Canadian Buyout Market Emerges From The Shadows –

When U.S. buyout pros look at Canada, most see a burgeoning but underserved market. An analogy could probably be made by highlighting the differences between the payrolls of the New York Yankees and the Montreal Expos. Each team is playing the same game, althoughbut one benefits from an unlimited stash of investment dollars.

But while Canadian firms have increasingly found themselves competing with the deeper-pocketed U.S. buyers in auctions, the Canadian LBO market has much better prospects than the Expos, and in the eyes of most, the industry has outgrown its characterization as a wanting private equity marketplace.

The capital overhang of Canadian LBO sponsors reached $26.5 billion in 2002, according to Macdonald & Associates. While that number looks paltry next to the more than $100 billion U.S. LBO sponsors have tucked away, a closer look at the data reveals a mushrooming market in Canada, one that has grown significantly since the start of the decade.

“We’ve estimated that between 2000 and 2003, there’s been about $6.4 billion that came into the asset class,” says Kirk Falconer, a director at Canadian research firm Macdonald & Associates. “I’d even hesitate to call it an overhang, since the money hasn’t really been around nearly as long as in the States… And we’ve really seen a pent-up demand for investment activity, so we’re not ready to say that there’s necessarily more capital than there will be investment opportunities. It’s not clear yet if that money will be around for all that long.”

James Leech, vice president at Teachers’ Merchant Bank, paints a picture of a Canadian market nearly identical to that of the U.S., just on a smaller scale. “The buyout market in Canada is really no different than that in the U.S. The U.S. market has been getting pretty mature, and just about every deal of size goes to auction. Our market is in the same place right now, just not as big… and the banks have opened up quite a bit here, much in the same way they have in the States.”

Indeed, even while Canada doesn’t have the high-yield market seen in the U.S., its proximity allows investors the same spoils domestic sponsors have found. “The bank market is really strong in Canada right now,” CIBC World Markets Vice Chairman Earl Rotman says, “and we’ll just bridge into the U.S. market to add high yield.”

That can be a necessity for mega deals, but for the majority of LBOs in Canada, a sponsor generally doesn’t need high yield to complete a transaction. “A company selling for 4.5x EBITDA would typically have 2x senior debt, 1x mezzanine and 1.5x in equity,” says Rod Reynolds, president and CEO of Roynat Capital, the merchant banking arm of Scotiabank.

Higher Valuations

Perhaps the only downside to the current dynamics is escalating valuations, a complaint that is heard increasingly in Canadian buyout circles. “The Canadian market is operating under the same trends that we see in the U.S.,” says Ghislain Gauthier, a senior vice president at CDP Capital, the private equity investment arm of Caisse de depot et placement du Quebec. “In the past year, the prices have gotten challenging given the capital available to private equity firms and the strength of the debt market, and we’re slowly starting to see the strategics come back.”

Perhaps more significant than all of that, though, is the army of private equity firms that sits just behind Canada’s southern border. In the U.S., where buyout shops have seen valuations reach dizzying levels, the reduced competition in Canada has made the marketit tough to ignore.

“I think you can get some better values. It’s harder to find those deals and you’re competing with Canadian firms, but from what we’ve seen, the valuations aren’t always as high as in the U.S.,” Harvest Senior Managing Director Ira Kleinman says.

Roynat’s Reynolds agrees, saying that a company in the U.S. that sells for a 5x-to-6x multiple would probably sell in Canada at a 4x-5x multiple. “There is generally a lower transaction value in Canada,” he says.

The KKR Factor

Canadian pros stress that the presence of U.S. buyout firms in Canada is nothing new. “U.S. buyout funds have been coming here for a number of years,” says Reynolds. “We saw a reasonable quantity five years ago, primarily focused on Ottawa…and it’s been increasing annually.”

But there’s no question that Kohlberg Kravis Roberts & Co. and Teachers Merchant Bank’s $2.6 billion acquisition of Shoppers Drug Mart in 2000 had a huge impact on both sides of the border. Not only did it demonstrate the profits that can be mined in the Canadian market, but it helped to open up the wallets of the Canadian institutional investors that wanted in on the asset class.

Following in KKR’s footprints, U.S. firms have been quick to test the Canadian waters. Among the more notable deals this past year, Harvest Partners and Lightyear Capital acquired bus manufacturer New Flyer Industries; Hicks, Muse, Tate & Furst agreed to buy cable operator Persona; Trivest Partners grabbed diet center Herbal Magic; and a team comprised of Sterling Capital, BNP Paribas Securities, Perry Capital and others bought out the oil-sands focused North America Construction Group. Other deals include Thomas H. Lee Partners’ going-private purchase of Nu-Gro Corp., an add-on to its United Industries lawn and garden platform; and the agreed-upon acquisition of Imperial Parking Co. by Gates Group, Prudential Capital and CapitalWorks.

Of course, not all U.S. firms are interested, in part because doing a cross-border deal requires plenty of red tape. “For whatever reason, some private equity firms tend to shy away,” says Kleinman. “There are more tax issues, some legal issues, and the reward system is different, but it basically has the same drivers that move the U.S. market.”

Those Americans who are interested have encountered a cooperative stance from Canadian firms, who have shown a willingness to partner on deals. “The landscape has changed in the past couple years,” Rotman says. “The U.S. players have discovered Canada, but there have also been a number of new indigenous Canadian sponsors. The trend toward partnership deals has extended here, and we expect that to continue.”

While getting someone to share the risk is always a good thing, the more important reason for buyout firms to team with Canadian sponsors is for guidance through the Canadian marketplace. Last year, Bain Capital teamed up with CDP Capital to carve out Bombardier’s recreational division, and most recently J.W. Childs Associates worked with Borealis Private Equity to buy Maax Inc., a publicly held maker of bathroom fixtures.

Institutional Investment Rising

The increase in activity across the border is not solely the result of U.S. firms pointing their radars north. Canada’s institutional investors have been more supportive of the asset class in recent years, allowing some of the established players to build their arsenal, while new sponsors are now able to get on their feet. The Canada Pension Plan Investment Board is among those ramping up its private equity portion allocations, with $5.3 billion committed to 39 funds as of the end of last year. Meanwhile, Caisse Chief Executive Henri-Paul Rosseau this past February outlined plans to boost its investment in private equity at the expense of its stock and bond holdings.

Among the general partners, Onex Corp. has led the charge of sponsors raising new funds, accumulating a total of $2.2 billion for its first fund involving outside institutional investors. Other firms that have recently capped off successful fund-raising efforts include EdgeStone Capital Partners, TriWest Capital Management Partners and CAI Capital Management.

Canada has also seen the development of funds-of-funds, with activity coming from Kensington Capital, a dominant player in the fund raising market of late, and TD Capital Private Equity Investors, itself having a raised a $526 million fund-of-funds in 2002. “This has been an important development,” Falconer says. “It reflects that new institutions have been coming into the market for the first time and the market is maturing.”

A Trusted Friend?

There can’t be a dialogue about private equity in Canada without discussing the income trust, which is fast becoming a favorite means to exit in Canada. While U.S. firms have been hamstrung by a meek IPO market and the exodus of strategic buyers, Canadian companies have benefited from the blossoming of the income trust, which has become a roughly $90 billion market.

Just as Shoppers Drug Mart demonstrated the potential that can be found in Canada, the floatation of the former Bell Canada Yellow Pages unit by KKR and Teachers as an income trust served as a landmark deal for private equity. The income trust, which most closely resembles a REIT in the U.S., allows businesses to access the public markets within a trust, and providing provides the added appeal of skirting corporate income taxes to a certain degree.

While IPOs are the exit of choice for high-growth stories, income trusts cater to relatively low-growth businesses with steady and consistent cash flows essentially serving the kinds of companies private equity firms love and target most.

CIBC’s Rotman describes, “It’s an efficient capital structure where the issuer pays out all of the free cash flow rather than retaining the capital… You try to maintain a sustainable but quasi-permanent level of leverage.”

“The market serves businesses for which an IPO is not available,” Kleinman adds. “Three to four percent growth rates don’t look too exciting in an IPO, but for the income trusts, which look more at current income, this kind of exit makes sense.”

Meanwhile, increasingly companies have been looking to bypass the middleman and access the income trust market directly, a trend that effectively serves as competition for private equity firms. “The trend [toward income trusts has been huge] the last two years,” Leech says. “It’s a great source for exits, but it also represents major competition, and we’ve certainly lost some transactions to that market.”

The huge growth of the income trusts has also raised the awareness of the Canadian government, which is considering new legislation that would cap its further expansion. The proposals would aim to prohibit pension funds from investing more than 1% of their total holdings in the asset class and additionally prevent pensions from maintaining a more than 5% stake in any one income trust.

Leech, who would feel this directly as part of Teachers, is against the plan. “This basically stems from a misguided view from the government that their tax base will erode on them. It’s very discriminatory against pension funds, and they’re attacking us because we’re a tax deferred vehicle.”

And while Teachers has more to lose than most pension funds since it invests directly in private equity, Leech believes all pensions could be at risk. “It will affect all pension plans. The new rules are quite punitive,” he says. “If a pension has an investment in a private equity fund and that fund has a large investment in an income trust, then the pension’s exposure to that fund is tainted… It’s creating a threat to private equity, because the pension funds will begin insisting that sponsors don’t go into income trusts.”

Looking Ahead

Going forward, most do not expect the income trust market with or without any new legislation to impact deal flow in the years ahead. And while the U.S. interest has brought new competitors into the market, Canadian firms don’t feel threatened by the new entrants.

“We’re seeing a lot of shopping around recently by the vendors,” TORQUEST Partner Eric Berke says. “The income trust market is an alternative for companies, but in many ways there are a lot of companies that aren’t quite ready for an income trust yet, and they need a financial sponsor to step in before that becomes available.”

One question commonly asked by the LBO community is how quickly when the anticipated turnover of Canada’s older entrepreneurs will is going to happen actually take place. “We’ve seen statistics that say 40% of Canadian businesses will turn over in the next five to seven years,” says Reynolds. “But we don’t actually see it happening yet.”

Regarding the U.S. interest, Berke says, “We don’t find it intrusive at all. In fact, we embrace it to the degree that it makes the marketplace more active, and we will seek out strategic partnerships when it’s prudent to do so… Vendors would usually try to see if they can get a deal done inside of Canada [with indigenous financial sponsors] before they will go out to a wider audience. There’s a tendency to want to keep deals inside the country, which stems from having a relationship with the investment banks.”

And even as Canada has long been considered an underserved market, the view among Canadian buyout shops is that the market has outgrown that characterization. “Frankly, we don’t feel the market is underserved here,” Leech says. “People may suggest that that is the case in venture, but in private equity, if there is a business to be sold, there is an ample amount of opportunities to do so.”

Additional reporting by Adam Reinebach