Institutional investors take aim at structural barriers to help companies scale

Up to $4 billion in “patient capital” needed

Several of the country’s largest institutional investors are finalizing an action plan that, if adopted, could halve the $4 billion capital gap that exists today for Canada’s rapidly expanding pipeline of early- and growth-stage companies.

A series of recommendations are expected to be released later this month in a report by the Advancing Innovation Roundtable, a group led by senior executives from pension plans, banks, endowments, venture capital firms and private equity funds. The 12-member roundtable is examining corporate structural barriers as well as government regulations that make it difficult for young tech companies to access growth capital.

The goal is to see private investors stepping up with the first wave of new capital by the end of the year.

“The focus is singularly around the scale up, post start-up phase ... and answering the access to capital question,” says Salil Munjal, roundtable chair and General Partner with Vancouver-based venture capital firm Yaletown Partners. “We felt that both the emerging growth company (less than five years old) as well as the slightly later growth company (older than five years) really demanded attention in terms of the ecosystem.”

Launched last September, the roundtable is sponsored by TMX Group Inc, which owns and operates the Toronto Stock Exchange (TSX), TSX Venture Exchange (TSXV) and TSX Alpha Exchange. Since then, the independent working group has met with investors, financial leaders and industry stakeholders in Toronto, Montreal and Vancouver to identify barriers that hinder growth beyond the seed and start-up stages.

The roundtable is setting its sights on the mushrooming number of homegrown companies in the technology, clean tech, life sciences and advanced manufacturing sectors. Many are graduates of the growing number of incubators and accelerators that help entrepreneurs validate their technology, build markets and attract experienced management—all of which lowers the risk for investors.

“The fact that these companies have initial customers and initial revenue provides comfort to investors that there’s a product there and they’re injecting the real commercialization capital to drive it forward,” says Munjal.

Despite this momentum, too few growth-stage companies scale into large, internationally competitive companies. In comparison, US tech companies are raising about 40% more capital than their Canadian counterparts.

“From the TMX standpoint, they were seeing fewer and fewer mature-stage companies that would end up being listed on the bigger exchange and raising bigger amounts of capital,” says Munjal. “As we have both sources of capital available in Canada, how do we utilize both? Are there regulations or business process that need to change?”

The roundtable’s work aims to complement the current Industry, Science and Economic Development Canada (ISED)-led Innovation Agenda consultation — which has identified scaling up as one of three innovation priorities for Canada (along with emerging technology and talent). It will also feed into recommendations from Finance Minister Bill Morneau’s Advisory Council on Economic Growth, led by Dominic Barton, global managing director at McKinsey & Company.

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Narrowing the funding gap

Munjal estimates Canada’s funding gap at about $1 billion for companies that are three to five years old, and $2-$3 billion for tech companies older than five years. If the roundtable’s recommendations are adopted, he said “it could make a big dent” in that $4 billion gap, “likely in the $1-2 billion zone”.

“The financial pillars in Canada, the pension plans, banks and insurers—the so-called patient money—are the ones that are not investing in the scale-up phase to the extent that those of us who are active investors think they should be,” says Munjal. “Part of the job of this roundtable is to understand those constraints so we can compose some recommendations.”

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“The private sector needs to figure out and understand the attractiveness of this sector … and that through the injection of early growth capital at the appropriate time you can realize some excellent returns that would fit into any large investor’s diversified portfolio, pension plan, bank or insurance company.”

For example, Yaletown Partners was the first and largest investor in Burnaby BC-based Bit Stew Systems, a leader in the development of software and analytics for the Industrial Internet of Things. That gamble produced a seven-fold return in less than three years following the company’s recent sale to GE Digital, one of the biggest tech buys in Western Canada in a decade. The investor syndicate included Cisco Systems, GE Ventures, BDC Capital and Kensington Capital.

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At the same time, Munjal says regulatory relief may be needed to incent institutions to invest in smaller companies. “This has nothing to do with government capital but everything to do with the nuances of banking regulations and pension plans and how they’re regulated and how investment capital is treated on their books.”

Overcoming structural barriers

The biggest solutions, say Munjal, must come from investors themselves, often working in partnership with the industries they represent. For example, most banks, pension funds and insurers are structured around investing large amounts in more mature companies. “How does a massive pool of capital such as a pension plan invest a relatively small amount of money into the innovation sector? That’s the nut of the challenge.”

Several models are being examined, including a private-sector led innovation-focused investment fund to complement the government’s Venture Capital Action Program. A spring 2016 report by Canada’s Auditor General highlighted the government’s “difficulty in convincing private-sector investors to participate in the Action Plan”, partly as result of high management fees. Despite the program’s early challenges, the roundtable will recommend that VCAP be renewed.

Another route is for investors to create their own funds which finance companies directly. This approach has been adopted by some pension plans, such as OMERS Ventures, but Munjal cautions that it “requires a much bigger commitment in terms of resources and allocations”.

The roundtable will also look at options for institutions “to invest directly and collaboratively, where you can share the risk and the rewards, and in the process hopefully bring some of the DNA of investing in this asset class back into their organizations for the longer term. That’s an example of something we will be spending some time on in the report.”

“At the end of the day our aim is … to create enough options for the different investment mandates and styles.”

Improving access to public markets

In addition to tackling structural constraints that impede the flow of private equity, the roundtable is looking at ways to better utilize two main sources of public equity — the TSXV and the TSX.

Since 2015, the tech and innovation sector on TSX and TSXV ranked #1 in the number of IPOs and new listings, with over 50 going public during that time. Valuations for tech companies are also on the rise. In the first three quarters of 2016, Canada’s main tech index outperformed other indices (e.g. TSX Composite and S&P 500) over the past one, three, five and 10-year periods.

In 2016, to the end of November, 34 tech companies went public on the TSXV raising about $86 million. More than $15 billion in equity capital has been raised by tech and innovation companies listed on TSX and TSXV since the start of 2015.

“One of the reasons it’s done so well has been the focus of new capital in the sector. Another cause has been very high quality companies. And a third cause has been, frankly, a scarcity of companies until recently,” says Michael Kousaie, head of Business Development at TSX.

The roundtable’s data will show that Canada is creating 1.1 times as many companies as the US (on a GDP-adjusted basis). Government innovation policy and the success of incubators and accelerators are credited with much of this growth, particularly between 2010 and 2015.

“It’s pretty startling in terms of the dynamic nature of what’s happening at the earlier stages of company creation. It’s right up there with Israel and the United States,” says Munjal. “We have created this top end of the funnel and it’s as full as it’s ever been.”

This trend hasn’t gone unnoticed among more conservative investors. Kousaie notes that in some cases, investment banks have begun talking to clients and prospective clients about eliminating their discounted-cash-flow valuation — a formula used to predict a company’s future performance that often disadvantages early stage and growth companies.

"Canadian investment banks are now telling their clients that the valuation discount for Canadian tech companies has now been eliminated ... in fact, some Canadian tech companies are now trading at a premium to their US peers," says Kousaie.

Flow-through shares and SR&ED

Over the past year, TMX has lobbied senior executives at Finance Canada, as well as ISED DM John Knubley, for policy changes that could improve the investment climate for growth companies.

Topping its wish list is a flow-through share program for firms developing innovative technologies with long development cycles. A similar program was introduced more than 60 years ago for Canadian resources firms, and several groups, including the Canadian Chamber of Commerce, have called for it to be extended to research-intensive companies.

The TMX also takes aim at the Scientific Research and Experimental Development (SR&ED) tax credit, arguing it penalizes companies that go public. Under the rules, once a company launches an IPO on a public venture capital market the investment tax credit drops from 35% to 15% and becomes non-refundable. As a result, TMX says young companies are forced to turn to venture capital or private equity, which dilutes their equity and increases the likelihood of them being sold to a foreign firm.

“We believe more entrepreneurs would consider taking their idea or business to new heights if launching an IPO did not negatively impact their SR&ED status,” TMX writes in its pre-Budget submission.

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