Prior to the recent economic downturn, the U.S. private equity industry experienced extraordinary growth.
Between 2006 and 2008, private equity firms raised over $850 billion. Appreciation in global equity markets enabled limited partners to increase their allocations to alternative assets. The increase in available capital resulted in larger private equity funds and a rapid proliferation in fund formation.
Typical private equity funds endure for 10 years, with a six-year investment cycle. During 2008 and 2009, however, private equity investment plummeted, bottoming in 2009's second quarter at just $8 billion. While private equity investment velocity increased thereafter, it remains substantially depressed. The result is that the U.S. private equity industry has over $485 billion of committed capital that must be invested in the next four years.
The convergence of circumstances outlined above will result in unprecedented growth of U.S./Canadian cross-border transactions led by U.S. private equity funds. Based on the following observations, we believe now is the time for lower middle market companies in Western Canada to consider tapping the U.S. market for third-party capital.
Canadian strength. A significant natural resource base, a healthy financial system and stable political climate have promoted strong domestic growth in Canada. The International Monetary Fund predicts that the Canadian economy will experience the fastest growth rate among G7 countries in 2011. The loonie has surpassed parity with the U.S. dollar. Finally, endogenic risks to the Canadian economy appear limited. To generate an attractive returns profile, private equity-backed companies need growth and stability, making Canadian-based companies increasingly attractive to U.S. private equity funds.
U.S. size. While Canada may be stronger economically, the U.S. private equity industry possesses the larger chequebook. According to CapitalIQ, there are more than 1,100 active U.S. private equity funds with a minimum of $100 million under management. In contrast, there are slightly more than 50 in Canada. The proliferation of U.S. private equity funds has also resulted in funds oriented around industries and business models, in contrast to Canada's more general model.
U.S. product breadth. The size of the U.S. alternative asset industry has also led to the formation of specialized funds. The industry includes funds that specialize in subordinated debt, growth equity, recapitalizations and buyouts among others. This specialization can lead to more attractive deal terms. Furthermore, the availability of mezzanine debt financing from U.S. funds enables companies to take on capital with limited dilution. While there is no firm count of subordinated debt funds in the U.S. and Canada, our experience is that this product has significantly less availability from Canadian funding sources.
Access to Canadian debt. The availability of debt financing to fund a buyout transaction has been a key driver of valuation. A review of Standard & Poor's leveraged buyout transaction data shows that for every dollar of debt available to fund a transaction, a sponsor can pay $0.50 to $0.75 in equity value to the selling shareholders. While Canadian banks have long been more conservative, it's currently easier to garner more attractive debt packages for companies with less than $10 million of trailing earnings before interest, taxes and depreciation in Canada. This new access can help Canadian companies to get deals done at higher valuations than in the U.S., where access to debt capital remains more challenging.
With its massive capital overhang, the U.S. private equity transaction market is expected to be robust in 2011-13.
With limited domestic options, sponsors will look to Canada to find an outlet for their committed capital. Canadian companies with strong growth potential will command premium valuations from U.S. equity sources and have access to specialized funds and products.
Christian Schiller is a managing director at Cascadia Capital, a Seattle-based boutique investment bank serving companies in diverse industries, including information technology, sustainability and middle market. Bryan Jaffe is a senior vice-president at Cascadia.
