Private Equity Rising in Canada

Glimmers of hope have begun to shine a light on Canada’s diverse private-equity market as it steadily gains strength

When
Lexpert last did a major piece on private equity in February 2013, we called it “Trouble in Paradise.” Sandra Rubin’s article pointed out that while PE deal flow was “nowhere close to what it used to be” before the financial crisis, there were “glimmers of hope.”

Hope’s most common characteristic, of course, is that it abounds. Sometimes it crystallizes, but more often it doesn’t. In this particular case, however, the glimmers have at least begun to bring a little light to the situation. Indeed, as Allen & Overy LLP’s M&A Index, Q4 2014 puts it: “Optimism becomes reality.”

That’s not to say that we’re back in the heady days. What we can say, however, is that the Canadian PE market has been gaining strength steadily in the last few years.

“Private equity was very active in Canada in 2014,” says John Leopold of Stikeman Elliott LLP in Montréal. “And that was true of all segments of the market, something that is reflective of how diverse the Canadian private-equity universe has become.”

As of September 30, 2014, investors disclosed some $26.4 billion in PE transactions, more than double the $10.2 billion total for 2013. Deal volume also grew, with the 289 deals recorded representing a growth of more than 40 per cent year-to-year.

And while the diminished economic outlook of the past few months has evoked consternation, some of its elements, like the recent drop in the price of oil and the fall of the Canadian dollar, may actually help sustain or even boost the PE market in 2015.

“Last year was a very good year for private equity in Canada and North America,” says Michael Akkawi of Torys LLP in Toronto. “The deal volume was high, especially in the mid-market [$100 million to $500 million], and I don’t see it changing this year.”

In order to truly understand the Canadian PE market, it is useful to begin the examination from a global perspective.

“As in the public M&A sphere, private transactions are growing strongly again,” Allen & Overy concludes in its M&A Index. “There has also been a growth in high-value deals, marking a shift towards more strategic transactions and with fewer divisional assets for sale in 2014. It seems that, in many sectors, work by companies to streamline their activities – a major preoccupation in the years immediately after the crisis – has largely been completed.”

The US and European market are growing fastest, leading the charge. From an industry perspective, life sciences and TMC (technology, media and communications) are the “powerhouses of deal growth,” while mining and financial services are in the “doldrums.”

But here’s what’s telling about the Canadian PE market: Canada ranks only behind the US and the UK in A&O’s list of “Top 20 global outbound acquirers and inbound target markets” for 2014. The country ranks fourth overall in deal volume (123), just behind China (142) and ahead of Germany (112), France (112), Japan (77), Hong Kong (75) and Singapore (66). Breaking out the numbers, we stand third in deal volume for outbound acquisitions (71) and fifth in volume for inbound acquisitions (52). Indeed, Canada’s numbers (71 outbound; 52 inbound) compare very favourably on a proportionate basis with the US statistics (316 outbound, 234 inbound). A Thomson Reuters study (Thomson Reuters publishes Lexpert) found that, measured proportionately, private-equity and buyout fund investment in Canadian companies in 2014 more than doubled the take for American companies.

A&O also ranks the top 10 overseas target markets for the 10 leading global acquirers in the US$100 million+ range. Canada also stands out here, placing second as a target for US acquirers in deal volume (28) and deal value (US$26.2 billion).

For its part, the UK appears to have minimal interest in investing in Canada, and despite the hullabaloo over resource acquisitions, Canada does not rank among China’s top 10 targets, putting the country behind places such as Australia, the Netherlands and even New Zealand. Otherwise, Swiss and Hong Kong investors have some interest in Canada, unlike their Japanese, German and Singaporean counterparts.

Conversely, 39 outbound Canadian deals valued at $78.3 billion found their way to the US. The crown jewel of Canadian acquisitions in the US was BC Partners’ US$8.3 billion acquisition of PetSmart Inc., the largest leveraged deal for an American company in 2014. The Isle of Man was second, getting some eight deals worth about US$9.8 billion at 8 per cent. The United Kingdom, Switzerland, France and Australia followed.

To be sure, A&O’s acquirer rankings include public as well as private M&A. But the statistics also demonstrate that private transactions rose from about 30 per cent to some 40 per cent of the market by deal volume between 2009 and 2014.

A&O’s numbers, then, corroborate the growth of PE in Canada, confirming that the country is an attractive target for PE investment from abroad, and finally, that Canadian PE is very active abroad.

Speaking of the Canadian PE market in the singular, however, is tantamount to an oxymoron.

“Private equity in Canada is very sophisticated, well developed, competitive and clearly delineated because we know who the players are,” Akkawi says. “But the fact is that we have knowledgeable private-equity funds in every geographic part of Canada, in most industries, and in all segments of the market by deal size.”

Increasingly, private investors spread their funds among a spectrum of transactions that vary in size.

“Many large private companies have snack brackets in the mid-range market,” says Derek Flaman, Michael Akkawi’s partner in Calgary. “Some would be looking at nothing less than $250 million, some might go as low as $100 million, and some prefer the $750 million range.”

Geographically, there are strong and varied PE markets in Toronto, Montréal, Calgary, Vancouver and the Maritimes. As of 2014 Q3, Québec led with the most deal activity, followed by Ontario and Alberta.

But the one challenge all these markets face is competition.

“A lot of the weaker players left the market after 2007, but that still left – to name just a few – domestic and foreign private-equity firms, pension funds and strategic buyers vying for the assets,” Akkawi says. “The key question for investors, then, is how to manage that kind of competition.”

With, as the industry calls it, a lot of “dry powder” (uninvested capital) around and with debt being fairly accessible (though perhaps becoming less accessible given the current state of the Canadian economy), the missing ingredient is high-quality assets. “The demand in Canada is definitely higher than the supply,” Akkawi says.

But investors and sellers have learned from the financial crisis experience. Many sellers are demanding high prices even as buyers are wary of paying too much. “Gone are the days when private equity just bid up prices to acquire an asset,” says Frank Arnone of Blake, Cassels & Graydon LLP in Toronto. “What they’re looking for now is value.”

Nowadays, that can be a chore.

“The strategics are buying and that tends to drive up valuation,” says Shahir Guindi of Osler, Hoskin & Harcourt LLP in Montréal.

But there are ways of dealing with these obstacles. “One way is to find new markets and new industries,” Akkawi says.

With an eye on the energy market, Kohlberg Kravis Roberts & Co. L.P. did just that when it opened a Calgary office in March 2014. By the end of the year, KKR, represented by Flaman, had announced a $500-million investment that gave it a 50 per cent equity position in a new entity, the Veresen Midstream Limited Partnership, that upon closing will own the North American energy infrastructure assets of Calgary-based Veresen Inc.

The Veresen deal, like others, suggests that the current havoc in the energy market hasn’t proven much of a deterrent, at least not to US investors. In January, two prominent US private-equity firms focused on energy, Riverstone Holdings LLC and NGP Energy Capital Management, committed $465 million to CanEra Resources Inc. III, a private Calgary-based oil and gas exploration and production company.

Other major US PE concerns, like The Blackstone Group LP, are reported to have raised US$4.5 billion for a new energy fund, and Warburg Pincus LLC is looking to the oil patch as well. What’s attracting the Americans, among other things, is the abundance of experienced management teams in the industry.

“Private-equity companies tended to stay away from commodity price risks, but that’s not necessarily the case anymore,” Arnone says.

Among other things, the Canadian currency’s devaluation of late could be an additional attraction for American funds.

“The relative pricing for US funds is cheaper than it otherwise might be because these funds have raised capital in US dollars and will be doing business in Canadian dollars,” says Michael Akkawi’s Toronto partner, David Seville.

Jeffrey Read, a partner at Borden Ladner Gervais LLP in Vancouver, also sees continuing demand for service companies in the extractive industries. Other investors see opportunities in the crunch that low prices are putting on certain aspects of the energy market.

“So long as oil prices remain low, Canadian companies will need support,” says Michael Caruso of Norton Rose Fulbright Canada LLP from his office in Toronto. “And private equity is a good place to find that support because investors are sitting on a lot of dry powder.”

In January, New York-based Riverstone Holdings, which specializes in the energy and power sectors, launched Riverstone Credit Opportunities, LP, which plans to invest US$375 million in energy by way of “capital relief” opportunities. Apollo Global Management, also based in New York, is reportedly setting up a new fund to buy the debt of oil and gas companies under financial pressure.

“What I’m seeing and hearing when I talk to private-equity clients is that they tend to have longer timelines of about three to seven years for liquidity events,” Flaman says. “So if they start when the cycle is at the bottom, the ultimate return will be better.”

Flaman says he’s expecting more private-equity capital infusions from both the US and Canada to support transactions along the lines of the Veresen deal. “Money should be coming out of Houston and also Toronto,” he says. “We could see Goldman Sachs, the Canada Pension Plan and OMERS, among others.”

Although Canadian pension funds have been somewhat preoccupied with foreign investments for the last few years, that may be about to change.

“As the big Canadian pension funds approach the domestic/foreign investments balance they desire, we will actually see them put more money put into Canadian investments,” Caruso says.

It’s not as if Canadian investors are in short supply in the private equity market: CVCA statistics show that Canadian funds account for 75 per cent of domestic private equity activity in 2014. In fact, the invasion of US private-equity firms is a relatively recent phenomenon.

“Historically it was all Canadian firms, but about five years ago two changes to the Income Tax Act made it much more viable for non-Canadian private-equity firms to invest in Canada,” says BLG’s Read.

The first change was the elimination of the section 116 clearance certificate for tax-exempt gains by non-residents on Canadian property, Jeffrey Read says. “That was problematic because it took so long, especially because the private-equity firms had to account for up to 50 limited partners on any given transaction.”

The second boost to investment was the elimination of withholding tax on interest payments between Canada and the US, including interest on non-arm’s length loans.

With the opening so widened, US firms poured in, altering the PE market dynamics.

“The US has about eight times the concentration of private-equity players in Canada, and they generally have a much better understanding of specific niches than is the case with Canadian firms,” Read points out. “We’ve had steady growth for five years, and during that time US private equity has approached us with a very eclectic business mix, including deals in the food industry, healthcare, pharmaceuticals and manufacturing.”

PE investors are also starting to look at more regulated industries, such as those with a Canadian ownership content quotient, as well as the professions, like law, where the potential emergence of alternative business structures may allow non-professionals into the sector.

“You’ve got to be more creative in the Canadian market, but smart private-equity players are finding ways to make deals,” Akkawi says.

They’re also finding ways to compete against strategic buyers, often by buying an industry platform that allows them to compete with strategic players for other, smaller assets in that sector.

ONCAP, a Torys client and the brainchild of Gerry Schwartz’s Onex Corporation, is a case in point. Established in 1999 with $400 million of capital, ONCAP invested in six platform operating companies and completed 15 add-on acquisitions. ONCAP II materialized in 2006 with $574 million of capital and continued the pattern of targeting small and medium-sized North American businesses, investing in eight platforms that bred 88 add-on acquisitions. ONCAP III, born in 2011, went on the same path with substantial minority or control equity investments in the $50 to $100 million range. In the three years since, the fund has invested in five platforms and nine add-ons.

“This kind of strategy allows private-equity investors to benefit from the synergies just like the strategic buyers do, and that allows them to compete on a more level playing field,” Akkawi says.

ONCAP’s acquisition of Mister Car Wash in 2007 is an excellent example of the “platform” approach. “Over the next seven years, ONCAP and management completed 38 add-on acquisitions, which represented more than 90 car washes and 20 lube centres,” Akkawi says. The company was successfully sold to Leonard Green & Partners in August 2014.

“Funds using the platform approach effectively amount to a strategic buyer with private-equity backing,” Arnone says.

Indeed, there’s no shortage of money looking for mid-market and smaller investments, whether by way of the platform strategy or otherwise. Toronto-based Birch Hill Equity Partners, with $2 billion in capital under management, has made 33 fully realized investments since 1994, also working with companies valued in the small to mid-market $30-million to $600-million range. Birch Hill closed its latest private-equity fund in 2011, capping the fund at $1.04 billion, considerably exceeding its original target of $850 million.

Vancouver-based Tricor Pacific Founders Capital Inc., which focuses on food and other consumer packaged goods, has a similar platform strategy. The company will invest $5 million to $25 million in initial platforms, then look to “add-ons of any size.” Halifax-based SeaFort Capital looks to “old economy” businesses, including manufacturing and distribution companies with earnings between $2 million and $10 million. Montréal’s Novacap Industries manages $1.5 billion and currently has more than 60 platform investments.

For its part, Toronto boasts, among others, Ironbridge Equity Partners, which makes investments of $5 million to $30 million in Canada’s lower mid-market and Imperial Capital Group Ltd., which focuses on opportunities in healthcare, business services and consumer products in the Canadian and American mid-market with a particular eye on companies having sales revenue between $20 million and $250 million.

Otherwise, Toronto-based Argosy Partners, a unique PE firm, buys shares from selling shareholders in medium-sized, owner-operated businesses through its well-established “The Shotgun Fund” and “The Succession Fund.”

“We’re focusing on situations where it’s not the company, but a shareholder who needs the money to buy out a departing individual,” says Larry Klar, an Argosy partner and Managing Partner of The Succession Fund. “Generally speaking, our clients are privately owned businesses who need to address the conflicts between those who want liquidity and those who want to stay.”

What often goes unnoticed is that the small market is still the largest by deal volume in Canadian PE.

“Some 75 per cent of private-equity deals have an enterprise value of $24 million or less,” says David Brown of Stikeman Elliott LLP in Vancouver.

Perhaps seeing something that their Canadian counterparts have long realized, even large US PE firms have emerged as significant players not only in the Canadian mid-market but also in the small market, in both cases partly because the pricing there is more attractive and less competitive than on larger transactions.

“One of my US clients has done six add-on deals in Canada, three of which were less than $20 million each,” Leopold says.

One potential hotbed for private equity may be in the Maritimes, where Victor Chu, a major international investor from China who is Chairman and CEO of First Eastern Investment Group, announced in late January that he was creating a $50-million PE firm focused on Nova Scotia companies with expansion potential into the Asian market.

New Brunswick, where tech giants like IBM, Salesforce.com and LiveOps have in the last few years bought out companies that started with seed capital from local investors, also has considerable potential for PE investment largely due to the vibrancy of its venture capital market and strong government support.

“We’ve gained an enormous amount of momentum in the last five years,” says Arthur Doyle in Cox & Palmer’s Saint John office. The province has one of the most competitive small business investor tax credits anywhere and recently expanded the credits for qualifying corporations and trusts. “Our investor tax creditor system is unique to New Brunswick,” Doyle says.

The New Brunswick Investment Management Corporation, a pension fund that is the largest institutional investor in Atlantic Canada with $10.1 billion in assets, has been the major driver of the province’s successful venture capital program, including a record 17 transactions in 2014. But the Fund also offers an Atlantic Opportunities Private Equity Fund that seeks investments in the $2 million to $5 million range throughout the Maritimes.

“There’s lots of capital here,” Arthur Doyle says. “What we need is more people with more ideas.”

Still, the past is hardly the definitive indicator of the future. So there are no guarantees that 2015, with its shaky economic beginnings, will continue the trend of steady growth in the Canadian private equity market.

But there appears to be no shortage of optimists around.

As Norton Rose’s Caruso says, “If we get caught in a downdraft, I think it will be a short cycle.”