US-based private-equity investors have contributed significantly to the steadily strengthening Canadian market
American investors, especially private-equity funds, will probably give mixed reviews to the significant changes to Investment Canada Act (ICA) review thresholds and disclosure requirements that came into force on April 24, 2015.
To begin with, the threshold for determining whether net benefit review is required for WTO private-sector investment will be C$600 million based on “enterprise value” as opposed to the previous C$369 million based on asset book value. The threshold will increase to C$800 million in 2017, C$1 billion in 2019, and be indexed to inflation thereafter. It’s not clear, however, whether the increased threshold will reduce the number of reviews given the new “enterprise value” standard for calculating the threshold.
US investors making public bids will also have to consider the timing of their ICA filings. Because enterprise value will be calculated at the time the ICA filing is made rather than at the closing of the transaction, investors may be able to file when values are not high enough to make their transactions non-reviewable. This may also work to the advantage of bidders who file first, as subsequent bidders may find themselves subject to review if the enterprise value has increased in the interim. As well, because SOE bids will be based on the C$369-million asset value threshold, the treatment of sovereign and private-sector bids could be different from an ICA filing perspective.
“The ICA process is now more than ever a material risk factor for consideration, and could certainly affect the valuation of targets,” says Subrata Bhattacharjee of Borden Ladner Gervais LLP in Toronto.
The practical implications of the ICA changes are especially meaningful for US-based private-equity investors, who have contributed significantly to the steadily strengthening Canadian market of 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 C$26.4 billion in PE transactions, more than twice the C$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 [C$100 million to C$500 million], and I don’t see it changing this year.”
According to Allen & Overy LLP’s M&A Index, Q4 2014, Canada ranks fifth in the world as an inbound target magnet. And 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 US companies. Indeed, Canada’s 52 inbound acquisitions compare very favorably on a proportionate basis with the US total of 234 such deals.
A&O also ranks the top 10 overseas target markets for the 10 leading global acquirers in the $100 million-plus range. Canada stands out here as well, placing second as a target for US acquirers in deal volume (28) and deal value ($26.2 billion).
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.
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,” says Akkawi. “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.”
Geographically, there are strong and varied private equity markets in Toronto, Montréal, Calgary, Vancouver and the Maritimes. As of 2014 Q3, Québec led with the most deal activity, followed by Ontario.
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, who practices in the Montréal office of Osler, Hoskin & Harcourt LLP.
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. (KKR) did just that when it opened a Calgary office in March 2014. By the end of the year, KKR, represented by Derek Flaman of Torys LLP in Calgary, had announced a C$500-million investment that gave it a 50 per cent equity position in a new entity, the Veresen Midstream Limited Partnership, which 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 2015, two prominent US private-equity firms focused on energy, Riverstone Holdings LLC and NGP Energy Capital Management, committed C$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 $4.5 billion for a new energy fund, and Warburg Pincus LLC is looking to the oil patch as well. What’s attracting Americans, among other things, is the abundance of experienced management teams in the industry.
“Private-equity companies used to stay away from commodity price risks, but that’s not necessarily the case anymore,” Arnone at Blakes says.
Among other things, the Canadian currency’s devaluation of late should 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 Akkawi’s partner in Toronto, David Seville.
Jeffrey Read of 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, a partner with Norton Rose Fulbright Canada LLP 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 2015, New York-based Riverstone Holdings, which specializes in the energy and power sectors, launched Riverstone Credit Opportunities, L.P., which plans to invest C$375 million in energy by way of “capital relief” opportunities. Apollo Global Management, LLC, also in New York, is reportedly setting up a new fund to buy the debt of oil and gas companies under pressure.
As it turns out, 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,” Read says.
“The first change was the elimination of the section 116 clearance certificate for tax-exempt gains by non-residents on Canadian property,” 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 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 says. “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, health care, pharmaceuticals and manufacturing.”
PE investors are also starting to look at more regulated industries, such as those that have 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, sometimes by buying an industry platform that allows them to compete with strategic players for other, smaller assets that are also in that sector.
“Funds using the platform approach effectively amount to a strategic buyer with private-equity backing,” Arnone says.
What must be remembered, however, is that in pure deal volume, the small market is still the largest PE market by deal volume in Canada.
“Some 75 per cent of private-equity deals have an enterprise value of C$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 C$20 million each,” says Leopold.
One potential hotbed for PE 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 C$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, New Brunswick 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.
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 PE market.
But there appears to be no shortage of optimists around.
“If we get caught in a downdraft, I think it will be a short cycle,” says Norton Rose’s Caruso.
Julius Melnitzer is a legal affairs writer in Toronto.