The allure of the private equity market is strong north of the 49th parallel. While Canada has not experienced an explosion in private equity on the same scale as its neighbor to the south, U.S. firms expecting to find Canada’s buyout market as a virgin territory akin to its unspoiled forests or great glaciers will be out of luck. Canada’s buyout market is growing just fine on its own.
“There’s a ton more activity here,” says Mary Macdonald, president and CEO of Thomson Macdonald (a division of Buyouts‘ publisher Thomson Financial). “The market’s getting much more active. From that point of view it absolutely mirrors the U.S. It’s just an order of magnitude lower.”
According to Toronto-based investment banking firm Crosbie & Co., M&A activity in Canada soared in 2005. The firm’s study showed a 42% increase in announced M&A deals between 2004 and 2005. Transaction values of mergers and acquisitions totaled C$166 billion (US$150 billion) in 2005, a significant rise from 2004, which saw C$112 billion (US$101 billion). One of the principal reasons for the increase is attributable to private equity.
One factor that has been driving the M&A market is the number of large and successful Canadian businesses that are owned by foreign entities. That has created a tendency for many of these wholly-owned Canadian subsidiaries to spin out. There has also been an increased awareness among business owners regarding the potential of private equity, and management buyouts are increasingly being favored over a sale to a strategic.
Perhaps most important, Canadian private equity firms have been fundraising at a very healthy clip, giving incumbent firms the capital to compete. Among the more notable funds, two years ago Toronto-based Onex Partners raised what is the largest Canada-based vehicle, corraling C$2.2 billion (US$2 billion) for Onex Partners LP, and this past February, Toronto’s Birch Hill Equity Partners, which spun out of TD Capital last year, closed Birch Hill Equity Partners III with C$850 million (US$767 million).
“It’s not quite as aggressive or quite as significant as in the U.S.,” says Pierre Schuurmans, chief operating officer with Birch Hill. “But there’s definitely been a rise in private equity fund raising that mirrors what’s going on in the U.S.” Schuurmans adds that Birch Hill’s latest fund has more of an even mix between U.S. and Canadian limited partners.
Are You Being Underserved?
With the increased activity, the private equity community cannot seem to agree on whether or not the Canadian market is underserved. Many U.S. investors say it is, while many Canadian professionals counter that U.S. investors are behind the curve.
“It’s always been an underserved market,” says one U.S.-based buyout executive. “Obviously there are fewer competitors with smaller transactions.”
While incumbent players agree that Canada, with a population about one tenth the size of the U.S., is a smaller market with smaller deals, they say that it doesn’t make it any less competitive.
“A few years ago there was a sense that the market was less competitive because it consisted of fewer players and it allowed active players to make better deals and get better results,” says Rick Nathan, president of the Canadian Venture Capital & Private Equity Association (CVCA). “That’s changed in that the market will rush in wherever there’s an opportunity.”
“There are some very experienced and astute Canadian investors,” adds McKenna Gale Capital Managing Director Stephen Stewart. “There’s this misconception that there are fewer groups and fewer experienced groups [in Canada].”
Mark McQueen, the president and CEO of Wellington Financial believes that much of the buzz about U.S. activity in Canada has been just talk. “You hear a lot more [anecdotally] about U.S. buyout players coming to Canada than you actually see them closing transactions,” he says. “I think there’s more sizzle there than steak myself.”
McQueen feels that while U.S. firms will have a significant role to play in very large deals, the Canadian middle market is well-stocked with enough home teams to keep out a significant U.S. invasion.
“On a $5 billion deal you’ll see partnering just like you see in Europe and the U.S. and Asia,” says McQueen. “As far as leading the deals, those are going to be few and far between, which is natural. On a $1.5 billion valued deal you’re going to need $400 million in equity and there are enough people up here to write that check.”
There is an overriding feeling that Canadian middle market funds have grown significantly over the past 36 months and that these firms will have an automatic advantage over U.S. firms, given their local knowledge.
Carey Diamond, president of Toronto’s Whitecastle Private Equity Partners, is among the local players that don’t see a particular opportunity for U.S. groups in Canada. “There is a fairly significant cost for U.S. firms to develop relationships and set up offices here,” he says. “Four or five years ago, firms that had $100 million under management now have $500 million to $800 million under management. The general atmosphere has changed because of greater Canadian involvement rather than American involvement.”
Where the Americans Roam
While Canadians are skeptical about Americans involvement in Canada’s middle market, many U.S. groups have certainly established a presence in the large market.
“On the large deals, U.S. players are critical,” says Macdonald. “We don’t have mega funds here so it’s just not the same. You’re always going to hear early entrants grumble a bit as more entrants come into the market, for obvious reasons.”
Indeed, in the large market, the U.S. interest in Canada has been palpable. Kohlberg Kravis Roberts & Co. and Bain Capital, in particular, have made Canada their proverbial backyard for dealmaking. KKR bought Canadian drug store retailer Shoppers Drug Mart for C$2.55 billion six years ago and a few years later scored big again, snatching up the former Bell Canada Yellow Pages division for C$3 billion. Most recently, the firm inked a C$3.1 billion acquisition of Masonite International. Bain Capital, meanwhile, has also locked up its share of deals, taking over Canadian discount retailer Dollarama in 2004 in a deal valued at more than C$1 billion and also buying the recreational division of Bombardier in a roughly C$1.2 billion transaction.
One of the reasons the mega-funds may be having a significant impact is that there are really only two large incumbent players: Onex Corp. and the Ontario Teachers’ Pension Plan (OTPP). Increasingly though, other firms such as Birch Hill and EdgeStone Capital Partners are becoming large enough that they could be considered a factor in multi-billion dollar deals.
Whether or not pricing is less competitive in Canada, there are other reasons that the Canadian market could attract U.S. investment. The two countries are culturally similar in many ways and Canada has solid economic growth and an educated workforce. The North American Free Trade Agreement (NAFTA) and other trade agreements have knocked down or reduced the impact of formerly prohibitive legal and tax issues. For these reasons, U.S. groups have been opportunistic in crossing the border.
“Private equity investors didn’t discover Canada yesterday or last week,” says Kevin Callaghan, a managing director with Berkshire Partners. “They’ve been up there for years.”
McKenna Gale’s Stewart, while cautioning that Canada is more competitive than many U.S. firms may think, still believes that there is a place for U.S. firms to partner with the homegrown groups. His firm has done deals with several U.S. firms, including Thomas H. Lee Partners, Monitor Clipper Partners and Sentinel Capital Partners.
The Subtleties Of Canada
One element of the Canadian private equity market that sets it apart from the United States is the presence of income trusts, which at the same time can generate feelings of love and hate. Up to now the robust market for these vehicles have proven to be a major competitor to buyout groups, but also served as an appealing conduit for liquidity. That could be changing, though as the market for income trusts corrects itself. One Canadian firm estimated that two-thirds of all business income trusts in Canada have had private equity sponsorhip at some point, and during the income trust market’s free fall last winter many groups began looking at income trusts as potential new opportunities.
Another distinction of the region is the make-up of the institional market. The pensions aren’t the passive investors many U.S. firms might be used to.
“One thing that [U.S. sponsors] need to know is about people such as ourselves,” says James Leech, a senior vice president at the Ontario Teachers’ Pension Plan (OTPP). “Their image of pension plans is that of U.S. pension plans, who are passive investors. Quite often they underestimate [Canadian pensions] and our capabilities in regard to being a direct investor.”
U.S. firms accustomed to a liquid debt market may also notice that Canada’s financing environment is notably restrained. Stewart describes that senior debt financing usually comes from large commercial banks which tend to be more conservative in their structure than U.S. banks. He adds that there isn’t a developed second lien market in Canada and that a public high-yield debt market is lacking as well.
Another difference, perhaps not so subtle, is that there are in fact different customs U.S. groups need to get used to when operating in Canada. “The political environment and business environment are very different. The labor force has a greater sense of entitlement,” says one U.S. buyout partner. “Canada has a very provincial political structure. What’s true in British Columbia is not necessarily true in Ontario and not necessarily true in Quebec.” He added that Ontario was the most business friendly of Canada’s provinces.
“You need to understand that Canada is not the 51st state,” says Steve Collins, a principal with Advent International. “After you spend a little more time there you start to discern some subtleties that make it operate differently from the U.S.”