Despite continued economic and geopolitical uncertainty, 2023 offered some measured optimism for the Canadian private equity (PE) market. A rise in aggregate deal value in comparison to 2022 suggests that PE firms are finding ways to overcome these challenges – both on the sponsor and investor sides. McCarthy Tétrault's PE professionals weighed in with observations on 2023 and predictions on what investors and firms can expect for 2024.
Takeaway 1: Despite Headwinds, the PE Market Remains Active
While there were fewer deals in 2023 than 2022, deal value remained robust. Large transactions were few and far between, with about 70% of 2023's deal count coming from add-on acquisitions. Inflationary pressures and rising interest rates have contributed to a more "stop-and-go" negotiation process, with deals taking longer to structure and develop, and some transactions failing to close altogether. Despite these headwinds, deal value grew by approximately 35% in 2023 to $19.2 billion – a reassuring sign looking ahead to 2024.
Takeaway 2: The Slowdown of M&A and IPOs is Causing Ripple Effects
A dearth of M&A and IPO exits has resulted in a slowdown in fundraising and increased demand for continuation funds and other liquidity alternatives. As fund sponsors have difficulty returning capital to investors through M&A and IPO exits, investors in turn have less capital to make new fund commitments, resulting in a slower fundraising environment. To free up money that investors can redeploy in new fund commitments, sponsors are looking for ways to return capital to their limited partners (LPs) outside of traditional exits – and continuation funds remain a compelling alternative . General partners (GPs) have also picked up on this high demand for liquidity solutions, and have been aggressively marketing secondaries funds to meet this demand.
Takeaway 3: Fund Terms are Adjusting to the Current Economic Environment – but Managers Stay Firm
Fund managers are reluctant to compromise on the favourable fund terms they obtained during the prior GP-friendly fundraising environment. While one might expect that the current fundraising challenges would lead to more investor-friendly fund terms, this has generally not been the case. Managers with an established track record continue to push for GP-friendly terms, and in certain instances GPs have obtained even more favourable terms than in the prior fundraising environment. While existing GPs are not giving up the gains they've made on fund terms, new GPs face stronger pushback from investors and may have to settle for neutral or LP-friendly terms.
Takeaway 4: PE Firms Should Be Mindful of Conflicts of Interest
When a conflict of interest (COI) arises, the client's best interests must take precedence. While most PE firms are not subject to the same level of securities regulations that apply to registered dealers and advisers, they will often owe a common law fiduciary duty to their clients: a duty that the Supreme Court of Canada has recognized. To that end, firms should be proactive in minimizing risks associated with improper handling of COIs and ensure they are exercising discretion and resolving conflicts of interests in a manner consistent with the best interest of the beneficiary/client. Measures that should be considered include establishing a conflicts committee, having adequate policies and procedures, conducting ongoing COI risk assessment, and investing in compliance staff and training.
Takeaway 5: Broadening Scope of National Security Reviews
The federal government's proposed Bill C-34 will further widen the scope of national security reviews for foreign direct investments. Among other changes, the Bill would broaden the types of investments that are subject to a mandatory pre-closing notification, increase fines for non-compliance and provide the Minister of Innovation, Science and Industry with expanded powers to impose interim measures and negotiate binding undertakings. This is of particular relevance to investments involving sensitive data or know-how, and for investors from so-called "non-like-minded" jurisdictions such as China and Russia.
Takeaway 6: The Distressed M&A Environment Provides Opportunities for Firms
Strategic PE firms can leverage the rise in insolvency and restructuring to acquire undervalued assets and secure their position in industries that otherwise have significant barriers to entry. 2023 was a very busy year for restructuring proceedings, and early statistics suggest that 2024 may be the same. The costs associated with these proceedings, which involve a court-supervised sale and investment solicitation process (SISP), may lead secured creditors to accept major compromises. PE firms that are agile, decisive and creative can place themselves well to acquire undervalued assets and potentially generate significant long-term value.
Takeaway 7: Private Equity Has a Role to Play in the Energy Transition
PE firms can contribute to the fight against climate change in varying ways. Concerns about temperature increases and extreme weather events have driven public policy that aims to facilitate clean energy projects. PE firms have an interesting role to play in these efforts – not just as sources of capital, but also as all-around aggregators and coordinators of energy transition. Armed with significant experience in deal structuring, risk management and operational efficiency, PE firms are uniquely positioned to make a difference in this space.
Takeaway 8: Updates to the Reportable Transaction Rules in the Income Tax Act Give Rise to Expanded Reporting Obligations
Reportable transaction rules can apply at various stages of a fund's lifecycle, and managers should remain prudent. Very generally, under the new reportable transaction rules, a transaction must be reported to the Canada Revenue Agency (CRA) if it (or any transaction in the series of transactions) qualifies as an "avoidance transaction" (as defined in the rules) and one of three hallmarks is present in respect of the avoidance transaction (or series of transactions): a contingent fee, confidential protection or contractual protection. These rules could apply at many different stages of a fund, including the LPA drafting process, the acquisition of portfolio investments or at the time of divestiture. As the rules are relatively new and are drafted quite broadly, firms must remain prudent in determining the potential application of the reportable transaction rules and should continue to monitor developments in both practice and in CRA guidance as to their interpretation. A failure to comply with reporting obligations under these rules can result in significant financial penalties, as well as an extended reassessment period, and effectively a lower threshold for the application of the General Anti-Avoidance Rule.
Takeaway 9: Heightened CRA Scrutiny on the Residency of Partnerships Requires Careful Structuring
While residency is sometimes overlooked when structuring a fund, it is crucial from a GST/HST standpoint. For Canadian GPs, forming a partnership under the laws of a foreign jurisdiction is not always sufficient to avoid the application of GST/HST rules. A partnership that is resident in Canada will generally be subject to the GST/HST self-assessment rules on services acquired outside Canada, and/or will generally be charged GST/HST on its expenses by registered suppliers and service providers, as applicable. While the Excise Tax Act (Canada) contains certain deeming rules which can impact the residency of a partnership, it is not uncommon for those rules not to apply and for the residency of a partnership to be determined based on the common law rule which looks to the location where management and control (i.e., mind and management) is exercised, rather than the residency of the person who exercises it. Whether a partnership is resident in Canada or not is a factual determination, and GPs should monitor their corporate governance on an ongoing basis and consider these factors when structuring their funds to ensure their funds are not at risk for GST/HST purposes.
Takeaway 10: The Year Ahead May Drive New Strategies and Structures
PE firms must continue operating creatively and strategically. In the current environment, it might be more feasible to sell only part of an asset, or to carve out a less attractive piece of a business, to facilitate a sale process. Add-ons will remain popular in the Canadian PE landscape and firms will likely be motivated to pursue more minority investments, joint ventures, lower-value deals and negotiate earn-outs. Although market conditions continue to be challenging, the long-awaited stabilization of interest rates and of inflation would only contribute positively to deal-making.
Discover how our national Private Equity Group can guide you through 2024 by contacting our presenters below or by reading our latest report, On Target: 2024 Private Equity Outlook.
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