How US Private Equity Can Move Capital to Canada

September 24, 2019

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Private equity investors in the U.S. could be forgiven for thinking their success has created scarcity domestically. Loaded with cash, they now sometimes struggle to find investments. Stacked with capital, they face stiff competition to deploy it effectively.

Meanwhile, north of the border, Canada presents a market brimming with opportunities. Next to the uber-competitive environment in the U.S., the Canadian private equity scene is far less mature. The numbers tell the story: according to the Capital IQ database, 536 U.S. funds closed 932 deals in the under-$150 million category, for the 12 months ending August 31, 2019. In Canada, those numbers were 64 and 98, respectively, providing a snapshot of mid-market private equity activity.

Before moving capital to Canada, keep in mind these five pointers to guide your entry into the market.

1. Industrials and manufacturing: not our grandparents’ factories

As a sector, industrials and manufacturing present key opportunities for U.S. private equity investors. One fifth of deal flow (21%) came from this space in the first half of 2019.

The Canadian government has ambitious goals for the sector. By 2030, it aims to increase manufacturing sales by 50%, to $1 trillion, and to increase manufacturing exports by 50%, to $540 billion. These hopes depend in part on factories that have shifted from traditional to advanced, and an Industry 4.0 focus among executives and business owners.

The government has moved to make these targets a reality. New tax write-offs offer support for all businesses that invest in technology – with manufacturers receiving a particular boost. Under rules that became law in June 2019, they receive a full deduction in the first year of the investment for the entire cost of machinery and equipment used for manufacturing or processing. The same holds true for the purchase of specified clean energy equipment by a business in any industry.

With the new write-offs, Canada’s marginal effective tax rate on new business investment (13.8%) is the lowest in the G7 and significantly lower than that of the U.S. (18.7%). They also help Canada keep pace with measures introduced under U.S. tax reform.

2. AI: Canada’s tech darling

Canadian leadership in artificial intelligence is no longer a secret, and U.S. private equity is primed to benefit.

Perhaps the most famous face on the booming Canadian AI scene is University of Toronto – and Google - pioneer Geoffrey Hinton, but AI expertise extends beyond the vaunted Toronto-Waterloo tech corridor.

In Quebec, AI animates one of five innovation superclusters subsidized by the federal government. Known as the AI-powered supply chains supercluster, it aims to help small and medium-sized business scale up by using AI to build intelligent supply chains in multiple industries. The supercluster rests largely on the work of Professor Yoshua Bengio, who continues to advance the country’s reputation in deep learning at the University of Montreal and at the Montreal Institute for Learning Algorithms.

Further west, U.S. private equity will note the Alberta Machine Intelligence Institute in Edmonton.

Canada’s AI pole position follows the footprint it staked out in 2017, when it became the first country to release a national AI strategy.

For private equity, the Canadian AI scene offers uncommon opportunity. The country’s tech sector in general has seen growing investment by private capital. It also benefits from tax incentives provided by the country’s world-class scientific research and experimental development program and by support from the Strategic Innovation Fund.

However, tech companies – and AI among them - sometimes struggle to access larger-scale funding. U.S. private equity can help fill that gap.

3. Go private

If the classic debate between private and public capital needs a clear winner, the last 10 years in Canada provide at least a hint of one.

In 2018, the Toronto Stock Exchange saw an 11% decrease in IPOs year over year. This tracks with long-term figures from 2016, when the number of publicly listed companies in Canada had dropped by 17% since 2007.

Business owners are less willing to stomach the hassle and loss of control that come with going public. Compliance also does not come cheap for public companies – disgruntled investors have increasingly launched class-action lawsuits in recent years.

These business owners may also no longer need the same amount of public money to fund their expansion as they once did. They can now access alternative funding, such as private equity and venture capital, in greater numbers. These sources rank far below the U.S. in scale, but they have increased nonetheless.

Canadian private equity also continues to take public companies private. In 2018, go-private transactions totaled $16.5 billion on 12 transactions, as calculated by the Capital IQ database. And in a 2019 deal that grabbed headlines, Onex Corp. bought publicly listed WestJet Airlines for around $5 billion.

4. Does economic cycle matter?

Rumours of a worldwide economic downturn. U.S. protectionism. Trade wars. No private equity investor can afford to ignore this wider economic picture. The Canadian economy, like the economy of any investment destination, will always carry some relevance. The question: how much relevance? The answer: not much, at least in most cases.

Investors coming to Canada generally don’t seek to diversify or manage risk — at least not primarily. In general, they look to expand their competitive landscape and find new opportunities. Most of the deal activity — whether in business services, manufacturing, or distribution - is less sensitive to the temporary whims of the markets.

Canada does have several cycle-sensitive sectors. These are concentrated among Canada’s benchmark industries, such as oil and gas and natural resources. Real estate investors will also find themselves more vulnerable to independent economic cycles. Yet oil and gas activity has slowed in recent years. And while resources and real estate investors may still see activity, the number of deals is far less significant than in the robust middle of Canadian markets.

By the numbers, Canadian GDP growth slowed from 3% in 2017 to 1.8 percent in 2018, and it is expected to grow by 1.3% in 2019 and 1.5% in 2020.

5. Roll up to win

When U.S. private equity investors come to Canada, they should consider rollups as an ideal strategy.

The opportunity is robust. Because of Canada’s geographic dispersion, many industries are heavily fragmented. In addition, business owners tend to avoid risk more than their counterparts in the U.S. — so fewer companies have expanded nationally. Perhaps most important, Canada offers a market with less institutional capital than in the U.S.

As a result, private equity investors who do cross the border not only face less competition and cheaper valuations. They also can take quick steps to drive value — such as modernizing systems or hiring new management.

Whether using a rollup or buy-and-build strategy, U.S. private equity investors will benefit from the relative familiarity of the Canadian market. The two countries share a business culture, a border, and — in most places — a language. This allows U.S. private equity investors to bring to Canada many of the same techniques honed in the U.S.

Investors coming to Canada will need to complete their homework — regulations differ, and the two business cultures are not identical. But the similarities outweigh the differences, particularly when compared with overseas markets. If U.S. investors do their due diligence and move strategically, they may find in Canada a nearby outlet for the ‘dry powder’ clogging up their balance sheets.

To explore Canadian private equity opportunities, reach out to one of our Private Equity professionals now