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Bankrolling Canada
Exposed: The secretive world of private equity
funding--and what it means to your company
Published By: Canadian Business
Date: November 24, 2003
Section: Features
By: Jason Kirby
Internet Link: Canadian Business
It happens a couple of times a year. A mammoth U.S. private
equity fund sweeps into Canada, buys up a company and
eventually flips it into the public markets. The process makes
for great headlines--and, for those involved, stunning
profits--but then quickly fades into the background. Those
megadeals, like last August's $1.2-billion announcement that
Bain Capital plans to buy Bombardier's recreational business,
are about the only times many people give any thought to the
secretive world of private financing. After all, they don't
call it private for nothing.
But while giants such as Bain Capital, Kohlberg Kravis
Roberts & Co. and the Blackstone Group may steal the
spotlight occasionally, dozens of mid-market U.S. funds are
streaming across the border in search of investments in the
US$10-million-to-$100-million range. After years of bland
returns in the tight U.S. market, the funds are targeting
Canada for many of the same reasons fuelling the soaring
loonie: a strong economy, profitable companies and, most of
all, relatively cheap assets. At the same time, the domestic
private equity sector has undergone a boom of its own, and
players here say they're up to the challenge. They'll need to
be. As one industry observer puts it: "If they don't get
their act together, the U.S. funds waiting at the gate will
eat them up."
Private equity refers to any deal that takes place outside
the stock markets, from early-stage venture financing to
management-led buyouts and corporate divestitures. (In the
United States, there's a sharper distinction between venture
capital and the rest, which is considered private equity.) In
recent years, more companies turned to private funds for
financings, eschewing public markets and the scrutiny that
comes with them. At the same time, wealthy individuals and
institutional investors, fed up with Wall Street shenanigans,
are pumping money into private equity funds, which have had
returns 10% to 15% higher than the stock markets over the past
few years. The Canadian Pension Plan Investment Board, for
instance, has said it wants 10% of its $61.6 billion in assets
in such investments.
Recent times have been difficult for private equity funds
south of the border, with average returns dipping into the
red. The reason: it's a seller's market. There is a large
number of funds, with about US$50 billion to invest, prowling
for opportunities. That, in turn, has driven up valuations for
private companies. Meanwhile, funds are having to put up a lot
more of their own money (up to 50% of a deal's value) than
they did in the leveraged buyout days of the 1980s, when funds
typically paid only 5% to 10%.
The key now in the private equity game is to add value to
acquired firms. That can mean providing strategic guidance as
a board member or parachuting new management into a broken
company. The average life of a fund is 10 years, so private
equity players must get down to business quickly. The question
for capital-hungry companies is who can do that better, U.S.
funds that boast experience, or Canadian ones here on the
ground.
Jay Jester, senior vice-president of Boston's Audax Group,
which has US$1 billion in assets under management, will fly up
to Toronto in mid-November to speak at a private-equity trade
show. The event is being hosted by the Toronto chapter of the
Association for Corporate Growth (ACG), a professional
organization that has several dozen chapters across North
America and Europe. Jester will be joined by 34 North American
funds that have a combined $20 billion to invest. But Jester
has more on his mind than delivering a speech. As a member of
the Boston chapter of the ACG, he has often made contacts with
lawyers, accountants and company executives at similar
conferences that have led to deals. "By our presence, we
want to let people know we're interested," says Jester.
"The idea is to turn loose ties into real deals."
Here's how Jester and other U.S. private equity managers,
with between half a billion and a billion dollars to invest,
view Canada: the bulk of companies here are considered
mid-market and fall below the radar of the giant private
equity firms, and because there are relatively few funds
operating in Canada, valuations are lower than in the United
States. Audax specializes in "hairy transactions"
involving troubled companies. It already has one Canadian
connection--CIBC has been an investor since Day 1. But Jester
says it could take some time before he finds a deal here.
"I'm never arrogant enough to say we're going to come up
with our gringo dollars and pick up companies on the
cheap," he says.
Some mid-market U.S. firms have already found success. Last
March, Craig Media turned to Providence Equity Partners of New
York to raise $110 million in advance of launching its new
television station, Toronto 1. Wellspring Capital Management,
also of New York, was behind the public offering of Hockey
Company Holdings Inc. (TSX: HCY) this past summer, and counts
the Ontario Teachers' Pension Plan as its largest investor
with a $117.5-million stake.
Still, in terms of mid-size domestic deals, Canadian firms
have led the pack. In February 2002, Toronto financier Brent
Belzberg launched TorQuest Partners. Its first fund, with $180
million in assets backed by several institutional investors,
purchased Granby Steel Tanks and Gerling Canada Insurance Co.
In late September, CAI Capital of Toronto closed its third
fund after attracting $375 million from investors, having
already made 13 investments since 1989. And Edgestone Capital
Partners closed its second fund in late October with $361
million. In November 2002, the fund partnered with former Bay
Street star Steve Hudson to buy Sy Sperling's Hair Club. The
number of Canadian funds is growing, as large pension funds,
which once invested directly, hand the job to independent
firms.
If Gilbert Palter, managing partner of Edgestone, is
worried about U.S. funds encroaching on his turf, he doesn't
show it. He says there are nearly insurmountable barriers for
foreign funds to succeed, and points to the different
regulatory and business environments. "Any U.S. firm can
assess a Canadian business, but they don't have the experience
of understanding Canada's unique logistics," he says.
"Sure, you can hire a consultant, but when you're writing
a $30-million cheque, you can't spend $3 million to $4 million
learning what you need." Says another private equity
investor, TorQuest's Belzberg: "I always tell Americans
that in Canada we all know each other and it's a very small
group. You have to be part of this community to be
successful." If anything, Palter says, U.S. investors
will give their money to Canadian firms to invest up here--Edgestone's
investors include GE Asset Management (General Electric's
employee pension fund) and Northwestern Mutual Life.
So which nationality of private equity fund should Canadian
companies be courting? It often comes down to scale. For small
companies looking to raise up to $10 million, domestic funds
are, for now, the easiest source of capital. For larger
companies, there are alternatives. Canadian funds have the
advantage of being up close and personal when advising
management on decisions--something a fund based in, say,
Dallas might find difficult. At the same time, because the
U.S. market is more mature, its funds specialize in specific
industries. For instance, there are U.S. funds that buy only
strip-mall restaurants or manufacturers of ladies'
undergarments. Canadian funds don't have the mass to do that
yet. Domestic and U.S. funds have begun to team up for
investments the same way investment banks form syndicates to
spread the risk around several institutions. That trend is
likely to catch on in a big way.
In the end, the arrival of new domestic and U.S. funds is
good for companies either way. The more competition, the
higher they'll be able to sell for. The flip side, of course,
is that higher valuations will mean lower returns for private
equity investors down the road. But until then, the feeding
frenzy will continue.
With files from Will Seccombe.
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