Torys LLP this week released its much-anticipated overview of Canadian private equity market trends in 2017.
My Torys colleagues and I believe there is plenty of reason to expect increased momentum in Canadian private equity deal activity in the year ahead.
While the data show that Canadian deal volume and aggregate deal values were lower in 2016 than in prior years, perceiving this decline as an indication of an overall weakening of the PE industry is a mistake.
That’s because institutional investor allocations to the PE industry continue to grow, and absolute dollars dedicated to the asset class are increasing. Investors are adjusting to the current deal and pricing environment and a new class of financial investor is emerging, all of which suggest that the market is poised to strengthen in the months ahead.
Before we jump into our discussion of deal-making factors in 2017, the following provides some statistical context on last year’s trends. Torys analysis is based on data sourced from S&P Capital IQ.
Canada’s 2016 private equity market by the numbers
The volume of domestic M&A deal activity involving a financial buyer or financial seller declined in 2016, following a downward trend since a peak of deal activity in 2013.
Similarly, aggregate deal values witnessed a two-year decline, falling to $30 billion in 2016.
PE deal role
The slowdown in financial buy-side deal activity continued last year, accounting for only 40 percent of Canadian deal activity involving a financial buyer in 2016.
In contrast, financial sell-side activity continued to rise, as financial sellers increasingly seized upon favourable market conditions and strong valuations to exit their investments.
Sales by financial investors to strategic buyers were the most popular private equity exit strategy in Canada, reaching their highest level since 2010.
The volume of sponsor-to-sponsor transactions increased slightly in 2016 at 14 percent of deals, while fewer strategic sellers sold their businesses to financial buyers in 2016, at 13 percent of deals.
Foreign financial buyers
Investment by non-domestic financial buyers in the Canadian market rose sharply in 2016, accounting for 41 percent of overall domestic PE activity.
In 2016, more financial-investor deal activity came within the range of “greater than $1 billion”, though the vast majority of transactions continued to fall in the mid-market segment, the staple of Canadian deal-making.
A new class of financial investor
In the last few years, family offices and sovereign wealth funds have emerged as serious contenders in the PE landscape.
Increasingly operating as traditional financial investors, they are turning to private equity for investment opportunities. Alongside PE investors, they are searching hard for good assets to invest their capital, heightening the competitive intensity in the marketplace.
We believe this new class of financial investor will assume more prominence in Canada’s market in the months ahead.
A frothy market
While investment opportunities exist, the price across asset classes continues to rise. In the United States, PE firms paid on average a 31 percent premium for acquisitions in 2016, an eight-year high, according to Bloomberg data.
In parallel with rising valuations, PE firms’ uncalled capital is growing: dry powder was estimated to reach US$757 billion at the end of 2015. As pressure to invest continues to mount and more investors enter the market, we anticipate that PE deal-making will gain momentum in the year ahead.
Doing deals in 2017’s market environment
In the current market environment, we believe financial investors are adjusting their investment strategies to navigate pricing and competitive hurdles in the marketplace.
Although deals continue to be sourced through proprietary and auction channels, market sentiment is that investors need to specialize in the sectors in which they operate in order to gain a competitive advantage: many consider that they simply cannot afford to do industry due diligence in “real time” as they compete for assets.
For example, we are seeing PE firms specialize in the healthcare and energy industries—the oil and gas sector alone captured almost one-third of all Canadian PE investments by the end of the third quarter last year, despite a general slowdown in the industry.
More pre-deal intelligence gathering, diligence
Aside from developing deep industry knowledge, investors are expending capital to hire key industry executives with the right contacts to source transactions and proactively identify assets before they come to market.
Efforts are also being made to meet owners of private businesses that may sell in the future, and network with management teams of potential targets and their competitors in order to be ready when a potential investment opportunity comes to market.
The general industry consensus is that if an investor first learns of a potential deal from the target’s advisors, it is essentially “too late”, losing out to those who have been laying the groundwork long before them.
In the broader marketplace, investors are also doing their diligence. They are identifying assets that other sponsors have held for an extended period of time as potential investment sources coming up for sale, and are watching for assets that might be spun-off in connection with corporate mergers.
Exercising pricing discipline
While PE investors are spending more time and money in advance of any deal being done, at the bidding stage many investors are exercising pricing discipline to ensure that they are not overspending in hyper-competitive auction processes.
Investors are also strategically acquiring add-on businesses in advance of purchasing core targets in order to gain a competitive edge over other bidders and are increasingly relying on representation and warranty insurance to make their bids more attractive.
In an environment where bargains on initial investments are rare, PE firms are also more focused on building value for their portfolio companies through the pursuit of aggressive M&A strategies, in addition to operational restructurings which may equally be critical to generating healthy returns.
In the long-term, we anticipate that these strategies will buoy deal-making in the Canadian marketplace, as private equity continues to be nimble in adapting to current challenges.
To read more about emerging private equity trends in 2017, we invite you to download a full copy of the Torys’ report. Please do this by visiting Torys Quarterly.
Cameron Koziskie is a partner at Torys LLP. He practices corporate and commercial law with a focus on private asset management, private equity and M&A. He wrote this article in collaboration with Michael Akkawi, a partner and head of Torys’ private equity practice, and; Sophia Tolias, a Torys’ counsel with an emphasis on M&A and private equity transactions.
Photos of Cameron Koziskie, Michael Akkawi and Sophia Tolias courtesy of Torys LLP
Photo courtesy ©iStock/Tomwang112