By KRYSTLE CHOW
Published in the Ottawa Business Journal newspaper and website.
July 25, 2011 (July 26 on OBJ.ca)

Click here to view this article on OBJ.ca.

VC portfolio featuring local assets attracts bids from Covington, GrowthWorks
As venture capital firm VenGrowth prepares to be acquired, the fate of several Ottawa firms in its portfolio hangs in the balance.

While VenGrowth is headquartered in Toronto, Silicon Valley North has factored heavily into the labour-sponsored fund’s past and present investments – former investees include Meriton Networks and Galazar Networks, and BelAir Networks, Espial and BTI Systems are among its current holdings.

As well, Bridgewater Systems and SiGe Semiconductor are two of its locally headquartered portfolio assets in the midst of an exit.

VenGrowth’s investments through its five funds, which have a combined value of more than $200 million, have attracted both a friendly shares-for-shares offer from Covington Capital, and a hostile bid from GrowthWorks.

It’s indicative of a consolidating venture capital industry facing dwindling liquidity and little means to raise funds, following the Ontario government’s phase-out of tax credits for individuals wishing to invest in labour-sponsored funds like VenGrowth and its two suitors.

Meanwhile, the funds’ shareholders are due to redeem their stakes, adding even more pressure on the VCs’ liquidity.

Temporary measures have been taken to satisfy investors, says David Ferguson, one of VenGrowth’s co-founders and managing general partners. Shareholder redemptions have been capped in three of its five funds to prevent a run on VenGrowth’s cash so as “to make sure we’re not fire-selling investments,” he explains, and the firm is also paying out dividends to shareholders as it sells off investee companies.

But the goal has always been to find a more permanent solution to the liquidity challenge, Mr. Ferguson says. That’s why VenGrowth is seeking to merge its five funds with Covington’s New Generation Biotech Equity Fund, with the combined assets to become part of Covington Fund II. This will then have roughly $365 million in total holdings, through more than 50 portfolio companies.

“The merger will allow the combined entity to have a stronger support position to continue to feed (portfolio companies) through the years,” notes Covington’s Scott Clark, adding his fund’s structure is very liquid.

That means a greater likelihood of follow-on funding for existing investee firms with promise in Ottawa and beyond, without constantly worrying about shareholder redemptions.

And because the merger will produce a larger entity with more diversified assets, it will also likely produce a smoother pattern of investee sales in cyclical markets.

“This quarter we might have a tech exit, the next a life sciences exit, so we’ll have more predictability about the business and be able to honour redemption requests with more certainty,” explains VenGrowth’s Mr. Ferguson.

GROWTHWORKS GRUMBLES

But all is not smooth sailing for the marriage, on which shareholders will vote in late August; GrowthWorks, another VC with a prominent local presence, is also vying for VenGrowth.

Among CEO David Levi’s arguments is that his company’s track record of investing in the Ottawa tech scene makes GrowthWorks a natural fit for VenGrowth.

GrowthWorks – which hopes to merge its target’s holdings into its own Canadian fund – shares investments in BTI with VenGrowth, and was also previously involved in SiGe. In fact, Mr. Levi points out that there’s an overall overlap of almost 20 per cent between VenGrowth’s and GrowthWorks’s portfolios.

“Bringing those ownership stakes into one set of hands will benefit shareholders and the company; it will be a stronger set of hands rather than two smaller pieces of ownership,” says Mr. Levi.

He questions, on the other hand, Covington’s familiarity with the region and therefore the latter’s commitment to local firms. “If we lose (the VenGrowth deal), there will be new managers with far less exposure and experience who will be looking to sell the companies,” Mr. Levi says.

Unlike Covington and other retail VCs, he adds, GrowthWorks continues to raise funds, and has been able to pay out 25-per-cent dividends through its Commercialization Fund in other provinces.

GrowthWorks has garnered much shareholder interest in its cause, with more than 11,000 support agreements signed in favour of a GrowthWorks victory.

However, Covington argues it’s worked with Ottawa firms such as Embotics, Protus IP and Epocal, with Mr. Clark emphasizing continued support for local companies.

“Clearly, Ottawa is important for any VC; we’re not going to force a sale at an inopportune time … the benefit of the merger is putting things back on the right plane so we can continue to work with the companies and give them the resources to help them grow,” says Mr. Clark. “We’ve got to make sure we’re giving them runway, and you can only do that if you have liquidity.”

VenGrowth’s Mr. Ferguson notes Covington has $95 million in cash and no debt, while GrowthWorks has shareholders with $122-million-worth of mature investments that they could redeem at any time, as well as debt that carries a 33-per-cent interest rate.

“GrowthWorks does not have the luxury to be making new deals,” says Mr. Ferguson.

THE LOCAL PERSPECTIVE

Ultimately, it’s unlikely there will be fresh investments for new startups in Ottawa or anywhere else in Ontario, regardless of who wins the fight for VenGrowth.

“This is about consolidating (funds) into a larger pool of companies and capital so that unitholders have the opportunity to get cash out for redemptions … and (the funds will have) greater flexibility to continue to invest in the most promising companies. It will not solve the problems with the dearth in capital,” says OCRI chief executive Claude Haw, a veteran of the VC industry.

Mr. Haw says he doesn’t see either GrowthWorks or Covington as being significantly better for the Ottawa area, pointing out that VenGrowth made many of its early local investments from Toronto before opening its local office in 2001.

Meanwhile, the consolidation will take out a weaker player in the industry, which could eventually improve the financing environment, says Rich Deboer, whose company Galazar Networks – a VenGrowth investment – was sold to Exar Corp. in 2009.

“The VenGrowth model wasn’t a good one … it wasn’t supportive of companies in Ottawa,” Mr. Deboer says. Because the VC operated according to a ratio of cash to investments, rather than by a maximum

investment amount that companies would know going into a deal, financings would change from quarter to quarter depending on how cash-loaded VenGrowth was.

As such, he found that the VC was practically “pushing money out the door” in Galazar’s series-B round, but then was completely the opposite during its series-C as capital dried up.

Still, at the end of the day, it’s not an “earth-shattering” bit of news, as local firms soldier on in the face of continually shrinking financing, adds Mr. Deboer. “I think Ottawa is still in a difficult position, and this is not going to solve it. It’s good, positive, but not material.”