PE in Canada: the state of the industry

May 2017  |  FEATURE|  PRIVATE EQUITY

Financier Worldwide Magazine

“The world right now is awash with private equity (PE) money,” said Cameron Belsher, leader of the mergers and acquisitions group at McCarthy Tétrault LLP, just a few short months ago – an assessment that certainly reflects recent activity in Canada’s PE industry.

Over the past 12 to 18 months, the country’s provinces and territories have been hotspots for PE activity, with an impressive catalogue of capital investments, exits and fundraising suggesting a market that will continue to strengthen throughout the course of 2017.

In ‘Private Equity Highlights 2016’, the Canadian Venture Capital & Private Equity Association (CVCA) notes that: (i) Q4 2016 saw $4.1bn in 137 deals, a 36 percent increase on the $3bn seen in Q3; (ii) total PE investment in 2016 amounted to $13.7bn (536 deals), a 40 percent fall from $22.9bn in 2015 (424 deals); (iii) there were 32 $50m-plus deals totalling $11bn in 2016, with the $1.6bn acquisition of Toronto-based Trader Corporation the top transaction; and (iv) $4.7bn was invested in Toronto-based companies (56 deals), followed by $3.2bn in Calgary (38 deals) and $1.3bn in Montreal (104 deals). In addition, the most active PE investors in Canada in 2016 were Hellman & Friedman LLC, PennantPark Investment Corporation and Thomas H. Lee Partners LP, which each invested in three deals.

In terms of sectors that have seen particularly high levels of activity, the CVCA reveals a 200 percent uptick in cleantech investment in 2016, with almost $2bn invested in 25 deals. This includes five $50m-plus deals, the largest being the $800m acquisition of the Montérégie-based Services Matrec Inc. Also featured heavily is Information & Communications Technology (ICT), with companies receiving $2.5bn (65 deals), up 352 percent from the $556m received in 2015 (59 deals). Turning to exits, mergers & acquisitions (M&A) continues to be the vehicle of choice for PE firms, with 49 exits totalling $6.5bn, down 44 percent from the $11.5bn seen in 2015. “The foray of PE investors into non-traditional sectors such as cleantech and ICT has been an interesting development,” says Darrell Pinto, a research director at the CVCA. “This is a trend that will continue in 2017 and beyond.”

Complementing the CVCA data is a report by Torys LLP – ‘Taking the Long View: Canadian Private Equity in 2017’ – which examines the nature of activity in the PE space over the past year and a half. Among the findings collated by Torys (based on data provided by S&P Capital IQ) are that investment by non-domestic financial buyers in the Canadian market rose sharply in 2016, accounting for 41 percent of overall domestic PE activity; many PE investors are exercising pricing discipline at the bidding stage to ensure that they are not overspending in hyper-competitive auction processes; and family offices and sovereign wealth funds have emerged as serious contenders in Canadian PE, a new class of financial investor which Torys believes will assume more prominence in the months and years to come.

However, puncturing this litany of positivity is the 40 percent contraction in total PE investment activity last year – a decline which is largely being attributed to continued volatility in the energy sector. Exemplifying this volatility is the revelation that, in 2016, oil & gas companies received $4.4bn (32 percent) of the funds invested, down 49 percent from 2015, which, although representing a slowdown, still meant that the oil & gas industry alone captured almost one-third of all Canadian PE investments by the end of Q3 2016.

Though the data detailed above does indeed show that Canadian PE deal volume and aggregate deal values were lower in 2016 than in previous years, this should not, according to Torys, be interpreted as an overall weakening of the country’s PE industry. On the contrary, institutional investor allocations to the PE industry are “continuing to grow” and “absolute dollars dedicated to the asset class are increasing”. Furthermore, financial investors are adjusting to the current deal and pricing environment and a new class of financial investor is beginning to emerge.

Clearly, as we proceed further into 2017, Canadian PE is nimbly adapting to current challenges.

Overcoming challenges

In the context of a potent but nevertheless contracting PE landscape (at least as far as 2016 is concerned), practitioners in the Canadian PE space are well-aware of the challenges they face, the uncertain environment in which they exist and the potential options for redress.

“Against the backdrop of a very strong fourth quarter, overall Canadian PE buyout and investment activity decreased last year, while aggregate value also declined,” says Jamie Koumanakos, a partner at Blake, Cassels & Graydon LLP. “Despite it being a relatively positive environment for sponsor exits due to high valuations in some sectors, funds remain wary of overpaying for portfolio companies in broad auction processes, and continue to face strong competition from strategic buyers.

“However, with availability of debt capital remaining high and on relatively favourable terms from US and Canadian sources, as well as relatively low commodity prices given the recent sector downturn, increased acquisition and investment opportunities have emerged for PE in Canada. In the cross-border transaction context, seamless coordination among relevant jurisdictions – often in conjunction with US or international legal counsel to the sponsor – and early identification of threshold Canadian transaction issues are increasingly important to ensure successful buyout execution and effective implementation of post-transaction business synergies.”

For Mr Pinto, a particular challenge for PE activity in Canada is that of rising valuations (a significant issue since 2014) and the adverse effect this is having on deals, most prominently with mid-market transactions. “Canadian PE has traditionally been most active in mid-market deals,” notes Mr Pinto. “$1.5bn was invested in 43 deals in the $20m to $50m deal size range in 2016, a 41 percent increase on the $1bn invested in 34 deals in 2015. With PE dry powder at record levels, competition among investors remains the biggest challenge. Rising valuations have had a dampening effect on dealmaking in this space over the past few years, but there are positive signs that this is changing.”

Trends and developments

As far as fundraising is concerned, the forecast for the rest of 2017 and beyond is positive. “Following a moderate 2015 with a reported $11bn of new fund commitments, Canadian fundraising levels increased significantly last year, with a reported total of $45bn raised across a number of investment strategies,” says Mr Koumanakos. “As with other jurisdictions, the market and terms for investments in funds with established sponsors and strong track records is competitive and increasingly sponsor-driven, while newer funds have, in some cases, continued to make more investor accommodations on fees and other key terms to reach a first close.”

On the buyout side, an ongoing trend in Canadian PE is the proliferation of cross-border activities. For example, a significant number of buyouts in Canada continue to be cross-border, with either inbound investment or acquisitions by US and international sponsors or outbound activity by Canadian pension plans and sponsors. Indeed, in 2016, 71 percent of cross-border activity involved PE investments. Furthermore, the mid-market is continuing to dominate PE activity in Canada, with oil & gas successful in holding its position as the ‘hottest’ sector. “Perceiving an opportunity to invest at, in some cases, significantly reduced valuations, sponsors have increasingly looked to Canada’s energy sector for acquisitions or investments, including in related service sectors,” explains Mr Koumanakos. “In addition, manufacturing, IT and natural resources continue to be of substantial interest to both international and domestic sponsors.”

Regulatory issues

With the regulation of financial markets more stringent than ever before, jurisdictions across the globe are seeing a raft of new rules and regulations, and the Canadian PE environment is no exception. Getting to grips with Canadian regulatory considerations such as the Investment Canada Act and Competition Act is no easy matter, especially for international investors engaged in complex cross-border buyout transactions.

“Typical key issues include navigating applicable Canadian securities requirements for public company acquisitions and the analysis of potential Canadian regulatory considerations, as well as cross-border acquisition tax structuring issues,” says Mr Koumanakos. “In the fundraising context, sponsors must address Canadian securities law requirements in respect of the offering and sale of securities in Canada. Canadian securities laws regulate entities that are engaged, or hold themselves out to be, in the business of trading securities or advising others regarding the purchase or sale of securities and those who direct an investment fund’s business.”

Moreover, Canadian securities regulators have suggested that, in many cases, PE and venture capital funds will not be required to register pursuant to the more onerous investment fund manager, dealer or adviser registration requirements.

Consensus: favourable options

Despite the drop in mega-deals over the past 12 to 18 months which led to a decrease in PE investment levels, the outlook for the Canadian PE industry is favourable, according to the McCarthy Tétrault LLP report ‘On Target: 2017 Private Equity Outlook’. “In 2017, we expect increased deal activity by domestic and international debt funds in Canada, including PE funds with both equity and debt capabilities”, states the report. “We expect there to be a particular focus on senior, mezzanine and distressed deals. The competition among such funds is intensifying, which could result in interest rate compression, increased leverage and more options for sponsors and borrowers”.

Mr Koumanakos believes that a sustained focus on the middle market, particularly in the oil and gas, energy, manufacturing and IT sectors, means sponsors will continue to view Canada as a favourable and economically stable jurisdiction for buyouts and investments. “In addition, we expect Canada’s pension plans to continue their active investment and acquisition strategy across a broad array of sectors in Canada and globally, including in infrastructure, energy and infrastructure assets,” he adds.

Momentum and acceleration

Presently there are a number of scenarios which could have a major impact on PE activity in Canada in the months and years ahead, such as how the US administration handles relationships with its allies abroad and the impact this could potentially have on cross-border PE deals.

For example, the current tax position allows Canadian Public Pensions to invest in US companies with no capital gains tax liabilities on either side of the border – cross-border activity which could be significantly affected if the US seeks to renegotiate trade deals with its North American partners.

Despite this, the overall consensus among PE practitioners appears to be that the industry has every reason to expect an increase in momentum and an acceleration of Canada’s innovation and growth ecosystem.

© Financier Worldwide

BY

Fraser Tennant