Canada catapulted itself into the mega-buyout boom last year, when three different bidding groups – comprised of some of the industry's most influential Canadian pensions and mostly US mega-buyout firms – battled it out in an auction for telecom giant BCE. While the $52 billion buyout is the largest LBO proposed to date and illustrates the unique power Canadian pensions wield as direct investors, it fails to represent the majority of the marketplace.
“The Canadian private equity market is largely mid-market with the significant majority of transactions occurring in the few hundred million dollars range, or between $50 million and $500 million in terms of enterprise value,” says Rick Nathan, president of Canada's Venture Capital & Private Equity Association and managing director at fund of funds Kensington Capital Partners.
Its youth and small number of players in comparison to the US' private equity market also makes it less competitive, with auctions a rarity.
“There's a few exceptions, but really, the majority of the buyout groups in Canada started in the early-to-mid-90s and so today they are on Fund III or Fund IV and there's just far fewer of them,” says Nathan. “It's been growing quickly, but there just aren't as many players. And this is already discounting for the relative size of the economy” to that of the US.
IT'S A SMALL WORLD
A recent trip to Toronto by this reporter found an incredibly tightknit private equity community in which, generally speaking, everyone knows everyone.
“I could get my Blackberry out and we could call all the GPs in Canada, there's not that many of us,” quipped one Canadian GP.
Beth Laschinger, a vice president with Key Principal Partners, a Cleveland, Ohio-based private equity firm that has been investing in Canada for eight years, agrees.
“You don't see necessarily the full-blown auction with 100 books sent around and the rigid process that we've gotten used to in the US,” she says. Instead, deal flow is more likely to come from a network-based referral process. “It is really important I think to try and tap into the deal community versus just showing up to see your specific portfolio company and heading back home.”
The modest size of the private equity market means carefully preserving relationships is key.
We've cleared the path for international investors
“In Canada, relationships and service and who you know and how you hire people, those things are in some ways more important than financial engineering,” says Brent Belzberg, senior managing partner and founder of Torquest Partners, a six-year old mid-market firm currently investing its second fund.
Constant contact with the same people means the hardball tactics that are sometimes seen in US deals simply don't fly.
“There are only five or six Canadian banks you can deal with, so if you don't have a good relationship with one of them you take away 20 percent or 15 percent of your market, so you're very protective of those relationships,” Belzberg says. He adds the same is true for management groups, agents and others.
Elmer Kim, a managing director at Whitecastle Private Equity Partners, a smaller mid-market player that is an affiliate of the Diamond family's investment arm, also notes the need to generate goodwill over the life of one's fund or career.
A deal in Canada, he says, “is not just a deal – it's a continuation of our fund and our businesses”. A smaller market means it's more difficult for people to start over with a tarnished reputation, he adds.
The Canadian market may also seem less aggressive than the US, Kim says, “partly because I think we're not as transaction-driven, we're not as leverage-driven, it's a smaller debt market”.
Canada has never really seen the assertive marketing of speciality products like second lien and high yield debt, he says.
“So when you don't get the same level of leverage I don't think we're running to hit the homerun every time at the plate, we're more singles and doubles kind of guys,” he says.
In keeping with the sports analogy, however, Kim notes that Whitecastle and most Canadian firms “punch above their weight class”, because they are nearly all generalists who put greater emphasis on operational versus financial restructuring.
Humberto Aquino co-founded fund of funds Kensington in Toronto.
“I was running away from a revolution in Central America and wanted to dedicate myself to merchant banking,” he recalls. After a stint with McKinsey, Aquino tried raising a fund but had difficulty doing so without a track record. He founded Kensington in 1996, but once it was awarded a significant mandate from a high-profile Canadian pension fund in 2002, attracting limited partners became a bit easier.
The firm's active investing model – which leads to lots of board participation and opportunities for coinvestments – means it regularly interacts with the funds in which it invests.
“We would not be able to have this approach if we were a large fund of funds in the US, investing only in mega-funds,” Aquino says.
The relationship-heavy, every-one-knows-everyone phenomenon can also equate to less risk, says Belzberg.
“Because it's a relatively small community, you tend to know the good guys from the bad guys and the good companies from the bad companies,” he says.
The limited number of private equity managers also means Canadian firms are able to choose top talent, says Kim. “We get to choose the best and the brightest.”
While pleased with present opportunities, Kim notes that Canada's private equity market is a good 10 to 15 years behind the US in terms of growth, and that foreign and domestic buyout groups would benefit from an increasingly dynamic, competitive landscape.
Canada's Government is trying to promote this by addressing two tax filing requirements for non-residents which had inadvertently affected private equity.
The need to obtain a Section 116 tax clearance certificate when selling an asset could take months, and “many non-Canadian investors have seen that as a serious impediment because it means they have to wait for their proceeds and if you're dealing with public market securities sometimes value changes, obviously”, Nathan says.
A similar condition to be changed required non-residents to file paperwork noting that they had sold an investment and need not pay any tax.
“In theory that sounds like no big deal, but in practice it was sometimes a huge deal where you had, for example, funds of funds that had to get tax returns filed on behalf of all of their partners,” Nathan says.
Limited liability companies are also set to be recognised by Canada once the updated Canada-US tax treaty is ratified by both countries, slated to take effect in January 2009.
The LLC problem has been a nuisance, notes Laschinger. “You had to be really careful about how you structured a private equity investment if you didn't want to have a double tax issue.”
None of these things were “deal breakers”, evidenced by a steady flow of non-Canadian dollars into Canada's buyout industry – but they were all speed bumps, Nathan says.
“We've cleared the path for international investors,” he concludes.