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Is It Finally Time For Private Equity?

By: Jim Helik

It always surprises me when people speak of ‘the market’ as if it were one monolithic creature. The whole idea behind Modern Portfolio Theory is that there should be market sectors that zig while everybody else zags. Of course, for the past few bleak years it can seem as if everything is correlated in only one direction – downwards.

I’m still unsure whether the private equity market is a non-correlated source of untold riches, but there is evidence that, at the very least, an increasing number of deals are taking place. Private equity, which includes venture capital but also includes buyout and turnaround money, typically refers to both equity and debt investments in companies that are not listed on a stock exchange (though some buyouts can include listed companies). It ranges all the way from start-up investments in companies with no sales, but just a concept, to bridge financing before a company goes public, and buyout funding for mature companies facing difficulties.

As an example of the increasing interest in this sector, in May it was announced that Don Hackett, a former executive of the famed money-losing company Drkoop.com, was able to raise $10 million for another healthcare services company – this time the more low-tech 1-800- Doctors Inc.

Closer to home, OMERS is currently forming a private equity fund that it will manage on behalf of foreign pension funds.

More specific numbers about this sector come from a two-volume report by Goodman and Carr, a law firm, and McKinsey and Company, a management consulting firm. It points out some interesting trends:

• Though it’s not always easy to define, the total private equity market in Canada stood at around $49 billion in 2002, up from the previous year.
• Venture capital is about half of this market, with buyout and mezzanine financing comprising the rest.
• Institutional investors, including pension funds and insurance companies, accounted for the largest share of assets – about 38 per cent. About half of these assets were directed towards buyouts, followed by venture capital funding, and only a small portion of mezzanine funding. Private independent wealth, historically an important player in the market, totalled one-quarter of all the assets. Labour-sponsored venture capital corporations came in next at 20 per cent.
• While pension funds and other institutional investors are pivotal to the marketplace, venture capital investments are mostly restricted to the largest players, such as the Canada Pension Plan Investment Board and OMERS. Smaller and mid-sized Canadian institutional investors have continued to show reticence in the private equity market due to the costs of market entry, limited access to private equity data, and potential governance problems (this is pretty much the same story as for real estate and other alternative investments).
• The largest institutions have identified current private equity commitments of between three and five per cent of total assets, with targets ranging as high as eight per cent.
• Market growth in the entire industry in 2002 came from fund managers who increased their funds available for later stage growth (in the second stage of a company’s life cycle, when there are revenues but no profits yet, and the third stage when a company finally hits the break-even point), and from the formation of new private equity funds in 2002 which focused on some particular niche, such as biotechnology. This contrasts sharply with the United States, where new capital inflows have slowed.
• The future, at least according to McKinsey and Company, should be strong. An increasing number of U.S. private equity firms, including Berkshire partners and KKR, have started investing in Canadian deals. Canada is seen as having a less competitive environment and advantageous valuations, again compared to the United States. Finally, while there have been fewer “exit opportunities” (chances to get your money back via a merger or an IPO) in Canada recently, the market has not dropped as far as has the U.S. market. Over the past two years, the number of deals in the Canadian mergers and acquisitions market has declined by 34 per cent and by 60 per cent in dollar value. The United States has seen the number of deals drop by 38 per cent and the dollar value decline 74 per cent.

So the Canadian market is young, growing, and dominated by only a handful of players. If history is any indication, this is the time when there are potential market inefficiencies and thus profits to be made. Everybody into the private equity pool!

Jim Helik is co-author of ‘Energy Markets Risk Management,’ a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University, in Toronto.

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