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Northern exposure

by Michael Gans and Kim Harle, Blake Cassels & Graydon | Published April 14, 2009 at 3:30 PM

It would be an understatement to suggest 2008 was a difficult year for private equity globally. Canadian private equity did not escape the trend, as 2008 saw significant drops in both fund formation and investment activity.

Canada, however, remains a marketplace that attracts significant private capital, and many of the top global private equity investors have some activity in Canada. U.S. sponsors active in Canada in 2008 included Blackstone Group LP, Carlyle Group, First Reserve Corp., H.I.G. Capital LLC, Sun Capital Partners Inc., Trivest Partners LP and Warburg Pincus.

Canadian funds remain materially smaller than their U.S. counterparts, with Onex Corp.'s $3.9 billion Onex Partners II LP fund being the largest in the marketplace. Active Canadian private equity funds in 2008 included, among others, Birch Hill Equity Partners Management Inc. and EdgeStone Capital Partners Inc.

Characteristic of the Canadian private equity marketplace is the widespread participation of Canadian pension plans, both in terms of investment dollars and strategic deal direction. Active pension plans include Canada Pension Plan Investment Board, Ontario Teachers' Pension Plan, Caisse de dépôt et placement du Québec and Omers Capital Partners.

Private equity investments by such plans cover a wide spectrum, including limited partner investments in private equity funds, co-investments with private equity funds and direct and co-sponsored buyouts. It remains whether the effects of the ongoing credit crisis will affect the commitment of these funds to private equity investing over the long term. Certainly, the investment activity of the Caisse will take a new direction given its C$39 billion loss, representing 25% of its assets, for 2008.

At first glance, Canadian private equity funds are very similar in form and governance to private equity funds in the U.S. In both countries, private equity funds are typically limited partnerships, managed by an affiliate of the fund sponsor, which is entitled to a management fee (usually 1% to 2.5% calculated on committed capital during the investment period and invested capital thereafter), and a carried interest of 20% payable out of the net income of the fund after limited partners have received a return of their contributed capital plus a preferred return (usually 8%).

However, in recent years, we have seen a divergence in some principal terms employed by funds in the U.S. and Canada, such as:

Budget-based management fees are not prevalent in Canada.

In Canada, the distribution waterfall used for determining timing of the payment of the carried interest to the general partner is usually calculated on a "whole fund" or aggregate basis, as opposed to a "deal-by-deal" basis. A commentator at a recent conference in Toronto said: "The deal-by-deal waterfall is dead." In our experience, this never had much traction in the Canadian market.

Limited partner distribution clawbacks are not common in Canada, and where they exist, they are usually limited to clawbacks to fund general partner indemnity claims if the assets of the fund are insufficient and are subject to a cap usually expressed as the lesser of a percentage of distributions and a percentage of commitments.

Portfolio company fees are more often offset 100% against management fees, as opposed to a 50:50 or 80:20 split, or some more elaborate sharing mechanism, as is often seen in the U.S.

Commitment offset mechanisms that are common in the U.S. are not seen in Canada. Under such a mechanism, the general partner's commitment is funded, in part, by limited partners, with a corresponding offset against management fees otherwise payable to the general partner. These mechanisms may be contributing to a trend of larger general partner commitments in the U.S. than experienced in Canada.

Co-investment rights are often more formal in Canadian fund agreements, as opposed to in the general partner's discretion, which is often seen in the U.S.

Investments are most commonly offered by private placement exempt from the prospectus requirements of provincial securities legislation. Marketing is typically limited to accredited investors -- institutional investors and private investors with significant assets or income. Private equity funds offered by way of private placement are often marketed through an offering memorandum, which must provide investors with a right of rescission or damages against the fund for misrepresentation. Since limits on holdings of foreign property were lifted a few years ago, we have seen a measurable increase in non-resident funds marketing to Canadian institutional investors.

Although the general partner of a fund may not need to register as a dealer or adviser under Canadian securities legislation, depending on the facts, the manager retained by the general partner or the fund (including a fund established outside Canada soliciting Canadian investors) may be required to register in those capacities.

Broker-dealer registration reforms are pending in Canada. Revised proposals are expected to be published shortly, with eventual implementation pushed back to late 2009. It is anticipated these registration reforms will, on one hand, require investment fund managers in Canada to register under a new category, while on the other hand exempting foreign dealers and advisers from being required to register in Canada if their services involve foreign securities or advising or managing funds established outside of Canada.

As wallets closed and deal flow decreased, 2008 proved to be a difficult year for Canadian fund sponsors and investors alike in terms of fundraising, the deployment of existing commitments and management of existing funds. We observed the following trends in 2008, and expect them to continue in 2009:

Fundraising: Many fund sponsors, particularly new entrants, experienced difficulty reaching their target commitments in 2008. We have seen a number of general partners with first closings in 2008 seek extensions from their limited partners of the outside date for subscriptions or "final closing date" set out in fund limited partnership agreements.

Capital call relief: While the amount of outstanding commitments or "dry powder" that many funds have on tap as they face the market downturn provides solace to many, some funds and limited partners are concerned over the ability of limited partners to meet their capital call obligations. Defaults, with their onerous consequences, are not in the interest of either the fund or the limited partners concerned. As a result, several creative solutions have emerged, such as the establishment of "fund within a fund" or feeder partnership structures within which limited partners seeking relief from their commitments can continue to hold interests in existing portfolio company investments, while other limited partners can maintain or increase their commitments and benefit from portfolio company investments made at lower multiples in the new "buyer's market."

Secondary sales: We have also seen an increase in secondary market activity as limited partners concerned over their ability to meet capital calls, or seeking to reduce their absolute dollar allocation to private equity in light of declining public markets, sell their limited partnership interests.

Given current market conditions, the challenges experienced by Canadian and international private equity in 2008 are likely to continue through 2009. In both the formation of new funds and the deployment (or redeployment) of existing capital, we expect the market uncertainty and related investment caution to result in a renewed focus on fees and deal terms, and a constant tension between the flexibility desired by investors and buyers and the certainty desired by sellers (whether funds seeking investment or of potential portfolio investments).

Nevertheless, Canada remains an attractive marketplace for both domestic and foreign private capital, and as global private equity and debt markets recover, there is no question that Canada will continue to be an important source of both private equity capital and investment opportunities.

Michael Gans is a partner at Blake, Cassels & Graydon LLP, a co-founder of the firm's New York office and co-head of the Firm's private equity group. Kim Harle is a partner in the firm's business group and is based in Toronto.

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