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  1. 1. THE GOODMAN AND CARR LLP REPORT ON THE CANADIAN PRIVATE EQUITY MARKET IN 2001 An in-depth review of key trends in the Canadian Private Equity Market in 2001 RESEARCH CONDUCTED BY
  2. 2. THE GOODMAN AND CARR LLP REPORT ON THE CANADIAN PRIVATE EQUITY MARKET IN 2001 An in-depth review of key trends in the Canadian Private Equity Market in 2001 RESEARCH CONDUCTED BY
  3. 3. CANADA’S PRIVATE EQUITY MARKET IN 2001 Introduction This report, prepared for Goodman and Carr LLP, documents current trends in Canadian private equity market, including buyout activity, mezzanine financing and venture capital. Data analyzed for the purposes of this report were drawn from The Private Equity Activity Survey, designed by Macdonald & Associates Ltd, and conducted by them over the period August- September, 2001. The format and analytical framework of the report are consistent with those issued by Macdonald & Associates in the past. *** Canada’s private equity market, characterized chiefly by activity in three distinct market segments – buyout and related corporate finance, mezzanine investment and venture capital – experienced major growth and diversification over the course of the 1990s, which has included a steady increase in the number of national and local investor groups and funds, as well as the size of capital pools managed by them. Since the late 1980s, multiple factors have contributed to this growth. One influence, of course, has been mounting demand for risk financing, from established middle market firms, in the case of buyout/mezzanine activity, and from emerging technology firms, in the case of venture capital. Another variable has been changes to the organization and structure of the financial system, as well as government regulation of that system, which has greatly facilitated supply. Still another has been the proximity of massive and highly sophisticated private equity markets in the United States, fueled by an ever-expanding volume of assets from institutional investors (i.e., pension funds, insurance companies, endowments/foundations, etc.). Due to its identification with fast-growing technology sectors in the national economy, venture financing perhaps enjoys the highest profile of the three market segments. Such financing is typified by an investor focus on company movement along a growth path, from start- up and early stage development to expansion, culminating in public offering or acquisition by a larger business entity, among other outcomes. To bring young firms to this point, investors commonly inject round after round of financing, often in strategic syndication with others, and give entrepreneurs access to management expertise, networks and other resources. For 16 years, Macdonald & Associates has tracked Canada’s venture capital industry, reporting capital under management totaling $18.9 billion at the beginning of 2001. Last year, the industry enjoyed record-breaking activity, with disbursements of $6.6 billion. -1-
  4. 4. Buyout and related types of corporate investment experienced a sea change in the past decade. In contrast with the leveraged buyout craze of the 1980s, buyout transactions in a modern context are often equity-based, with investors pursuing a value-adding strategy that helps businesses meet their goals. Buyout activity targets mature firms, typically situated in such traditional sectors as manufacturing and services, that are addressing a particular “event”, such as a significant management change, an inter-generational transfer of ownership, acquisition of – or merger with – another corporate entity, expansion, divestiture of product divisions, or a situation of financial distress. Generally speaking, mezzanine financing is conducted in the same middle market territory as buyout activity. However, the former is distinguished by the financial instrument utilized, with subordinated debt occupying an integral position in certain event transactions, alongside equity or, in some instances, acting as a viable alternative to equity. Consequently, mezzanine investor groups are highly specialized and frequently organized in dedicated pools. *** The Private Equity Activity Survey was sent out to major private equity investor groups located predominantly in Ontario and Quebec, representing a balance of buyout, mezzanine and venture investment mandates, as well as the lion’s share of assets and deal activity in national markets as a whole. In all, 62 investor groups were contacted, with 48 (or 77%) responding with completed survey questionnaires over the period of issue. These respondents provided data for over 85 funds. The survey sought to obtain data pertinent to the operational mandate of investor groups and, where relevant, the essential characteristics of specific funds within these groups, including capital under management, sources of capital supply, investment objectives and portfolio holdings. For groups/funds that raise capital from external sources, questions were also posed concerning the terms and conditions of limited partnerships. The Private Equity Activity Survey represents a useful early effort in describing the full universe of Canadian private equity investing. In so doing, it has gathered much original data that have heretofore been unavailable to industry professionals, agents and informed observers. To assist analysis of these data, Macdonald & Associates has provided a broad methodological framework that is comparable to recognized market parameters in the United States. This said, it is important to note that the first-time nature of this exercise, plus the limited sample on which it is grounded, prevent an in-depth understanding of the current state of the national private equity market. For this reason, readers of this report should view survey findings as a first step in this direction. -2-
  5. 5. (I.I) Size and Dimensions of Canada’s Private Equity Market in 2001 CANADIAN PRIVATE EQUITY MARKET ON THE RISE Total Private Equity Capital Under Management By Survey Respondents By Market Segment, 2001 11% 46% 43% Venture Capital Buy-O ut/Corporate Finance Mezzanine Capital $23.5 Billion © 2001 Macdonald & Associates Limited. All rights reserved. By focusing on many of the largest investor groups and funds with headquarters or a significant presence in Ontario and Quebec, The Private Equity Activity Survey was able to capture a sizeable proportion of the private equity market universe in Canada. Taken together, surveyed fund assets were a whopping $23.5 billion. By a small margin, the biggest share of this dollar amount was held by funds residing in the venture capital market: $10.8 billion, or 46% of the aggregate. The second largest share – $10.1 billion, or 43% of the total – was held by funds concentrating on buyout and related corporate finance activity. The balance, or $2.6 billion and 11% of the pool overall, was situated in funds specializing in mezzanine investment. According to Macdonald & Associates, the survey’s venture capital portion accounts for just over half of total capital under management by the industry, nationwide, which stood at $18.9 billion at the beginning of 2001. It is estimated that there are more than 150 groups in Canada managing funds with a dedicated mandate for venture financing. -3-
  6. 6. As there have been no published estimates of the magnitude of Canadian buyout and mezzanine activity prior to now, it is impossible to state precisely what proportion has been captured by the survey. However, Macdonald & Associates estimates that buyout and mezzanine capital under management totals well in excess of $17 billion, nationwide. It is further estimated that between 40-45 investor groups have funds with dedicated buyout mandates, or with significant exposure to the buyout market. Working in the same environment are an estimated 25-30 investor groups with dedicated mezzanine pools, or pools with some focus on such activity. When actual venture capital resources and actual/estimated buyout and mezzanine resources are added, the estimated size of the Canadian private equity market in aggregate is shown to be at least $36 billion in 2001. This compares against the American private equity market, the capital under management of which has been estimated at over $680 billion (US dollars) in the same year. These statistics point to remarkable growth and development in Canada’s private equity markets – from a nascent period in the 1980s, when private equity activity was limited in mass and scope and largely undifferentiated regarding its business targets, through the 1990s, when a steady increase in the number of Canadian-based investor groups and funds was accompanied by heightened market specialization. As in the United States, time and experience led to the three fairly distinct market segments identified here. Further data taken from the survey suggest that much of this market growth occurred very recently, as a great number of funds polled saw inception in the period 2000-2001. In the buyout/mezzanine arena, some the newest (and largest) funds include Borealis Private Equity, CCFL Subordinated Debt Fund III, Clairvest Equity Partners, Kilmer Capital Fund, NB Capital Mezzanine Partners II, ONCAP, RBC Capital Partners Mezzanine Fund, Schroders Canadian Buyout Fund II, TD Canadian Private Equity Partners and the Tricap Restructuring Fund. In venture financing, examples include Borealis Financial Technology Fund, Brightspark Ventures, Celtic House Fund II, Skypoint Telecom Fund II, the latest Technocap Fund, VenGrowth Investment Fund V, Ventures West VII and the Working Ventures Technology Fund. In addition, the new Novacap II features both buyout and venture sides to its mandate. This accelerated spurt in new fund formation is confirmed by Macdonald & Associates in the venture capital industry, which witnessed particularly large inflows of new resources between 1999 and 2000, with the national pool expanding by 56%. -4-
  7. 7. (I.II) Capital Under Management by Investor Type STRUCTURE OF CANADIAN PE FUNDS DIVERSE Private Equity Capital Under Management of Survey Respondents By Investor Type, 2001 18% 38% 3% 14% 27% C orp orate G o vernm ent Ins titutio nal LSVCC P rivate Inde p end e nt $23.5 Billion © 2001 Macdonald & Associates Limited. All rights reserved. In the United States, private independent funds – based predominantly on the limited partnership model – dominate private equity markets, accounting for close to 80% of buyout, mezzanine and venture investment. Canadian markets are very differently structured. Despite the critical importance of private funds in this country, they reflect a comparatively smaller share of capital under management. This is the case for several reasons, not the least of which is the restricted exposure of Canadian pension funds and other institutional investors to private equity as an asset class. Resources managed by private independents responding to the survey totaled $9.0 billion, or 38% of aggregate capital under management. Such funds have been fully active across the spectrum since the earliest days of private equity in Canada, evident in the activity of such veterans as CAI Capital Group, CCFL, McKenna Gale Capital, Penfund and Schroders & Associates in buyout and mezzanine markets and McLean Watson, Novacap, Quorum Funding Corporation, Technocap, VenGrowth Capital Partners and Ventures West Management in venture financing. -5-
  8. 8. Since 1997, Macdonald & Associates has reported some renewal in commitments of pension fund and other institutional capital to limited partnerships in the venture capital realm. This trend has also led to a modest proliferation of new buyout funds in the past couple of years. Beginning in 1983, labour-sponsored venture capital corporations (LSVCCs) have been established by federal and provincial government statutes and tax credits on a national basis, and in eight out of ten provinces, to fill a perceived gap in the supply of risk financing. Today, there are approximately two dozen LSVCCs in existence, including the Canadian Science and Technology Growth Fund, CI Covington Fund, First Ontario, Fonds de solidarite des travailleurs du Quebec (FTQ) and Working Ventures Canadian Fund. The LSVCCs responding to the survey manage $6.4 billion, or 27% of private equity resources represented by the survey as a whole. The primary venue for LSVCC investing is the venture capital market, where they are currently responsible for 39% of all national resources, according to Macdonald & Associates. Representing 18% of the total pool described by the survey, or $4.1 billion, corporate investor groups – or the subsidiaries of major Canadian financial and industrial corporations – assumed a highly influential position in private equity markets during the past decade. By a country mile, corporate-financials represent the most sizeable component of these groups and are, in turn, dominated by the country’s largest banks. Since the restructuring of the banking sector in the 1980s, which included new freedoms and strictures offered by government regulatory changes, corporate-financials have gradually established a comprehensive presence in all three market segments – buyout, mezzanine and venture capital – though strategic emphasis of these differs among them. Today, nearly all of Canada’s leading banks and non-bank financial institutions have a stake in private equity, led by such subsidiary operations as BMO Nesbitt Burns (and BMO Capital Corporation), HSBC Capital, RBC Capital Partners, Scotia Merchant Capital Corporation (and Scotia-owned Roynat) and TD Capital. Along with private independent funds, corporate-financials have become especially influential as drivers of the recent expansion in new Canadian buyout pools. Indeed, these groups are converging – for instance, in the launching of TD Canadian Private Equity Partners. Corporate-industrial funds are more prominent in venture financing, as these funds typically have a dual interest in returns and having a strategic window on up-and-coming products and companies in technology sectors. Two high profile examples of this trend in Canada are BCE Capital and the venture arm of Telesystem. -6-
  9. 9. In American private equity markets, the involvement of pension funds, insurance companies and other institutional investors is predominantly facilitated by limited partnerships and related vehicles. In Canada, several large institutional investors, such as Manulife, OMERS and Ontario Teachers PPB, have taken the unique step of hiring in-house teams of senior private equity professionals who conduct a significant portion of their overall activity on a direct basis. Like bank subsidiaries, the internally directed activity of such institutional investors is frequently felt right across the three market segments. Because of the sheer volume of assets allocated to direct institutional investment, such groups have very recently emerged as a powerful force in buyout, mezzanine and venture investment in Canada, accounting for $3.2 billion, or 14% of total capital under management in this survey. Government-owned investor groups usually undertake investments that might not otherwise be made in private equity markets, such as small deals or activity located in rural or remote communities and regions of the country. This is the rationale behind the integral role of the Business Development Bank of Canada in mezzanine and venture capital markets, as well as that of Innovatech du Grand Montreal in Quebec. This survey found government funds accounting for 3% of capital under management, or $810 million. -7-
  10. 10. (I.III) Capital Supply of Private Equity Funds INSTITUTIONS AND INDIVIDUALS KEY TO PE SUPPLY Capital Supply for Private Equity Survey Respondents By Source, 2001 1% 3% 4% 30% 32% 5% 25% Pension Insurance Corporations Individual Government Foreign Other $23.5 Billion © 2001 Macdonald & Associates Limited. All rights reserved. Despite the fact that Canadian pension funds make significantly fewer capital commitments to private equity markets, as compared to their counterparts in the United States, they remain a crucial supply source in this country. Indeed, according to this survey, pension funds were responsible for $7.0 billion of the supply to buyout, mezzanine and venture investment, or 30% of aggregate amounts contributed. These dollar totals take into account the commitments of pension funds to limited partnerships and other externally managed vehicles, as well as in-house allocations to direct investment activity. It should be noted that the bulk of pension fund resources flowing to private equity can be attributed to a small handful of public sector organizations, among the largest of which are the British Columbia Investment Management Corporation, Hospitals of Ontario Pension Plan, OMERS, Ontario Teachers PPB and Quebec’s CDP Capital. Several new entrants to private equity markets, such as CPP Investment Board, may substantially increase the supply role of pension funds in the near future. -8-
  11. 11. Like pension funds, insurance companies constitute a key source of private equity supply in the United States, a situation that is not comparably reflected in Canada, despite the active market engagement of such groups as Clarica Life Insurance Company and Manulife Capital. Nonetheless, insurance companies accounted for $1.2 billion of the commitments supporting buyout, mezzanine and venture capital industries, or 5% of the total. As in the case of pension funds, this share captures both direct and indirect investment activity. Interestingly, the supply levels of pension funds and insurance companies, as described in this survey, surpass those that are typically attributed to them by Macdonald & Associates for venture financing. This suggests, as will be expected, that these institutional investors prefer buyout and mezzanine investing, chiefly because the latter are associated with larger funds and larger transactions, shorter investment horizons, and less perceived risk, among other factors. In what is a sharp contrast between Canadian and American private equity markets with respect to capital supply infrastructure, individual investors occupy an especially important position in this country, representing $7.5 billion or 32% of aggregate sources, as determined by respondents to this survey. There are two essential components to the individual investor category in Canadian supply conditions. The first is the literally hundreds of thousands of Canadian individuals that own shares in LSVCCs. Indeed, with the use of government tax incentives, LSVCCs have demonstrated a remarkably potent capacity for raising capital on a retail basis, ensuring that individuals leveraged 55% of all new commitments to the venture capital industry alone in 2000, according to Macdonald & Associates. The second component is high net worth individuals – in some instances, angel investors – seeking participation in corporate and private independent funds. A high profile illustration in venture financing is the privately backed Celtic House. Based on survey responses, major Canadian financial and industrial corporations contributed $5.8 billion to the dollar value of buyout, mezzanine and venture capital funds, or one-quarter of amounts recorded overall. The lion’s share of this supply constitutes the internal allocations of corporations to their private equity subsidiaries. In addition, several banks and non-bank financial institutions are pivotal to the capitalization of numerous limited partnerships. As well as backing their own venture and/or mezzanine divisions, Canadian governments also provide resources to some private independent funds. The survey found over $1.0 billion in government-sourced capital supply, or 4% of the aggregate. As private equity increasingly becomes cross-border in nature, American and other foreign investors will more regularly form a vital part of limited partnership supply. Survey respondents reported $291 million from this source, or 1% of the whole. Other capital sources identified in the survey, totaling $758 million and 3% of all private equity suppliers, comprise a diverse category. Much of this amount was simply undisclosed, with the balance made up by the contributions of general partners to funds managed by them, other institutional sources, etc. -9-
  12. 12. (II.I) Investment Focus of Private Equity Funds: Buyout/Mezzanine Capital MIDDLE MARKET “EVENTS” DRIVE BUYOUT/MEZZ ACTIVITY Preferred Transactions of Responding Buyout and Mezzanine Funds 40 30 20 10 0 E xpansions Mergers & A cquisitions MB O /O the r B uyout A ctivity C orporate D ivestitures S uccessio n Financing R e-Financings P rivate P lacem ents in P ublic C om panies Financial D istress/R estructuring O ther Middle Market A ctivity © 2001 Macdonald & Associates Limited. All rights reserved. As was noted in the Introduction, demand for buyout and related corporate finance, as well as for mezzanine investment, generally comes from mature medium-sized or larger firms with track records, consistent revenue streams and experienced managers. Most of these middle market companies are privately-owned and reside in traditional manufacturing and service sectors (and some established technology sectors), which have confronted major competitive pressures since the early 1980s, due to economic globalization, altered trading relationships on a continental basis, innovation and other factors. The ensuing North America-wide restructuring has shaped much of the current domestic demand for non-venture private equity, as companies re-organize, consolidate, modernize and attempt other strategic transitions. To assist them, investors engage in what are known in the industry as “event” transactions, or financings linked to specific objectives of the portfolio company. Common event transactions, identified in the figure above, are at the heart of most buyout and mezzanine activity in Canada. - 10 -
  13. 13. Of buyout and mezzanine investor groups/funds responding to the survey, over 80% identified three types of transactions that are key to their mandates: medium-sized/large company expansions, mergers/acquisitions and management buyout-outs (MBOs), along with other types of buyouts. These results are consistent with research attesting to increasing middle market demand for expansion/buyout capital and the rising rate of mergers and acquisitions, among other trends in both Canada and the United States. Weighted almost as heavily were corporate divestitures, which have also been in growth mode since the late 1980s, succession financing, which is vital to a growing number of family- owned businesses started in the postwar years (and that seek to transfer ownership to younger generations), and company re-financings. Somewhat less priority was given to investment in publicly listed firms, which may involve so-called “orphans” or deal making that is too complex or cumbersome to be handled in exchanges. This was also the case with transactions emphasizing financial distress, restructuring or turnaround. Despite some of the differences in survey ratings, what stands out is the relatively equal merit given to most event transactions by respondents. This suggests that most Canadian buyout and mezzanine investor groups/funds are pursuing a “balanced” strategy and are not as yet as specialized as their counterparts in the United States. There, an exclusive focus on core activity is quite common. This conclusion vis-à-vis the Canadian situation was confirmed in interviews conducted prior to the release of The Private Equity Activity Survey, with buyout/mezzanine professionals arguing that domestic deal opportunities were too few, and the market too under- developed, to permit extensive specialization at this juncture. However, notable exceptions to this general rule have emerged very recently. Examples of specialized approaches include the Shotgun Fund and Succession Fund of Argosy Partners, the Tricap Restructuring Fund, which focuses on under-performing companies that require comprehensive restructuring plans, and several sector-specific funds, such as those managed by RBC Capital Partners and TD Capital. Buyout/mezzanine professionals interviewed prior to the survey’s issue also noted that preferred investment size was probably the more appropriate measure of market distinctions at the present time. This observation was also borne out in the data. The average preferred investments of responding buyout/mezzanine funds ranged between $10 million and $50 million. However, certain groups – such as some corporate investor groups and institutional investors – clearly favoured the upper end of the financing spectrum (e.g., $20- 75 million and above), while private independent funds were more inclined towards the low end (e.g., $5-20 million, with many fund ranges below the $10 million level, especially in the mezzanine segment). - 11 -
  14. 14. (II.II) Investment Focus of Private Equity Funds: Venture Capital INNOVATIVE FIRMS SPUR VC FUNDS TO SPECIALIZE Preferred Deal Focus of Responding Venture Capital Funds By Stage, 2001 12% 31% 57% A ll S tag es E arly S tag e O nly E xp ans io ns and L ate S tage s O nly © 2001 Macdonald & Associates Limited. All rights reserved. As was noted in the Introduction, demand for venture investment primarily comes from new and developing firms in innovative sectors. For instance, according to Macdonald & Associates, close to 90% of Canadian industry disbursements in 2000 went to cutting-edge information technology sectors – communications and networking, internet-related products, computer software, electronics and semiconductors, etc. – as well as biotechnology and other life science sectors. A growing proportion of companies situated in technology sectors are exceptionally young in age and development. In fact, so far in 2001, 58% of venture resources have flowed to seed, start-up and other early stage financings, which is indicative of a trend that has, in turn, shaped the investment mandates of funds and a move towards greater market specialization. Enhanced specialization in the venture capital arena is also apparent in survey findings, with almost one-third of responding venture investor groups/funds flagging an exclusive focus on early stage companies – just a few years ago, very few would have been so identified. By contrast, only 12% of respondents in this market noted a singular emphasis on expanding companies and other late stage activity. The majority of respondents (57%) reflected a “balanced” strategy, whereby they have an interest in multi-stage activity. - 12 -
  15. 15. This degree of attention paid to the early stage end of the investment spectrum is illustrated by the recent rise in seed financing, or financing of the initial commercialization of laboratory research and technical innovation. Prior to the late 1990s, seed deals were almost unheard of, however, they are now a substantial fraction of industry activity (4% of disbursements in 2000), as groups like Brightspark and Ventures West Management have gained expertise in this field. Another measure of specialization is the increased propensity of investor groups/funds to adopt sector-specific mandates. This is a key aspect of industry evolution, as the diversity and complexity of new technology products require more focused expertise among venture professionals. Examples abound among the respondents to the survey, including Celtic House (communications and electronics), Skypoint Capital Corporation (communications and computer software), RBC Capital Partners’ Life Science Fund and XDL Intervest Capital Corporation (communications and internet-related products). Not surprisingly, preferred investment sizes among venture capital industry respondents ranged far below those on the buyout and mezzanine sides of private equity. The average captured by this survey was between $3 million to $8 million. Venture investment ranges were almost uniformly below the $10 million dollar mark, with only a handful of funds expressing preferences for a maximum level of $20 million. It is worth noting however, that venture financing is more likely to be syndicated, with larger deals often attracting four or five different investors. - 13 -
  16. 16. (II.III) Investment Activity of Private Equity Funds: Portfolios PE DISBURSEMENTS EXPERIENCING GROWTH Private Equity Disbursements of Respondents 2000 – Q2, 2001 $2.8 Billion $1.8 Billion $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 2000 Q2, 2001 Buy-Out Mezzanine Venture Capital © 2001 Macdonald & Associates Limited. All rights reserved. Of all the data collected by The Private Equity Activity Survey, those pertaining to portfolios and recent transactional activity and disbursements of buyout, mezzanine and venture investor groups/funds were the least robust. This is because a substantial fraction of respondents viewed such information as too sensitive and proprietary, and much of the data provided were incomplete. In addition, some very major funds, established only in recent months, are not yet actively investing. As a consequence, the statistics compiled here, though representative and important as a snapshot of trends in private equity investment and portfolio holdings, understate what is actually taking place overall. In total, approximately three-quarters of responses to the survey gave full or partial information about their market activity to date, with their existing investment portfolios holding 1,981 companies. The current at-cost value of these portfolios in aggregate is estimated to be $11.7 billion. Buyout portfolios held 319 companies of this total, while mezzanine portfolios featured 451 firms. As was mentioned previously, these typically are well-established, middle market businesses. Survey responses confirmed this fact, with those from the buyout/mezzanine realm most frequently citing the range $10-100 million as an appropriate level of annual sales, and at least 5 years of operation as an appropriate age, for a company first entering a portfolio. A significant minority of respondents had a higher minimum threshold for sales (e.g., $25-50 million). - 14 -
  17. 17. Venture portfolios held 1,210 companies of the total. As was also noted earlier, these are often fledgling technology companies, without a history of profitability. For this reason, very few venture investor groups/funds specified preferred characteristics with regard to revenues or age for target investments. Those functioning with a threshold suggested a minimum of $1 million in annual sales and one year of operation. The rate of capital invested across the Canadian private equity spectrum appears to have gained considerable momentum in the past couple of years, which is in line with the recent rate of new fund formation. Disbursements by responding investor groups/funds stood at $2.8 billion in 2000, with venture capital leading at 62% of the total, followed by buyout activity at 27% mezzanine financing at 11%. Despite volatility in public markets and an uncertain economic climate, capital flows appear to be as strong, or even stronger, in 2001, with respondents perhaps finishing the year at over $3 billion, though amounts invested to date may be heavily influenced by a small number of exceptionally large buyout transactions in the first six months. Generally consistent with these findings, Macdonald & Associates has recently reported sizeable deployments by the entire venture capital industry, including $6.6 billion invested across the country in 2000. Thus far in 2001, capital invested has remained remarkably durable under the circumstances, totaling $3.8 billion in the first nine months. In other words, the Canadian industry continues to invest at 2000-like levels, unlike the industry in the United States, where disbursements this year have now fallen by more than 60% back to pre-1999 levels. The bulk of the $4.5 billion disbursed during 2000-2001 by groups responding to the survey should find its way to Canadian companies. This statement is based on the expressed intention of most respondents to invest primarily in this country (an estimated 72% of managed resources). This includes the vast majority of venture investors, which are traditionally active close to home – and, in particular, LSVCCs, which are legally required to do so – in contrast with buyout investors, which frequently function with mandates that extend into North American and other international spheres. When it comes to deal making, roughly half of all respondents to the survey indicated a preference for syndication and assuming a lead among co-investors. The vast majority of these were venture investors – a trend that is increasingly evident in large financings in technology sectors. Less than 20% of respondents preferred co-investment on a more passive basis. Close to half of buyout and mezzanine investor groups/funds signaled a strategy of infrequent syndication, which is quite common in non-venture private equity markets. - 15 -
  18. 18. (II.IV) Investment Activity of Private Equity Funds: Exit Strategies and IRR Targets When it comes to strategic plans for exiting investments and projecting returns at the time of dispositions or fund liquidations, buyout, mezzanine and venture investors reveal key similarities and differences. Responding investor groups/funds to the survey provided important information on these matters by indicating their anticipated timing for exits, and the typical nature of these, as well as target returns, by fund and by transaction. While investment duration is highly dependent on economic and market cycles, on average, respondents aimed to exit – or based on recent history, expected to exit – a portfolio company within 5-6 years, with few distinctions apparent between the three private equity segments. When exits take place, most respondents (61%) hoped they would occur through company acquisition by, or merger with, another business entity. Initial public offerings accounted for close to one-fifth of anticipated exits, though this was largely driven by the responses of venture investor groups/funds. Very few other exit opportunities were preferred, with the exception of company buybacks, which represented somewhat less than 10% of the total. Most private equity investor groups surveyed had established target rates of return (IRRs) on a per fund basis, while a sizeable fraction also had such benchmarks on a per transaction basis. Target IRRs by fund in the buyout and venture capital domains were largely comparable, typically ranging from 25% to 35% (though a minority of funds had higher and lower benchmarks). Where these existed, target IRRs by deal were more variable, but most tended to fall within the higher range of 30% to 40%. Because they feature quasi-equity instruments (which include characteristics of debt), mezzanine investor groups indicated lower target IRRs for their activity, with these ranging from 15% to 25% for projections per fund. Most funds used the upper end of this range (i.e., 20-25%) for benchmarks on a transactional basis. - 16 -
  19. 19. (III) Limited Partnerships: Key Terms and Conditions The terms and conditions of a limited partnership are vital to both limited partners (LPs) and general partners (GPs) and can be the subject of intense discussion as the two sides hammer out agreements and negotiate issues over a partnership’s lifetime. In interviews conducted prior to the release of The Private Equity Activity Survey, senior fund managers expressed doubt about whether partnership terms were likely to vary substantially across Canada – regardless of the private equity market segment. This view was borne out on many items discussed by respondents to the survey. One of the reasons for this result is that LPs and GPs have apparently worked hard to advance their primary concerns. In so doing, they have sought to observe “best practices” recognized among management professionals and institutional investors across North America on matters pertaining to fund management, organization and financial arrangements. Like investment data, data relevant to partnership terms and conditions suffer somewhat from reticence on the part of some investor groups/funds to share details of their operations, as well as the limited sample on which the survey is grounded. Nonetheless, the survey findings summarized below – derived from 45 Canadian private equity funds – do provide an interesting and informative sketch of this evolving business. On the whole, this survey picked up relatively few differences between the essential frameworks of funds residing in the buyout/corporate finance, mezzanine and venture capital segments of private equity investment. As key differences have been reported in much larger and more comprehensive treatments of this topic in the United States, including Key Terms and Conditions for Private Equity Investing (William M. Mercer, 1996) and Private Equity Partnership Terms and Conditions (Asset Alternatives, 1999), it is likely this is due to Canada’s smaller and still developing market. The following findings on partnership terms and conditions are generally presented in the order questions were asked on the survey questionnaire. 1. Practices in Fund Management/Organization Limits on Fund Size The vast majority of survey respondents (84%) indicated pre-established limits on the size of their private equity funds, though very few specific details were given. For the most part, upward limits were provided, with respondents pointing to the final levels at which funds closed, suggesting they had met their targets. A small handful of respondents noted the use of ranges to determine the targeted size of funds, reflecting minimum and maximum parameters. - 17 -
  20. 20. Life of the Partnership Consistent with standard practice in American and Canadian private equity markets, the average lifetime of a partnership, according to survey respondents, was 10 years. Several funds also noted an option to extend terms, subject to the approval of the LPs (and sometimes at the discretion of the GPs) for 2 years or more. Investment Restrictions Virtually all respondents to the survey identified restrictions of some type on the investment activity of a given fund. The most commonly identified restriction referred to the percentage of fund capital invested in a single company in the portfolio. 45% of respondents cited 20-25% of total fund assets as the standard limit in this regard, with other answers ranging widely, from as low as 10% to as high as 49.9%. Lower threshold levels were more typical in venture capital funds, while higher levels were more typical in buyout funds. Approximately one-third of respondents highlighted prohibitions on investment in particular sectors, such as real estate, natural resource extraction, the financial sector, gaming, etc. Several venture capital funds also specifically ruled out non-technology sectors. Other investment strictures were less frequently mentioned, but were clearly important to individual funds. In the case of several buyout and mezzanine funds, there were prohibitions on transactions involving start-up and other early stage companies in the domain of venture capital, while some venture capital funds excluded deals involving publicly listed firms. Other excluded activity included particularly long investment horizons (e.g., 10 years) and investments in other private equity funds. Non-resident Participation Over two-thirds of survey respondents (68%) indicated a policy enabling the participation of non-resident investors in fund activity. A common method for implementing this policy was the establishment of parallel funds. Co-investment Rights Reflecting the strong and growing interest of many LPs to obtain rights of co-investment alongside on-going fund activity, 82% of survey responses flagged this particular provision. About one-fifth of respondents confirming the existence of co-investment features said they extended these rights to all LPs – in some cases, at the discretion of the GPs. However, the majority specified that such rights exist only for “lead investors” or “significant limited partners” – in other words, LPs with very substantial equity stakes in funds (e.g., in excess of 10% or 20% or total capital under management). - 18 -
  21. 21. GP Co-investment Rights Only 10% of survey respondents indicated the existence of rights to co-investment opportunities for GPs and their affiliates (e.g., employees in a given investor group). Such provisions tended to be found where major corporate investor groups were the sponsors/managers of funds and, consequently, sought co-investment rights that approximated their equity stake. Post-expiry Capital Calls Forty-six percent of survey respondents indicated that capital calls could be made following the expiry of the commitment period for specific uses, the most frequently cited being completion of pre-determined investments, follow-on financings of existing portfolio companies and significant expenses of the fund. Re-investment of Capital Gains A minority of survey respondents (32%) confirmed an ability to re-invest a given fund’s capital gains, usually within specified limits of time (i.e., only within the first 1 to 5 years of the partnership’s term). Advisory Committees Eighty-four percent of survey respondents confirmed there was a formal advisory committee attached to their funds. According to respondents, committee functions tend to be chiefly input-oriented and related to broad matters of fund governance. These matters pertain to the resolution of conflicts of interest, changes to LP agreements, issues that were not covered by LP agreements, and the review and approval of valuations, et al. Committees also act as forums for GP status reports to the LPs, as well as other kinds of information sharing. They may also feature consultative discussion of fund strategy, private equity market trends, potential deal opportunities, etc., however, almost all respondents were clear that these bodies had no direct role in investment decision-making. - 19 -
  22. 22. Key Person Provisions To address LP concerns about a potential loss during the partnership’s term of managers possessing essential skills and experience, the vast majority of survey respondents (77%) flagged the existence of key person provisions. In general, key person provisions dealt with the possibility of turnover of certain named individuals in GP management groups or retention of a specific number of managers (e.g., one- fifth or one-half of the overall GP team), since the fund’s inception. Some funds specify an LP notification process in the event of management turnover and “exceptional circumstances” if turnover cannot be reasonably prevented. Depending on the nature of the turnover, respondents identified several allowable actions on the part of the LPs, including suspension of any further capital calls (beyond those already advanced) or termination of the fund. Another action may be postponement of any new investment activity until LPs agree on the replacements for lost managers. Guidelines for Fund Wind-downs/Liquidations Concerning the act of winding-down or liquidating funds, very little information was supplied by respondents to the survey, with several stating they had no formal policy in place. Those that did comment on this topic cited standard procedures in private equity markets whereby GPs or their agents assume full responsibility for settling accounts and distributing all remaining cash proceeds and in-kind assets linked to the partnership at its termination date. The manner and timeframe for this process are usually at the discretion of GPs, though some respondents mentioned a requirement for input from LPs/Advisory Committees in certain circumstances. Defaulting LPs Although examples of LPs defaulting when a capital call is made are considered fairly rare, 79% of respondents to the survey identified policies and processes for handling such an event. In general, GPs introduce penalties, such as forfeiture of the LP’s stake in the partnership or access to profits, as a means of discouraging defaults. Other legal actions may also be pursued. In addition, GPs look to fill the capital supply gap by offering all or part of the defaulting LPs’ interest up for sale to other investors. - 20 -
  23. 23. 2. Financial Terms and Conditions GP Capital Commitments LPs are strongly interested in a GP equity stake in private equity funds – reflecting a commitment over and above their responsibilities as managers – as a way of more closing aligning interests between the two parties. It may not be surprising then to see that virtually all survey respondents indicated some level of GP capital commitment to their funds, usually within a range of 1-5%. A handful of respondents reported GP commitments that surpassed the 5% level. Management Fees Management fees were reported by all respondents to the survey, calculated as a percentage of total capital commitments in a given fund. The average fee was 2%, with only minor variance in some funds. Investment-Related Fees The extent to which portfolio firms were charged investment-related fees for such services as originating the transaction, monitoring company progress over time, and other kinds of consultation, etc., varied among surveyed funds. Only about one-third of respondents (34 %) observed this general practice and most of these were in the buyout/mezzanine fund segments of private equity, as is commonly the case. Organizational Expenses Very few survey responses were given with respect to organizational expenses (e.g., travel, legal, accounting and other expenses), as a percentage of total fund size, often because the calculation was infrequently made. Those responses that were obtained indicated organizational expenses to be 0.2%, on average. This is an interesting finding, as LPs in American private equity markets are increasingly trying to gain insights into such expenses, and to control them. - 21 -
  24. 24. Carried Interest Almost universally, survey respondents indicated the rate of carried interest to GPs to be 20%, which is, of course, standard practice in American and Canadian private equity markets. In a few funds, carried interest was directly linked to performance and could, as a consequence, vary by several percentage points, plus-or-minus, from the 20% standard. In this way, treatment of carried interest complemented or replaced the use of preferred returns (see below) in these funds. For reasons of confidentiality, most survey respondents declined to disclose the portion of carried interest that is held by, or is available to, fund managers. Close to two-thirds of funds (64%) indicated a policy whereby carried interest was subject to claw-back if judged too high relative to overall returns at the time of termination. Preferred Returns The large majority of survey respondents (79%) indicated having a preferred (or hurdle) rate of return that is generally available to the LPs prior to GP receipt of carried interest. The preferred rate differed from fund to fund (i.e., from a low of 5% to a high of 25%), with an average set return of 8%, on balance. For the most part, the policy for LP distributions prior to GP receipt of carried interest – where it was articulated by survey respondents – is clearly linked to the delivery of preferred returns and other essential items, such as return of original capital contributions, repayment of fees, etc. A small number of respondents noted detailed schedules for making these minimum distributions over the lifetime of the partnership. Nature of LP Distributions Survey responses provided little information about frequency of cash/in-kind distributions to LPs over the course of a fund’s term. Most respondents noted that major distributions were made only when investments were fully matured, while shorter-term streams tended to comprise dividend, interest or fee income, et al, when realized. Some funds had schedules for distributions (i.e., annually, semi-annually, quarterly, and where divestments have occurred), while distributions in other funds were more at the discretion of GPs. Placement Fees Forty-one percent of survey respondents acknowledged incurring placement fees in their funds. GPs bore this expense in approximately 60% of the reported cases (with LPs assuming such costs in the others). - 22 -
  25. 25. Fund Valuations Valuation practices in private equity investing vary quite widely from fund to fund, with few broadly accepted guidelines in the industry. It is not surprising then that only 43% of survey respondents reported the existence of a clearly defined policy regarding the determination of fund holding values. It is likely that such policies exist among other funds polled, however, several respondents were reluctant to disclose these for reasons of confidentiality. Where guidelines were noted, illustrative details were restricted. Some funds rely on formal methodologies established for evaluating privately owned assets, supplied by auditors, and as described by the British Venture Capital Association or the National Venture Capital Association (in the United States). Others rely on recognized “best practices” in private equity markets in Canada and the United States, such as GP-LP agreement on fair value based on recent market experience, peer performance, benchmarks against public markets, and other credible financial techniques. A reliable means for some fund managers is basing valuations on the last round of financing in a portfolio firm that is conducted with the participation of a third party investor. Other approaches were also mentioned. Fifty-seven percent of respondents indicated that fund valuations were performed by GPs – often subject, however, to the review of independent auditors, as well as LPs/Advisory Committees – 20% indicated valuations were undertaken externally by independent auditing firms, and the rest declined to answer. - 23 -
  26. 26. Conclusion It is evident from the findings of The Private Equity Activity Survey that the Canadian market is currently enjoying an unprecedented period of expansion and diversification, rooted in mounting business demand and improving supply conditions underlying the activity of private independent funds, corporate funds, LSVCCs and other major investor groups. These trends are best documented for the venture capital industry; however, this survey indicates that the same may be broadly asserted in the case of buyout and related corporate investment activity and mezzanine financing as well. Nonetheless, all segments of the private equity market in Canada remain in an early phase of growth, as compared to the United States, and are likely to encounter significant challenges in the years ahead. Among the most critical to longer-term market development is a still reticent community of Canadian pension funds, insurance companies, endowments/foundations and other institutional investors, which largely remains uninformed about private equity as a viable and strategically important asset class. This is no small point, as American institutional capital infusions over the 1990s effectively led dynamic market growth in that country and continues uninterrupted today. It is difficult to imagine a comparable Canadian experience without this institutionally sourced participation. As was noted in the Introduction, this survey has been a major first step in describing the size, scope and dimensions of Canada’s entire private equity universe. More work will be required to flesh out the details of evolving market segments to give industry professionals, institutional investors, market intermediaries and observers the data and analysis they need to address challenges and monitor trends in capital supply, deal opportunities and investments over time. - 24 -
  27. 27. List of Respondents to The Private Equity Survey Argosy Partners MWI and Partners Merchant Banking BCE Capital NB Capital Partners Business Development Bank of Canada Novacap Investments BMO Nesbitt Burns ONCAP LP Borealis Capital Corporation Ontario Municipal Employees Brightspark Ventures Retirement System CAI Capital Group Ontario Teachers Pension Plan Board CCFL Mezzanine Partners Orchard Capital Group Canadian Science and Technology Growth Fund Penfund Management Celtic House International Primaxis Technology Ventures Covington Capital Quorum Funding Corporation Clairvest Group Roynat MB I & Company First Ontario Labour-sponsored Investment Fund RBC Capital Partners Fonds de solidarité des travailleurs Scotia Merchant Capital Corporation du Québec (FTQ) Schroders and Associates Canada HSBC Capital (Canada) Skypoint Capital Corporation Innovatech du Grand Montreal Technocap Jefferson Partners Capital Telsoft Ventures JL Albright Venture Partners TD Capital Kilmer Capital Partners Tricap Restructuring Fund Manulife Capital VenGrowth Capital Partners McCarvill Mezzanine Financial Corporation Ventures West Management McKenna Gale Capital Working Ventures Canadian Fund McLean Watson Capital XDL Intervest Capital Middlefield Bancorp MM Venture Partners - 25 -