While institutional private equity isn’t new, it’s growing fast and eager for deals. The segment includes buyout funds, which inject capital into troubled companies or other firms ready to move to the next level (e.g., an acquisition or public listing), and mezzanine lenders, which provide a debt/equity hybrid to growing companies that ranks behind senior debt but ahead of common equity should the borrower default. Excluding venture capital, private-equity capital in Canada totalled $30.2 billion in 2004, up 16% over 2003. Flush with cash, “the traditional private-equity firms are becoming more aggressive,” says Peter Wallace, CEO of Toronto-based Newport Partners Income Fund, which invests in private businesses itself. “They want to invest in smaller companies.”
What’s attracting all that capital? Performance. According to Toronto-based industry statisticians Thomson Macdonald, mezzanine and buyout firms in Canada enjoyed a 20.1% average annual return over the five years ending Dec. 31, 2004, while VC firms lost 2.4% a year.
As a result, fresh capital injections from pension funds, corporations and, increasingly, retail investors are changing these sectors. Typical deal size for mezzanine lenders used to be $10 million to $50 million, says Robert Palter, a principal at McKinsey & Co. in Toronto. Newish players such as the $75-million Return on Innovation (ROI) Fund now make deals of just $1 million to $3 million. As a labour-sponsored fund, ROI Fund is unique in that, rather than taking only equity in long shots, it offers a mix of subordinated loans and equity capital to stable, mature companies with positive cash flow. This has brought venture financing to smaller firms in such diverse sectors as real estate, coffee distribution, pipelines and plumbing-supply manufacturing. But this is not prime-plus-two bank lending: ROI Fund’s first six investees paid an average rate of 13.68%.
More good news for entrepreneurs: private-equity providers are again looking at an array of businesses. “It’s not all about technology and intellectual property,” says Palter. “People are even willing to look at service businesses if they have a good value proposition.”
Buyout funds traditionally aim to take effective control of mature operating companies, improve them over three to five years, then cash out through a major “exit event” such as a buyout, public offering or merger/acquisition. The average target: a 30% compounded annual return. With competition for good deals growing, more buyout funds are working with smaller companies (i.e., less than $10 million in revenue) and increasingly are willing to accept minority ownership stakes. Typical is Winnipeg-based Richardson Capital Ltd. Its RFG Private Equity Limited Partnership No. 1 emphasizes its ability to deal with existing management rather than run over them. And, while it prefers to invest $10 million to $60 million, it will consider smaller investments for “extraordinary” opportunities.
“On the buyout side, there’s a lot of equity looking to be placed,” notes Goodman & Carr’s Herman. “The market has become much more competitive, which is good for sellers.” But don’t expect average deal size to fall too far, he adds. Investors require more due diligence and hands-on approaches than do lenders, and those costs don’t change when you move to smaller deals with lower potential paybacks.
If your established firm needs a deep-pocketed partner over the medium term, ask your accountant or lawyer for introductions to local private-equity players. If they don’t know who to talk to, have them consult with more plugged-in colleagues on your behalf.