Click here for printer friendly page

Canadian private equity market growing, but unlikely to reach U.S. levels

The Canadian private equity market is growing with investment now emerging from pension funds and insurance companies. Scot Blythe from advisor.ca considers the opportunities available in Canada and the extent to which the market will need to develop if it is to catch up with the US.

When Canadian investors think of private equity, they usually think of venture capital invested in start-up companies, and in particular, of labour-sponsored investment funds. While labour-sponsored funds are the vehicle best known to retail investors, they accounted for only 12 per cent of the market in 2000.

However, start-up financing does comprise much of the private equity placements in Canada — some 45 per cent of the $6.3bn invested in 2000, according to Canadian Venture Capital Association research compiled by Macdonald & Associates. Those placements involved 2,566 investments, averaging $4.4m.

Much of that capital is supplied by pension funds, insurance companies and private equity funds, some run by the domestic banks, some by independent merchant bankers — though as the U.S. venture market turned down in the aftermath of the dot-com bust, foreign investors increased their share from 20 per cent to almost one-third of the private placements through the first half of 2001.

Some of those investors are comparatively faceless, with little public presence. Others, especially the large public-sector pension plans, are not. Indeed, the profile of the whole universe of private equity investments will likely grow as Canadian public-sector pension plans seek to diversify their assets beyond stocks and bonds.

In recent weeks, for example, the Canada Pension Plan Investment Board, which is diversifying out of a bond-only portfolio, has teamed up with the $36.5bn Ontario Municipal Employees Retirement System (OMERS) in a private equity investment in Borealis Capital Management, the merchant capital firm run by Newcourt Credit founder Steve Hudson. In that, the CPPIB joins established private-equity players like the $125bn Caisse des dépôts et placements and the $73bn Ontario Teachers Pension Plan in the alternative assets field.

With private equity investments, institutional investors are looking for more than just attractive new businesses — or better, business ideas — that have yet to trade on public stock markets. While early-stage financing — the seed and follow-on money fledgling firms need to develop products and begin marketing — remains the most prominent part of the whole venture capital field, there are other returns to be sought from private equity.

Apart from early-stage financing, the Canadian Venture Capital Association (CVCA) lists three other major categories of private equity investment: expansion funding, buyouts and takeovers, and turnaround plays. According to the CVCA, 49 per cent of the investments in 2000 went to expansions — a little more than went to early-stage projects.

For OMERS and the CPP Investment Board, Borealis gives them exposure to a Canadian venture fund as well as a buyout fund. And the CPP board has gone further, enrolling in limited partnerships in the U.S. to take advantage of a growing secondary market, where venture investors sell their stakes in private companies without resorting to a stock exchange and its frequently volatile price-discovery mechanisms. What this secondary market provides is something that benefits companies and investors alike: a way to exit illiquid investments without doing grievous harm to the investment or the company.

Private equity investments are normally highly illiquid — precisely because they don't trade on a stock market, and so have a small ownership base, usually limited partners — and they require a long holding period, as long as 10 years, before a business plan and an idea receive the approbation of a stock market listing.

That said, private placements are not necessarily more risky than other investments.

‘This is not a dangerous asset class. It's a different one,' says Scott MacNab, who is one of the managers of Clarica's $4bn private debt and private equity portfolio. MacNab made his remarks about private equity investments recently at the Strategy Institute's second annual conference on alternative investments in Toronto.

To reap the rewards of private equity investments requires experienced guidance — experience being defined as having lived and invested through a full economic cycle or two.

‘I do see this product being offered at a retail level,' Kevin McKenna said at the same conference. But he warns that ‘the experience level in this industry is not where it should be,' in part because Canada's private equity markets are much younger than those of the U.S.

Experience is required to figure out whether a placement is going cheap for no good reason, or whether it is going cheap because the prospective partner is the last hope to bail out the business owners, McKenna adds.

When ‘pricing expectations are too cheap relative to the underlying risk,' a fund manager has to ask, ‘how bad was my risk-adjusted return analysis,' McKenna offers. It's hard to know how bad it was, he suggests, since, for private-equity investments, ‘there are not too many quantitative processes available,' because there are no benchmarks like the S&P 500 or the TSE 300.

McKenna is a managing director of McKenna Gale Capital, a mezzanine firm whose two funds, with $300m in assets, provide financing to private companies through a combination of subordinated and convertible debt and common equity to make placements tax-efficient for investors.

In the private capital world, mezzanine financing kicks in well after the start-up phase, to finance acquisitions, expansions and recapitalizations, among other things. McKenna expects a ‘carried interest' rate — profits — of 20 per cent on such deals.

At the mezzanine level, the compound return expectations are 18 per cent-25 per cent, figures George Soare, a managing director at BMO Nesbitt Burns Equity Partners. BMO's private equity activities encompass some $750m in assets.

Soare adds that private equity returns are higher than for public equities because the private market is not only illiquid, it is also inefficient.

While stock markets daily winnow out winners and losers, for a private-equity investor the process is protracted.

For every deal he concludes, Soare says he's turned down 100. It's a labour-intensive process, summoning dozens of accountants, lawyers and bankers to go through a deal and do the due diligence. ‘That's staggering,' he adds.

For all that effort, institutional investors are looking at a minimum 35 per cent return on early-stage investments, the classic venture-capital play, Soare says. Later-stage investments, such as buy-outs and takeovers, are expected to yield 25 per cent to 30 per cent.

That's partly the result of market inefficiencies that also give investors opportunities that aren't available on stock markets. But the burden rests on the private investor who must do ‘a lot of fundamental analysis' of a business, as well as commit to ‘provide cash flow for growth.' Otherwise the investment may tank.

However attractive the potential returns, the due diligence to make sure an investment stays above water — and much more — does exact a burdensome cost for institutional investors. ‘The time to execute deals is much longer than in public markets,' Clarica's MacNab observes. All the same ‘return expectations exceed those of the public market'.

While he's always ‘looking for attractive returns relative to the risk profile,' in the end the ‘risk is always commensurate with yield.' Tracking yield is the hard part, since, as MacNab acknowledges, ‘there's no benchmarks in this business.' Unlike stock markets, ‘it's one thing to get your underwriting right, it's another how you're going to manage [the investment] over time.'

Still, managers don't expect the Canadian private equity market to grow to similar proportions as the U.S. market. The oft-cited example is the Yale University endowment fund, of whose $11bn in assets, 25 per cent is invested in alternative investments. That's five times the average of the U.S. pension and endowment industry.

In Canada, pension funds have less than 2 per cent of their assets in private equity; in the U.S. the comparable figure is 5 per cent to 6 per cent, notes Soare.

‘There is a big catch-up,' he acknowledges. ‘I think there's going to be a natural limit to the capital available because the market is so thin' compared to the U.S. market. There, the market is deep enough to support a secondary market for private placements. One firm, Paul Capital Partners (PCP), runs limited partnerships that have invested $12bn in buying out other limited partnerships that have decided to sell their stakes. The CPP Investment Board has taken a $135m stake in one of PCP's limited partnerships.

Overall, the U.S. private equity market is estimated at $170bn in annual inflows — though 2000 was a record year that saw almost a doubling of commitments. The Canadian market, overall, will probably take in less than $7bn this year, MacNab says.

It's a sizeable amount, but not enough. While Canadians are used to a factor of 10 when making comparisons to the U.S., the venture capital field represents only 4per cent of the U.S. total, not 10 per cent. More than that, the institutional presence in 2000 was just $1.5bn — the same size as foreign, mostly U.S. investments — though that does not include investments pensions funds made through private equity funds. Private funds contributed almost $1bn, and labour-sponsored funds accounted for about $750m of the 2000 total investment of $6.3bn.

MacNab argues that ‘we'll never catch up. The Canadian market just doesn't have the structure and depth of the U.S. market,' and in Canada, ‘the preponderance of pension funds have no private equity investments'.

Still, he admits, there are advantages to having a small Canadian market, particularly in influencing how a fund or company develops. ‘If you invest $5m in a U.S. $2bn fund, you better send along a stamped, self-addressed envelope.'

For more information please contact sblythe@advisor.ca.

Copyrght © Advisor.ca 2001