percent of the total) in 88 companies.

As mentioned previously, the low participation of institutional investors as suppliers of VC raises significant concerns from the Canadian VC industry and other industry players and government. This is particularly so given the potential contribution that they could make to the Canadian VC industry, in light of the remarkable contribution they have made to the U.S. VC industry.

Recent federal budgets measures, new Canadian-grown funds of funds (e.g. TD Capital, EdgeStone Capital Partners and the BDC Fund of Funds) and the recently published performance benchmarks should encourage institutional investors' long-term participation in the VC industry. See Section 9 and Part IV for more details on policy issues and research projects related to institutional investors.

7.3.4 Corporate Funds

Corporate VC funds are mostly subsidiaries of industrial or financial companies. In Canada, the most active corporations, in terms of the number of companies financed in 2002, were Desjardins Venture Capital, RoyNat Capital, Royal Bank Capital Partners, TD Capital, BMO Capital Corporation, Hydro-Québec CapiTech, Trudell Medical, CIBC Capital Partners, BCE Capital, and TELUS Ventures Fund. Since these are mostly financial corporations based in and around Toronto, most corporate VC investment went to Ontario firms.

Following are more details on corporate investors' trends between 1996 and 2002 and in the first nine months of 2003.

1996–2002 overall venture capital investment trends and analysis — declining market share for corporate funds

From 1996 to 2002, corporate funds played a minor role in the Canadian VC market. Corporate investments grew by a modest 34 percent, from $108 million in 1996 to $144 million in 2002 (with a peak at $502 million in 2000). The number of financings increase d by 158 percent, from 50 deals in 1996 to 129 deals in 2002.

This increase in the number of deals compared to the amount invested has resulted in a decline of corporate funds' relative share of total VC investment, from 10 percent of total investments in 1996 to 6 percent in 2002, for an average share of 9 percent over the period.

Figure 49: Amounts Invested and Number of Financings by Corporations, 1996–2002

Investment focus

• Average deal size — From 1996 to 2002, corporate VC investors invested 32 percent of their capital in deals worth between $1 million and $5 million, and invested 63 percent in deals worth more than $5 million. This trend toward very large deals was even more pronounced in 1996 and 2001, when mid-sized deals attracted 24 percent and 22 percent and large deals attracted 73 percent and 72 percent. Smaller investments have represented a very small proportion of corporate investment since 1996, suggesting that corporate funds may not be a significant source of funding for small firms or for firms seeking small amounts of capital.
• Stage of firms — As was the case for most investor types, early-stage financings increased by 266 percent from 1996 to 2002 (compared to 2 percent for later-stage investments). As a result, early-stage firms' share of total corporate investments grew from 20 percent in 1996 to 60 percent in 2001 and 46 percent in 2002, for an average of 37 percent over the period. Nonetheless, corporations remained focussed on later-stage investments, which accounted for an average of 63 percent of total corporate investments over the period. Along with LSVCCs, corporate funds devote the highest proportion of their investments to later-stage firms.
• Sectoral focus — As with most investor types, corporate VC funds have shifted investment from the traditional sectors to information technology. Corporate VC investors increased investments in information technology by 124 percent, from $42 million in 1996 to $94 million in 2002 (compared to a decline of 5 percent for traditional sectors). As a result, information technology firms' share of corporate investment increased from 39 percent in 1996 to 65 percent in 2002, an average of 47 percent over the period. Despite this trend, traditional-sector investments (28 percent of total) outpaced investments in life sciences (19 percent of total), at exactly the national average.
• Regional focus — From 1996 to 2002, corporate investments were mostly concentrated in Ontario (45 percent of total), B.C. (22 percent of total) and Quebec (21 percent of total). Corporate investors were more interested in B.C.-based firms than were any other investor types (11 percent of total). However, this trend has softened in recent years. In 2002, Ontario (51 percent) and Quebec (31 percent) were the main recipients of corporate funds, while B.C. attracted 7 percent. Across Canada, the distribution of corporate investments is consistent with the overall distribution of VC by all investors. The Prairies attracted 9 percent of total corporate investments, and Atlantic Canada received 3 percent.

Recent situation: corporate investors remain cautious

In 2002, corporate investors followed other investor types and adopted a cautious approach, investing only $144 million (compared to $279 million in 2001 and $502 million in 2000). In the first nine months of 2003, however, corporate investments approached the total amounts invested in 2002 ($102 million versus $144 million), which suggests that corporate investments have remained stable compared to those of other investors.

7.3.5 Government-Owned Funds

Governments create funds to fill or reduce a gap in the market. In 2002, the main government-owned funds, in terms of number of firms funded, were the BDC, Innovatech Montréal, Innovatech Québec et Chaudiere-Appalaches, Innovatech sud du Québec, Investissement Québec, Société générale de financement (SGF), the Crown Investments Corporation of Saskatchewan, Crown Capital Partners Inc., InNOVAcorp, and the Société de diversification économique de l'outaouais.

Following are more details about government-owned funds' investment trends and preferences from 1996 to 2002 and for the first nine months of 2003.

1996–2002 overall venture capital investment trends and analysis: despite a small share of total investments, government funds were, along with foreign investors, the main driver of venture capital activity growth in Canada

Government-owned funds, along with foreign investors, have been key drivers of the growth of VC activity since 1996. Investment by such funds increased 433 percent, jumping from $62 million in 1996 to $329 million in 2002. The number of financings grew by 121 percent, from 98 in 1996 to 217 in 2002. As a result of this growth in capital and deals, the average annual share of total VC investment (7 percent from 1996 to 2002) grew by 123 percent, from 6 percent in 1996 to 13 percent in 2002.

Figure 50: Amounts Invested and Number of Financings by Government-Owned Funds, 1996–2002

Investment focus

• Average deal size — Despite the predominance of deals worth more than $5 million, government funds balance investments between mid-sized and large deals. From 1996 to 2002, the average distribution of government funds by deal size was 46 percent for deals above $5 million; 26 percent for deals between $1 and 5 million; 5 percent for deals between $500 000 and $1 million; and 4 percent for deals under $500 000. The overall focus on deals above $5 million was not as pronounced as was the case for other investors. With a large proportion of investments made in deals above $5 million, the average deal size increased by 141 percent, from $630 000 in 1996 to $1.5 million in 2002, averaging $1 million over the period.
• Stage of firms — Government funds' investments have been relatively well distributed between early-stage and later-stage investments. From 1996 to 2002, the average share of total investments was 51 percent for early-stage firms and 49 percent for later-stage firms — the highest average proportion attributed to early-stage financings among all investor types.
• Sectoral focus — Compared to the other investors, government funds have focussed on life sciences investments. From 1996 to 2002, 35 percent of government funds' investments went to life sciences firms. However, this trend has reversed over the past two years, with the number falling from 41 percent of total (or $25 million) in 1996 to 28 percent of total (or $92 million) in 2002. This strong focus on life sciences is likely linked to the high concentration of government investments in Quebec, which is home to a significant number of biopharmaceutical companies (see further in this section). Information technology firms accounted for an average of 46 percent of total government VC over the period, a larger proportion than life sciences firms attracted but still below information technology firms' importance to other investor types.
• Regional focus — Government-owned funds have been concentrated in Quebec, where you would find, on average, 68 percent of them between 1996 and 2002. Ontario attracted 12 percent of them over the period. This concentration in Quebec is related to the number of significant government funds in Quebec, whereas the role of provincial government-owned funds varies greatly in the other provinces. For example, in the 1960s, 1970s and 1980s, several of these government funds — such as SGF, the Innovatech Montréal, Innovatech Québec et Chaudière-Appalaches, and Investissement Québec — were created in Quebec to spur private sector economic development in that province. The presence of these funds, which were all among the most active funds in Canada in 2002, partly explains this strong focus of government funds' investments in Quebec.^{Footnote 83}

Recent development: government-owned funds are the only investor type that did not experience a decline of investments after 2001

In 2002, government-owned funds were the only investor type to maintain investment levels, totalling $329 million in 217 financings (compared to $323 million in 247 financings in 2001).

This stability likely explains government funds' market share rise to 13 percent in 2002 (up from 8 percent in 2001), which was higher than the 7-percent average from 1996 to 2002. As well, government funds' specific mandates (such as to support early-stage financings or regional investments) may also explain the relative stability of their investments during periods of difficult market conditions. See Part III for more details and analysis of government programs and funds.

In the first nine months of 2003, government-owned funds accounted for 14 percent of total VC investment, with $129 million in 136 companies, and 27 percent of the total number of financings (141 deals). We need more data and analysis before we can tell whether these trends will continue.

7.3.6 Foreign Investors

Foreign investors are non-resident private VC funds or corporations that invest in Canada. Most foreign investors (close to 95 percent) in Canada in recent years were from the U.S. — more specifically, from Massachusetts and California.

In 2002, the most active foreign investors included VIMAC, Kodiak Venture Partners, Morgenthaler Ventures, Technology Crossover Ventures, Flagship Ventures, Pilgrim Baxter; Norwest Venture Partners, Prism Venture Partners, Menlo Ventures, and Kinetic Capital Partners.

Following is an overview of foreign investment trends in Canada from 1996 to 2002 and for the first nine months of 2003. Before 1999, foreign investors were virtually absent from the Canadian VC market, and, as a result, some of the trends presented for the past seven years are somewhat diluted by the 1996-1998 period.

1996–2002 overall venture capital investment trends and analysis: foreign investors emerged as the main venture capital investors in Canada since 1999

The most notable recent development in the Canadian VC market has been the increasingly significant role played by foreign, mostly U.S., investors. Indeed, the data show that foreign investment has driven Canadian VC activity growth. The amount invested from 1996 to 2002 increased from $31 million to $650 million, for a growth of 2021 percent.

This trend gathered strength in 1999, when foreign venture capitalists invested more than 10 times the amount deployed in 1998 ($497 million, up from $41 million), and in 2000, when foreign investments reached a peak of $1.4 billion. Since 2000, foreign investors have remained the most important players in the Canadian VC market. Their average share of total VC investment grew by 788 percent, from 3 percent in 1996 to 29 percent in 2001 to 26 percent in 2002 (for a total average of 16 percent from 1996 to 2002).

This surge of investment may be linked to several factors, including, among others, the increasing use of co-investment or syndication of deals by Canadian and U.S. firms; the increasing success of Canadian information technology firms, particularly in Ottawa; the increasing awareness of Canadian opportunities; and the relative saturation of the U.S. market since 2000.

Figure 51: Amounts Invested and Number of Financings by Foreign Investors, 1996–2002

Investment focus

• Average deal size — Foreign investors targeted very large transactions. More than 99 percent of their investments in 2002 were channelled into deals worth more than $5 million, as were 91 percent of their investments from 1996 to 2002. Foreign investors have pushed the increase in the average deal size in Canada from 1996 to 2002. Indeed, the average deal size of foreign investments increased by 430 percent, from $1.6 million in 1996 to $8.6 million in 2002 (with a peak at $14.7 million in 2000), for an average of $6.8 million from 1996 to 2002. Deals under $1 million attracted less than 2 percent of foreign investments from 1996 to 2002.
• Stage-of-firms focus — While the average deal size indicates an interest in later-stage firms, the data show that foreign investors (like other investor types) are investing more in early-stage firms in recent years. Since 1999, early-stage financings have attracted an increasing share of foreign investments, from 31 percent in 1996 to 43 percent in 2000 to 52 percent in 2001 and 70 percent in 2001. Nonetheless, in 2002, and from 1996 to 2002, later- stage financings attracted an average of 67 percent and 57 percent of total foreign investment, respectively.
• Sectoral focus — Foreign investors have been mainly interested in information technology firms, which have received 75 percent of foreign investment over the past seven years. This trend was more apparent in 2000, when these firms attracted 93 percent of total foreign investment. Foreign investors' concentration on information technology meant that they virtually ignored other sectors. Life sciences attracted an average of 15 percent of total foreign investment from 1996 to 2002 (6 percent in 2002), and other technologies attracted an average of 18 percent over the period (4 percent in 2002). Foreign investors tended not to target traditional sectors, investing just $15 million in 2002, for a 2-percent share. This strong focus on information technology explains the regional distribution of foreign investments.
• Regional focus — Foreign investors invested an average of 56 percent of their investments in Ontario — from only 44 percent in 1996 to 80 percent in 2002. Unlike most investor types, foreign investors also targeted B.C.-based firms, who attracted an average of 24 percent of foreign investment from 1996 to 2002. Recently, however, foreign investors have shifted focus to Ontario-based firms, resulting in a declining share for B.C. firms, from 33 percent in 1996 to only 11 percent in 2002. While Quebec-based firms captured an average of 29 percent of total investment in 2002, they only attracted 7 percent of foreign investments. Several potential factors account for this trend, including foreign investors' focus on information technology rather than life sciences; the lack of foreign investors' awareness of opportunities in Quebec or other provinces; the strong presence of government-owned funds in Quebec; its distance relative to Ontario; and the language barrier. Some of these factors may also explain why foreign investments were almost absent from Alberta (average of 2 percent), and completely absent from Atlantic Canada, Saskatchewan and Manitoba.

Recent situation: the importance of foreign investors may be temporary

In 2002, foreign VC investments peaked at 26 percent of total VC activity in Canada, with $640 million invested. Foreign investors also concluded the largest deals in 2002, averaging $9 million. Despite the decline in market share from 29 percent in 2001, foreign investors continued to account for a substantial portion of total VC investments in 2002.

However, foreign investors almost vanished from the Canadian VC market in the first six months of 2003, although they have re-emerged in the third quarter. In the first nine months of 2003, foreign investors disbursed $124 million to 31 companies (representing 13 percent of total investment and 6 percent of financings).

While foreign investors have played a vital role in the growth and stability of the Canadian VC market, their participation is relatively recent. We do not know if their shift to the Canadian VC market is permanent or whether it is the result of special circumstances that developed in the U.S. before the collapse of the technology sector. It could be argued that this situation was simply the result of a capital overflow from the U.S. VC market due to market saturation in the late 1990s and U.S. VC firms' attempts to extend and diversify their portfolios.

Nevertheless, we should examine the uncertainty of foreign investment and its importance to the Canadian industry, particularly in terms of its role in providing expansion-stage investment and in terms of its impact on Canadian businesses. Foreign investment increases the supply of capital to Canadian firms; builds strategic networks and partnerships with more experienced venture capitalists; increases specialization of Canadian VC funds; and increases competition for SMEs seeking funding. However, foreign investment may also tempt (or force) Canadian firms to move all or part of their operations abroad.

To better understand foreign VC investment in Canada, PricewaterhouseCoopers reviewed foreign VC investment in Canada to profile foreign investors who have invested in Canada and Canadian companies funded by foreign investors. Next, it will assess foreign investors' impacts on Canadian firms — specifically, on firms' R&D spending, sales, location and job creation. This study should provide a more complete picture of foreign VC investment in Canada, and should inform policies that will support a viable and independent VC industry.

7.4 Comparison: Canada–United States

As discussed previously, international comparisons are somewhat problematic, especially when applied to types of VC investors in different countries, as VC investment vehicles vary from country to country. This diversity of fund structures is generally linked to two factors:

• National taxation and regulatory regimes and policies differ internationally, reflecting different mandate and public policy objectives. For example, in Canada, government's involvement in the VC industry over the past 10 years was aimed at an infant industry, while the more mature U.S. industry may not have needed the same kind of support.
• The availability of investor-ready firms needing VC investment differs in various countries with cultural and economic factors, including education systems, R&D conditions, and tax and regulatory frameworks conducive to creativity, innovation, risk taking and entrepreneurship.

Furthermore, different countries adopt their own national standards of methodology and categorization, which further complicates cross-border comparisons. One of the key differences between the Canadian and U.S. markets is that, compared to the U.S., the Canadian VC industry reports both fundraising and investment activities by investor types, while in the U.S. only fundraising (or commitment) activities are reported. VC investments made by type of investor are not reported. Therefore, it is extremely difficult to compare international investment trends by investor type, unless you compare fundraising trends and sources of capital.

Government direct and indirect involvement: Canada versus the United States

In general, while government participation in the VC market is more limited in the U.S. than it is in Canada, the Canadian government is less involved than often believed. As mentioned in Part III, there is an important distinction between direct and indirect involvement.

Canadian government-owned funds' VC direct investments accounted for an average of 7 percent of total VC investment in Canada between 1996 and 2002, compared to 8 percent in the United States. The Small Business Investment Companies (SBIC) program is the principal U.S. government body involved in the VC market and can be compared to several Canadian government-owned funds.^{Footnote 84} These SBICs range from small, local firms to large, publicly traded companies, and can be owned by other financial institutions, such as banks.

However, the major difference between the two governments' involvement in the VC market is their indirect participation. As explained previously, Canada's VC industry has a unique structure, with the LSVCCs being the most significant VC fundraisers and investors from 1996 to 2002. LSVCCs accounted for an average of 46 percent of total new funds raised between 1996 and 2002 (and 54 percent in 2002), and an average of 27 percent of total VC investments over the period (and 25 percent in 2002).

As explained in subsection 7.3.1 on LSVCCs, while LSVCCs play a significant role in the structure and development of the Canadian VC industry, they are unlikely to drive that industry's growth, as their importance has been declining over the past seven years (from 40 percent of total in 1996 to 25 percent in 2002). Consequently, as discussed under the next heading, institutional investors must participate in providing capital to private independent funds.

To improve our understanding of the importance and future role of LSVCCs in the Canadian VC market, Industry Canada is extensively reviewing their structure, operation, and investment trends and performance.

Institutional investors participation: Canada versus the United States

Another major difference is the relatively low participation of Canadian institutional investors in the Canada VC market. By constrast, U.S. institutional investors, particularly pension funds, have been the key drivers of U.S. VC industry growth since 1996. In the U.S., pension funds tend to finance private independent VC firms by investing in funds of funds rather than by investing directly in companies. Through this mechanism, they provided about half (46 percent) of all new capital invested in the VC industry from 1996 to 2002. Moreover, in 2002, institutional investors provided more than 80 percent of the new commitments to the U.S. VC industry. Among these institutional investors, pension funds (42 percent) and endowments and foundations (22 percent) accounted for the largest shares.

While Canadian pension funds have been steadily increasing their funding to Canadian private independent VC funds over the past few years, particularly in 2002, these types of investors in Canada have a long way to go before they can achieve comparable levels of institutional support. From 1996 to 2002, Canadian pension funds provided an average of 18 percent of the total new capital raised (and 16 percent in 2002), compared to 46 percent (42 percent in 2002) in the U.S. In contrast to historic trends, institutional investors accounted for 45  percent of new capital raised in 2002 by private independent funds.

The historic shortfall in Canadian pension funds' funding of private independent VC firms has been partly offset by increasing levels of direct VC investment by large Canadian public sector pension funds. Indeed, institutional investments represented an average of 14 percent of total VC investments in Canada from 1996 to 2002 (and 11 percent, or $96 million, in 2002).

As presented in Section 9 and in Part IV, the lower participation of institutional investors in the Canadian VC market, and the way in which pension funds participate in the Canadian VC market, will keep affecting the growth of the Canadian VC industry, particularly the growth and size of private independent VC funds and of the average deal size of Canadian VC deals. Both are significantly lower than in the U.S. market. The strong participation of U.S. institutional investors has resulted in U.S. private independent funds being relatively better funded and larger than their Canadian counterparts. In fact, U.S. private independent funds accounted for an average of 81 percent of capital under management in the U.S. from 1996 to 2002, compared to only 24 percent for Canadian private independent funds.

To better understand the investment practices of both Canadian and U.S. institutional investors and current barriers to Canadian institutional investments in private equity, Macdonald & Associates Limited is surveying Canadian and U.S. institutional investors, at the request of Industry Canada and several provinces. The final report will, among institutional investors, raise awareness of barriers and opportunities in the Canadian VC market.

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^{Footnote 78} This grouping of investors is used by Macdonald & Associates Limited in their annual review of the Canadian VC industry.

^{Footnote 79} In the U.S., institutional investors have been, primarily, indirectly involved as suppliers of funds.

^{Footnote 80} VC funds raise new capital from domestic investors (e.g. individuals, corporations, pension funds, endowment, governments, insurance companies, mutual funds) and foreign investors.

^{Footnote 81} VC funds can be LSVCCs or corporate, foreign investors, government, institutional, or private independent funds. They disburse their funds in Canadian and foreign high-growth-potential businesses, based on predetermined investment criteria.

^{Footnote 82} However, investment pacing rules also require that LSVCCs keep large amounts of capital available, and this capital is not necessarily available for immediate investment in new ventures.

^{Footnote 83} The new provincial Liberal government (2003) is reviewing all of its investment funds and programs, and may shift to a more private sector approach.

^{Footnote 84} The SBIC program was created in 1958 to fill the gap between the availability of VC and the needs of small business in start-up and growth stages. SBICs are privately owned and managed investment firms that use their own capital, as well as funds borrowed at favorable rates with the Small Business Administration (SBA) guarantee, to make VC investments (often including a debt component) in small businesses. SBICs are licensed and regulated by the SBA. They are profit-motivated businesses that provide equity capital, long-term loans, debt-equity investment and management assistance to qualifying small businesses.

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