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Cablegate: The Canadian Financial Services Sector:

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.

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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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