Article by Patrick G. Barry, Sarbjit S. Basra and Claire M.C. Kennedy
Despite reduced activity levels in recent years, private equity has grown to be a significant alternative asset class in Canada.
Private equity activity in Canada has, as in the U.S. and elsewhere, continued to suffer the effects of the relatively weak investment environment that has persisted since 2001. Nevertheless, the total amount of capital committed to private equity in Canada rose by the end of 2003 to C$48.6 billion (an increase of over C$8 billion from 2002). Of this amount, the buyout and the venture capital sectors comprised approximately 47% each, with the remaining 6% being accounted for by the mezzanine debt sector.
Private independent fund managers represented 36% (C$17.5 billion) of the total capital, followed by institutional investors at 32% (C$15.4 billion) committed to private equity in 2003, labor-sponsored venture capital corporations and provincial venture capital corporations at 19% (C$9.2 billion), corporate funds (i.e., divisions or subsidiaries of Canadian financial or industrial corporations) at 8% (C$4.1 billion) and government funds at 5% (C$2.5 billion).
Overall, institutional investors accounted for approximately 50% of the private equity funding in Canada in 2003, with over 90% of this amount coming from the largest public sector pension funds. Individual investors and Canadian financial and industrial corporations are the other major sources of capital for private equity funds in Canada, re p resenting 21% and 14% of the total amount committed in 2003, respectively.1
Major Players: Recent Developments
With respect to institutional investors, the Canadian private equity market is dominated by a relatively small number of pension funds and institutions, such as the Canada Pension Plan Investment Board, Ontario Teachers' Pension Plan Board ("Teachers"), Ontario Municipal Employees Retirement System ("OMERS"), Hospitals of Ontario Pension Board, CDP Capital (the private equity arm of the Caisse de depot et placement du Quebec), Alberta Revenue and British Columbia Investment Management Corporation. In 2003 and 2004, a number of these institutions, such as Teachers' and OMERS, announced an intention to allocate additional capital to direct investing activities, although they have also indicated a continued intention to invest in private partnerships sponsored by Canadian private equity firms. This move to greater direct investing is expected to have some effect on the ability of Canadian-based private equity firms to raise new funds, although the extent of that effect has yet to be felt.
With respect to fund sponsors, private equity firms of various sizes are active in the Canadian private equity market in a wide range of investment categories: venture (early, mid and late stage), buyout, mezzanine debt and funds of funds, with further segmentation based on geographic and other factors such as the type and size of the target investment opportunities. In addition, certain fund sponsors limit their funds to particular industries such as real estate and infrastructure projects. Moreover, a number of fund sponsors are institutions that have established a fund to serve as that institution's exclusive or primary private equity vehicle for certain types of deal flow initiated by that institution.
The final closing in 2004 of the C$2.2 billion Onex Partners LP, which will focus on buyout opportunities in North America, was a significant development in the Canadian private equity industry as it created the largest private equity fund formed by a Canada-based sponsor/manager. In addition, the following fund sponsors completed fundraising for the following funds in 2003 and 2004:
CAI Capital Partners and Co. III (C$375 million, buyout)
EdgeStone Capital Partners
EdgeStone Capital Equity Fund II (C$361 million, equity securities of mid-market companies)
EdgeStone Capital Venture Fund II (C$102 million to date, earlystage technology companies)
Jefferson Partners IV (C$150 million, venture)
McKenna Gale Capital
MG Stratum Fund III (C$305 million, mezzanine debt)
TD Capital Mezzanine Partners
TD Capital Mezzanine Partners Fund (C$500 million, mezzanine debt)
TD Capital Private Equity
TD Capital Private Equity Investors Fund of Funds (C$526 million)
Ventures West 8 (C$250 million, technology start-ups)
Private equity funds in Canada are typically formed as limited partnerships, principally because of the flow-through tax treatment provided for partners. An additional benefit of a limited partnership structure is the limited liability protection afforded to limited partners. Most funds are also set up as committed funds-meaning that limited partners are contractually required to contribute capital up to their committed amount, subject to limited opt-out rights for tax, legal or regulatory reasons.
The overall structure of a fund is dependent primarily on the investors participating in the fund and their unique requirements and characteristics in respect of their investment in the fund. For example, in addition to the main partnership, a fund sponsor may establish U.S.-based or other offshore partnerships to accommodate nonresident investors. Such "parallel" partnerships are typically permitted to invest on a side-by-side basis (i.e., in parallel with the main fund). Moreover, depending on the nature of coinvestment rights provided to significant investors and the existence of coinvestment programs for employees of an institutional investor, additional limited partnerships may also be established to permit such investors or employees to coinvest with the main fund vehicle(s).
Most private equity funds in Canada are established in the jurisdiction where the fund sponsor or the general partner of the fund principally conducts its business. However, fund sponsors may in certain situations decide to establish the fund partnership in the province of Manitoba, as the provisions of the Manitoba limited partnership legislation provides greater limited liability protection to limited partners as compared to the legislation in effect in the other provinces, including Ontario.
Tax is a key consideration in the structuring of private equity funds, which, as noted above, are generally formed as limited partnerships and often have a mix of domestic and foreign, and taxable and tax-exempt investors (e.g., pension funds).
Canadian tax-exempt investors, which accounted for approximately 50% of private equity funding in 2003, are subject to the "foreign property" rules in the Income Tax Act (Canada) (the "Tax Act"). Under these rules, subject to narrow exceptions, all partnership interests are deemed to be foreign property regardless of where the partnership is organized, the tax residence of its partners or the location of its assets, all of which may be 100% Canadian. The principal exemption is the "qualified limited partnership" ("QLP"), which is defined in the regulations to the Tax Act. The QLP definition is quite complex and its requirements must be met at all times from the time of the formation of the partnership. It is therefore essential to consider the QLP rules before an initial limited partnership agreement is signed, because it will not be possible to amend a partnership agreement to make an existing partnership qualify as a QLP.
The current QLP rules require that the QLP limit its activities to investing in shares, options and debt of corporations. (A QLP is not permitted to carry on an active business directly or through a partnership.) In addition, a QLP must be unitized and have only one class of limited partner units that are "identical in all respects." A QLP is also limited in the amount of foreign property it can hold (currently 30%). The fact that a QLP can hold foreign property up to this limit means that limited partners can "leverage" their foreign property exposure by investing in a QLP, the units of which will be 100% non-foreign property, that is partially invested in foreign property. This ability to leverage foreign property is not available to partners holding more than 30% of the units (alone or together with a non-arm's length group). An outright prohibition on any partner (or non-arm's length group) holding more than 30% of the units was eliminated in 2003 in favor of a look through rule whereby such limited partners pick up their proportionate share of a QLP's foreign property (i.e., no foreign property "leveraging" is permitted for them).
Earlier this year, the Canadian Department of Finance released draft regulations that will further relax the QLP requirements. In particular, the "identicality requirement" will be relaxed so that the units of limited partners need only be identical with respect to capital contribution obligations and distribution entitlements. Consequently, the draft rules will permit different voting entitlements for limited partners, which is a common feature of non-QLPs. The investment restrictions will also be relaxed to permit QLPs to invest in other QLPs. In addition, the 30% foreign property limit is proposed to be repealed. Instead, the 2003 "look-through" rule will be extended so that where a QLP's foreign property holdings exceed 30%, all limited partners (not just those holding more than 30% of the units) will pick up their proportionate share of the QLP's foreign property. The draft rules are proposed to be effective for 2003 and subsequent taxation years.
Unfortunately, while the purpose of the proposed amendments is clearly to provide relief, there are technical problems with the draft Regulations and, as written, the proposed changes are in certain respects inconsistent with customary commercial terms. It is understood that the Department of Finance is aware of these issues and is considering possible further changes to the QLP regulations. Thus, although the draft regulations represent a welcome liberalization of the QLP regime that should help eliminate a number of practical problems, further changes will be required to achieve this result.
Given the significance of institutional investors in the Canadian private equity market, the QLP rules will continue to be a key structuring consideration for private equity funds. Even with a revised version of the proposed changes, there will remain considerable complexity in the QLP rules, particularly in respect of distributions and income and loss allocations. Structuring to take these new rules into account and careful ongoing attention to these matters will continue to be essential for fund sponsors and investors.
The following are some of the key trends that are developing in Canadian private equity fund formation:
- Management Fees. Management fees continue to face downward pressure from limited partners, particularly in the buyout sector. Limited partners are increasingly of the view that the interests of a fund sponsor/general partner are more closely aligned with the interests of the limited partners through the performance-based incentive provided by the carried interest, rather than the management fee. In short, from a limited partner's perspective, there should be little if any profit margin on management fees, as they are intended to provide the management company with sufficient revenue to cover operating costs of the management company and not to serve as an additional source of income. Another obvious reason for reducing management fees is that payment of management fees by limited partners reduces the return earned by such partners on their invested capital. A related trend is a greater insistence by limited partners of the need for information on operating budgets for the management company and the need for transparency of operating costs.
- Carried Interest. The general partner's carried interest (i.e., the right to receive a certain percentage of the net profits of the fund-also referred to as the "promote" or an "override") is generally set at the traditional 20% level. However, general partners and limited partners are now increasingly likely to change the priority of distributions as between the general partner and the limited partners so that limited partners recoup to a greater extent the capital they have contributed to a fund prior to the general partner receiving any of its carried interest. Related to this issue is a desire on the part of some limited partners to minimize the chance of a claw-back event by reconciling the carried interest distributions on a more frequent basis, rather than waiting until the liquidation of the fund.
- Performance Data. Limited partners a re increasingly asking for more detailed and regular information on the performance of the underlying investments of the fund.
- Co-investment Rights. While the ability of a limited partner to coinvest alongside the fund has existed for some time, limited partners are now increasingly formalizing such co-investment programs with fund sponsors.
Private Equity Investment Transactions
Overview: Direct Private Equity Investors
The high end of the Canadian private equity investment market is dominated by a small number of Canadian players, including the private equity arms of pension funds such as Teachers', OMERS and the Caisse and private equity firms such as Onex, as well as private U.S.-based firms such as Bain Capital, Kohlberg Kravis Roberts & Co., Thomas H. Lee Partners and Oak Hill Capital Partners.
There are many Canadian firms operating principally in the middle market in Canada, including EdgeStone Capital Partners, TD Capital, ONCAP (Onex's small-cap fund) and CAI, although the number of active investors has decreased in the last several years as a result of a decreased emphasis on private equity investment by some of the Canadian chartered banks. Some of these middle-market firms manage or sponsor equity and mezzanine funds, while others specialize in only one area.
In the venture capital area, both U.S. and Canadian-based venture capital firms are active in Canada, although activity by U.S. firms dropped in 2003 from the high levels of activity seen in 1999 through 2001. Some of the more prominent Canadian venture capital firms include EdgeStone Capital Partners, Celtic House, Jefferson Partners, Mosaic Venture Partners, Ventures West, VenGrowth Capital Partners and J.L. Albright. The Caisse and Teachers' are also active direct venture capital investors.
Recent Market Activity
Private equity investment activity levels in Canada continued to be relatively low in 2003 as compared to levels in the late 1990s and 2000. According to McDonald & Associates Ltd., the total amount of private equity investment in Canada was approximately C$4.2 billion in 2003, compared to approximately C$5 billion in 2002. Of the total from 2003, approximately C$1.5 billion was invested in start-up and early-to intermediate-stage businesses, approximately C$2.1 billion was committed to buyout transactions, and C$572 million was loaned or otherwise disbursed in mezzanine finance transactions.
This low level of private equity investment activity in 2003 was a continuation of a trend that started in early 2001 and continued through to the end of 2003. The reduction in activity levels was caused, in part, by a significant contraction in credit availability in Canada. This credit contraction also resulted in an increase in the required equity-financing component for many transactions. In 2004, it appears that credit availability in Canada is improving, although a reduction in the corporate and commercial loan portfolios of a number of Canadian chartered banks is expected to limit this improvement.
In late 2003 and the first three quarters of 2004, U.S.-based firms continued to dominate investment transactions in the high end of the Canadian private equity market. These transactions included:
- the acquisition by Bain Capital, the Caisse and members of the Bombardier family of Bombardier's recreational products division, for approximately C$960 million;
- Bain Capital's purchase of Super Pages Canada, a directories business owned by Verizon Communications Inc.; for approximately US$1.54 billion; and
- the acquisition by Thomas H. Lee Partners of Progressive Moulded Products Ltd. from an investment group led by Oak Hill Capital Partners.
As was the case in 2002, there were relatively few public market exits from private equity investments in 2003. An exception was the completion of Onex Corp.'s exit from the Canadian sugar-refining business when it disposed of its investment in Rogers Sugar Income Fund through a secondary public offering of units of the fund. Earlier in 2002, Onex had sold its interest in Lantic Sugar to Rogers Sugar in exchange for units of the fund. In 2004, there have been a number of investment exits through initial public offerings, including the following:
- the C$200 million IPO of Osprey Media Income Fu n d , whose investors included Scotia Capital and Teachers' Merchant Bank;
- the C$85.7 million IPO of Richards Packaging Income Fund, in which both EdgeStone Capital's equity fund and mezzanine fund were investors; and
- the C$32 million IPO of Q9 Networks Inc., whose investors included TD Capital, Scotia Capital, VenGrowth Capital Partners and J.L. Albright.
Selected Legal and Business Issues
Buyout Sale Process in Canada
In Canada, it has now become the norm for buyout transactions to take place after having been fully marketed by an investment bank or other intermediary, typically through a modified auction process. This has been the case for some time in the high end of the market, but it is now unusual to have even small buyout transactions completed without being marketed. The most typical process is to have multiple parties submit, through an intermediary, expressions of interest containing an indicative range of values; based on the expressions of interest, the seller will then narrow the list of potential purchasers, typically going forward on an exclusive basis with one party before negotiating detailed terms. A relatively recent phenomenon in Canada is the emergence of auctions where detailed terms are negotiated with multiple parties, with the winning bidder not being selected until the last possible moment. The ability of sellers to engage in this type of auction is contingent on a number of factors, including the strength of the buyout opportunity and the willingness of potential purchasers to participate in this type of process.
Income Fund Public Offerings
In Canada, income trusts have become a very effective public market exit vehicle for private equity participants. In fact, a significant majority of the initial public offerings in Canada in the last several years have been by way of income trust. In the past, only mature businesses with steady cash flow streams were deemed appropriate for conversion into income trusts; however, in recent years, sellers and investment bankers have become more aggressive in the types of businesses that may be converted.
The basic income trust structure is generally the same across all industries, although it is often modified in order to accommodate specific tax, corporate, regulatory or planning objectives. In a typical situation, a Canadian resident trust issues and sells interests, usually in the form of units of the trust, and uses the proceeds from the sale to acquire a business or income - producing asset. The business or asset is recapitalized, principally with debt held by the trust and often with senior debt held by a bank or other financial institution, with the result that the taxable income of the business is reduced significantly, or even eliminated, as a consequence of the cost of carrying the debt.
In addition to the public offerings noted above, perhaps the most notable recent income trust conversion was the 2003 conversion of Yellow Pages Group, Bell Canada's former yellow pages directories business, into Yellow Pages Income Fund and the related C$935 million public offering of units of the fund. At the time of its conversion, the principal shareholders of Yellow Pages Group were funds managed by Kohlberg Kravis Roberts & Co. ("KKR") and Teachers' Merchant Bank. In June 2004, KKR disposed of its last remaining interests in Yellow Pages Income Fund, marking the end of its staged exit from this business.
Going Private and PIPE Transactions
Private equity investors in Canada have traditionally been reluctant to attempt to take publicly traded entities private or even to make investments in public entities (often referred to as "PIPE" transactions-private investments in public equities). This is because of, among other things, private equity investors' unfamiliarity and unwillingness to deal with the Canadian securities regulatory regime governing such public company investments, as well as the uncertainty and costs associated with many types of these transactions.
Going Private Transactions
In the province of Ontario, Ontario Securities Commission Rule 61-501 governs the conduct of insider bids, issuer bids, going private transactions and related-party transactions. The requirements of Rule 61-501 would typically have to be considered in connection with the acquisition of a Canadian public company by a private equity firm, particularly if the acquiror wishes to involve management of the target in the making of the bid. If an acquisition is being completed by way of takeover bid and there are management shareholders of the target company, the prohibition on collateral benefits contained in Canadian securities laws may also affect the ability of the acquiror to involve management of the target company in any transaction. These rules operate collectively as a significant constraint on the ability of potential bidders to work with management in conjunction with a possible going private transaction.
There are few recent examples of private equity investors that have taken Canadian public companies private. In mid-2004, an investor group led by Hicks, Muse, Tate & Furst, TD Capital and CIBC Capital Partners acquired Persona Inc., a cable television operator, in a transaction valued at approximately C$406 million. In another 2004 transaction, an investor group led by TD Capital, OMERS Merchant Banking Group and industry executives completed the acquisition of CINAR Corp., a publicly traded integrated entertainment and education company, by way of a plan of arrangement.
As noted above, it is relatively rare for private equity or venture capital firms in Canada to make investments in publicly traded entities. However, there is a small market for PIPE investment transactions, which typically involve small-capitalization public companies. PIPE transactions are often attractive to small to medium-size public companies because of, among other things, their limited access to capital or, in some cases, their need for the expertise and experience offered by a private equity firm (for example, where expansion capital is required in connection with a possible acquisition transaction by the operating company). As is the case with going private transactions, the regulations associated with investing in Canadian public companies often discourage investors from completing PIPE deals in Canada.
There are certain aspects of Canadian securities laws that discourage PIPE investments, including the following:
- The holding of 10% or more of any class of voting or equity security (or securities convertible into voting or equity securities of a public company) requires public disclosure of that fact; and
- Any owner of 20% or more of a class of voting or equity securities is considered to be a holder of a control block, and the holder is subject to potentially problematic rules relating to the acquisition and disposition of securities of the company.
In addition to the issues raised by Canadian securities laws, Canadian public companies are typically reluctant to grant to private equity investors the types of rights and controls such investors would typically obtain when making a significant private company investment. It is not unusual for a private equity investor to negotiate the right to nominate one or more directors of a public company in which it is making an investment. However, it would be atypical for a shareholder of a Canadian public company to have approval rights over fundamental corporate decisions and preemptive rights with respect to the issue of treasury equity securities, rights that are commonly granted in the context of private company investment transactions.
Even if the above-noted issues are overcome, private equity investors often find that there is effectively little or no liquidity for an investment in a small-capitalization public company. In that situation, depending on the rights it has been able to negotiate, an investor may find that, unless it has effective control of the company, it will be in the difficult situation of having limited influence over the business and affairs of the company and no ability to exit from the investment.
This article first appeared in The 2005 Lexpert/American Lawyer Guide to the Leading 500 Lawyers in Canada.
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