1. finance
2. investing
3. venture capital

Why buyout investments are good
for Canada
Canada has a relatively nascent but fast-growing domestic
private equity industry, with $66 billion raised since inception
through 2006. Buyout investors, a subset of Private Equity investors,
add substantial value to companies through strong governance, a
results-oriented mindset that challenges conventional thinking, and a
long-term perspective that builds sustainable value. Stronger
Canadian companies translate into a stronger and more productive
Canadian economy. The CVCA estimates that over the last 5 years,
Buyout investors have added $25-30 billion in value (GDP) to the
Canadian economy and created 114,000 jobs. They have also raised
corporate and capital gain tax revenue, contributed to the
development of a stronger Canadian capital market, and provided
benefits to pensioners.
1
In the last 24 months, there has been a noticeable increase
in Private Equity (“PE”) activity. PE touches the lives of
Canadians in a myriad of different ways, from the way we
reference information (Yellow Pages), to the way we shop for
consumer goods (Shoppers Drug Mart), to the way we dispose garbage (BFI). This list goes on to include many wellrecognized Canadian brands such as Bell Canada, Sunquest
Vacations and Porter Airlines.
Despite this recent activity, it is interesting to note that the
Canadian PE industry still remains relatively nascent and
public awareness and understanding is muted when compared to the US and Europe. This general lack of familiarity
with PE can sometimes lead to misconceptions that include
the notion that PE benefits only high net worth individuals,
PE firms are short-term focused and PE reduces employment
in the economy. However, the reality is that PE actually creates long-term benefits for a large set of stakeholders, ranging from individual Canadian companies to current and
future pensioners. Numerous studies, including those conducted by consulting firms McKinsey, AT Kearney and Ernst
& Young demonstrate that PE results in a stronger economy
with higher productivity and employment.
The purpose of this report is to provide clarity on what
Private Equity is, explain how it makes money and illustrate
the benefits it provides to the Canadian economy.
The report is structured as follows:
Section 1:
Definition of PE, its different forms, and how it compares to
other financial and investment instruments
Section 2:
Description of how Buyout firms raise, make and distribute
money
Section 3:
Overview of the PE industry in Canada
Section 4:
Discussion of how Buyout firms add value to companies and
how that translates into value for the broader economy
Section 5:
Implications and conclusions
3
1.0 What is private equity?
1.1 Definition of PE
In its broadest sense, Private Equity is an investment in publicly traded or private shares of a company through a pool of
private capital raised from institutional or high net worth
investors in hopes of growing, developing, and improving
that company. In other words, it is when one private party
invests in another party with the intention of adding value
and generating a return.
1.2 How PE contributes to the broader
financial industry and how it compares to
other traditional investment management
PE firms are an integral part of the financial services industry, contributing to its overall health and its rapid growth in
recent years. When PE firms raise debt for their investments
they contribute revenue to lending institutions. When they
acquire and sell companies they use advisory services from
investment banks. In addition, when PE firms sell their
investments back to the public market via IPOs at higher valuations, they add to the health of capital markets.
PE funds are commonly compared to mutual funds.
However, PE funds differ from mutual funds in that they play
a very active “hands on” role in the management of the companies in which they invest, they bear more risk in the
investment and they tend to hold their stake for longer periods of time. (Exhibit 1) Moreover, PE fund managers have
returns expectations of 25% while Canadian equity mutual
fund managers’ expectations are in the 8-9% range, largely
mirroring the performance of the TSX300 over a 10year
period.
Exhibit 1: How PE Funds Compare to Mutual and Index Funds
Private Equity Funds
Private Equity Funds
4
Mutual Funds
Mutual Funds
Index Funds
Index Funds
Description
• PE fund managers actively select
• Mutual fund managers select
• Index fund managers mirror
Risk
• Investors take significantly more risk
• Lower risk (i.e., market and
• Market risk with market returns.
Hold period
• Long term horizon (e.g., 5+ years)
• Variable horizon – can buy
• Only change composition when
and manage public, private
companies in their portfolio and invest
their own personal assets and often
have seats on the board
(i.e., company, illiquidity and leverage)
and must contribute large sums to invest
in the fund and may be personally liable
via their board positions for Portfolio
companies and their performance
public securities, passively
monitor performance, and
have no obligation to invest
personal assets
company risk) with lower
returns. Accessible with small
sums of investment
and sell stocks on daily basis
composition of the publically
traded index, passively monitor
performance, have no obligation
to invest personal assets
Accessible with small sums of
investment
index changes
1.0 What is private equity?
1.3 The development of the PE industry
JP Morgan is considered the father of PE given his investment approach used in the early 1900’s. Though “Private
Equity” has existed in its current form since the 1960s, it has
historically been comprised largely of informal arrangements. A mechanic lacking funds to grow his company who
borrows from friends and family in exchange for a portion of
the business has in essence engaged in a PE transaction.
‘Angel’ investors who provide capital for a start-up business
in exchange for equity in the firm are also making a PE deal.
Today the term Private Equity implies a more formal, systematic mechanism of investment. A broad group of
investors are brought together in a legal partnership structured to acquire a stake in a business to which they add
resources (capital, intellectual, or both) and typically sell
1.4 What Are the Different Kinds Of Private
Equity?
Just like there are different types of mutual funds and index
funds, there are also different types of PE. The industry can
be broadly segmented based on when the PE investment is
made in a company’s development. (Exhibit 2)
Venture capital refers to capital provided to an early stage
(e.g., startup) company in exchange for equity. VC firms offer
industry expertise and capital to help a company grow from
a startup to the point where the company is generating revenue, or profit. Typically, less than 100% of the equity of the
company is acquired, generally with no debt. Perhaps the
most well known recent example is RIM, which benefited
from early stage investment by Canadian PE firm Helix.
that stake later when value has been created.
Exhibit 2: Investment Types at Different Stages of a Company’s Development
Early stage
Later stage
Mature stage
Timing:
Business plan through revenue
generation
High revenue growth; start
of profit generation
Stable revenue growth, stable profit
margins
Venture Capital
Mezzanine
Buy-out
• Funding to a nascent company
in order to finance it through to
the revenue or profit generation
stage
• Take equity stake in exchange
for funds
• Funding of companies
that are transitioning from
early stage to mature
stage
• Debt that is convertible to
equity (Mezz debt) is
often used to fund growth
between equity financing
rounds
• Acquisition of a controlling stake
in an established company in
order to improve performance and
productivity
• Take controlling stake in
exchange for funds and debt
5
1.0 What is private equity?
Do Buyout Firms Overly Burden Companies with Debt?
A common misconception about Buyout firms is that they burden companies with too much debt. The perception
is that this causes companies to be unable to produce sufficient cash flows to pay interest, forces them to undergo
cost cutting and leads them to bankruptcy.
In reality, all stakeholders are affected when a company has too much debt: creditors do not get their money back,
employees lose jobs, and shareholders lose their investment. Moreover, too much debt limits the ability of the
company to invest for growth and absorb any market instability. Thus, Buyout managers carefully assess the debt
levels of the companies so as to not to risk their investment. They are seeking to optimize the amount of debt to
maximize returns to their investments without destabilizing the company.
Recent research has proven that despite using higher levels of debt relative to the typical public company, Buyout
firms do not put companies in jeopardy because they increase profitability and cash flow to support these interest
payments. (See section 4.1) A recent study in Belgium involving 53 companies showed that 2 years after a leveraged buyout, the average company’s cash flow increased from 4% to 7% of sales (This increase was achieved
while the average number of employees grew by over 13% for the same period).
In addition, these larger levels of debt are typically paid down before the Buyout company sells the company back
to the market. When the European PE & VC Association, EVCA looked at companies that were floated back into the
stock market by buyout firms in 2005 and 2006, it observed that their debt ratio of total assets did not significantly differ from blue chip companies. Companies sold by buyout firms had debt to asset ratios of 65%, while blue
chip companies had ratios of 64%.
The way debt creates value is described in detail in Section 4.2.
Mezzanine funds invest in a broad spectrum of companies
that are in between the early and full growth stages. To
supplement the equity investment, they typically use
Mezzanine Debt, which is debt that is convertible to equity.
Companies will use mezzanine debt where they are limited
in their ability to raise debt from traditional sources (e.g.,
banks) and they do not want to sell equity to finance their
business today.
Buyouts purchase the majority of the equity in more mature
companies using a significant amount of debt (typically
~60% of the purchase price). The typical target of a buyout
is a company that has operating profits between $5 Million
and $1 Billion+ and has reasonably stable cash flows to support the use of debt. A well recognized Canadian example is
when OTPP and KKR bought Shoppers Drug Mart, an already
well-established retail chain, using a combination of their
own equity plus debt raised from banks.
6
We will size the entire Canadian PE industry in Section 3 in
order to give the reader the right information on the magnitude of the market in Canada. However, for the rest of this
report we will concentrate on buyout firms because they are
the biggest sub-segment of PE in Canada (58% of Assets
Under Management).
2.0 How do private equity firms make money?
2.1 How money is raised, made and
distributed
In its broadest sense, a Buyout firm makes money by adhering to the old adage of buying low and selling high. To see
how this works, we can break the typical PE deal into three
phases.
1. Fundraising
The first step is raising the funds used to invest in companies. Not all funds are formed in the same manner or with
the same terms and conditions. Most, however, structure
their funds as one or more partnerships between the
investors and the PE firm, in which the fund sets out its
objectives, its process for making investment decisions,
how investors participate, and the responsibilities of the PE
firm on behalf of its investors.
These funds are structured as long-term vehicles, often with
expected investment horizons of 15 years and sometimes
longer to permit an orderly exit from its investments. During
this investment period, investors have little if any liquidity
of the capital they have committed.
Investors in these funds are typically Limited Partners (LPs).
LPs include Pension Funds, University Endowments,
Financial Institutions and, often, high net worth families, all
of whom can be thought of as ‘silent’ partners in that their
role is limited to providing capital.
The PE firms, acting as General Partners (GPs) of these
funds, invest the fund’s capital into multiple companies
over the life of the fund and typically manage these investments in exchange for a management fee and a share of any
gains realized on the portfolio. LPs typically expect GPs to
contribute between 1% and 10% of the fund, which often
represents a significant portion of their personal capital, to
ensure alignment of objectives with the LPs. Many funds are
even higher than 10%. Once any fund is invested, the PE
firm will tend to raise another fund, often turning to the
same investors, thus reinforcing how the fund’s objectives
are aligned with those of its investors.
2. Creating value
After extensive research and due diligence Buyout firms use
the capital raised to invest in Portfolio Companies that are
determined to either have significant untapped growth
potential or are under valued. Once acquired, GPs employ a
variety of strategies (discussed in Sections 4.1 - 4.3 below)
to increase the value of their Portfolio Companies. The holding period for any particular investment varies but is typically from 3 to 5 years and sometimes longer. When the business is ready, they then sell (“exit”) the Portfolio Company,
hopefully for more money than they invested in it, thus realizing a gain on their invested capital.
Ultimately, the most prevalent means of creating value is to
increase the productivity of the business, by investing in
innovation, in creating scale through capital investment or
further acquisition, or by hiring more experienced management to help the business evolve.
3. Distributing the returns
The returns are generated in two stages, i.e., during the
‘hold’ period when the PE firm is in control of the Portfolio
Company, and at exit, when the Portfolio Company is sold.
During the hold period the PE firms receive a management
fee, which is typically ~2% of funds under management.
This management fee is used to pay the salaries of the PE
managers and also to cover the PE firm’s expenses. At exit,
the majority of any gains go to the LPs, who typically receive
80% of the returns. The GPs receive a maximum of 20% of
the gains, which is referred to as the GPs carried interest, or
carry.
In case of losses, there is no downside protection, and both
LPs and GPs could lose up to 100% of their investment. In
addition, the GPs are potentially liable on behalf of the
Portfolio Company since they assume seats on the board.
This means that GPs operate under the same set of liabilities as directors of a public company do. Specifically, all
Buyout firms in Canada operate under Federal and
Provincial legislation that places the exact same obligations
on directors of Buyout owned companies as on any other
companies.
7
2.0 How do private equity firms make money?
2.2 How fees paid to a fund manager are
taxed
Management and advisory fees paid to a fund manager are
taxed as income and bear personal tax at rates of 39 to 48%
if paid directly to individuals or 30 to 36% if paid to a corporate manager, varying by province. Such fees are also subject to the Goods and Services Tax. Where the funds are paid
to a corporate manager, net earnings of the manager tend to
be paid to its employees as salaries and bonuses, which
again are taxable at top marginal personal tax rates and
which may attract further payroll taxes.
2.3 How fund gains are taxed
As indicated PE funds are typically structured as partnerships, which are flow-through vehicles for tax purposes.
Gains of the fund are allocated to LPs and GPs based on the
terms of the partnership agreement. Accordingly, where the
GP’s entitlement to fund returns is 20%, 80% of the fund’s
income (which may include interest, dividends, and capital
gains) is allocated to LPs. Interest, dividends, and capital
gains are then taxable at the applicable rates of the fund
Rates vary by province but for an individual resident in
Ontario, interest is taxable at roughly 46%, dividends at
roughly 23%, and capital gains at roughly 23%. For a private
corporation resident in Ontario, interest is taxable at 49%,
dividends at roughly 33%, and capital gains at 24%; these
rates are correspondingly reduced upon the payment of a
taxable dividend.
The alignment of tax consequences for the return to LPs and
the return to the GPs drives a common motivation for the
performance of the fund. In many respects, this parallels the
awarding of stock options to the leadership of a public company. As the shares rise in value, shareholders earn capital
gains on the appreciation in value; executives earn a gain on
their stock options, which is generally taxed at capital gains
rates for Canadian tax purposes. 1
Despite the fact that Canada’s Buyout industry is relatively
nascent when compared to the US and UK, the tax on carry
is among the highest, with the UK at 18% and the US ranging from 15- 23% as of 2008. (See table below) Glossary of
Buyout Terms:
investors.
Canada
US
UK
Current (2008)
20 - 24%
15 - 23%
18%
Expected ( by 2011)
20 - 24%
20 - 29%
18%
Note: Provided as a range up to the highest state/provincial rate. In Canada, the highest rate is 9.63% in Nova Scotia and the lowest is 5% in Alberta.
In the US, for 2008 the highest state and city rate is 10.5% for individuals resident in New York City. In 2011, the highest state and city rate is expected to be
9.5% in Vermont. The lowest US rate is 0% in several states. For 2008, the maximum US federal tax rate on long term capital gains is 15% and under the current legislation is set to revert back to 20% in 2011.. The combined US tax rates take into account the partial deduction of state and city taxes for federal tax
purposes.
In the UK, gains were historically taxed at three income tax rates (10%, 20%, and 40%, depending on an individual’s taxable income band). These rates were
reduced where property, giving rise to the gain, met various holding period thresholds. For example, gains from the shares of private companies that were held
for over 2 years were taxed at an effective rate of 10%. Earlier this year, legislation was introduced to replace this multiple rate regime with a single rate of 18%,
effective for gains realized after April 5, 2008.
1 Quebec residents bear a higher tax rate on stock option benefits than capital gains, but this rate is still more favorable than the tax rate on other
employment income.
8
2.0 How do private equity firms make money?
GLOSSARY OF BUYOUT TERMS
LP
Limited Partners - have limited liability, i.e. they are only liable to the extent of their
registered investment, and they have no management authority.
GP
General Partners - have management control, share the profits of the fund
investments in predefined proportions, and have joint liability for the debts of the
partnership.
Management Fee
A fee charged by GPs for managing a fund. The management fee is intended to
finance set-up costs and everyday operations and compensate the fund managers
for their time and expertise.
Hurdle Rate
The minimum amount of return that GPs are required to return to investors before
GPs can take any profit.
Carried Interest or
A share of any profits above the hurdle rate that the general partners of private
‘carry’
equity funds receive as compensation
Clawback Provision
A special provision in Limited Partnership Agreements that requires GPs to use
‘carry’ from profitable investments to cover for any losses incurred by other fund
investments.
Portfolio Company
Assets Under
A company into which the GPs invest PE fund money. PE funds typically own 100%
or hold a controlling interest in a company.
The market value of investments managed by a fund or management firm.
Management (AUM)
9
3.0 Overview of the Canadian PE Industry
3.1 Size and growth of the Canadian PE
Industry
Although the majority of this report is focused on Buyout
funds, in this section we will describe the entire PE industry
(VC, Mezzanine and Buyout) to give the reader an accurate
assessment of its size. Growth in PE has been exceptional
with assets (or capital) under management (AUM) by
Canadian PE firms topping $65 billion in 2006, up 16% from
2005. Out of the $65.5 billion AUM, approximately $20 bil
lion was raised from foreign sources and approximately $46
billion was raised from domestic sources. Out of the funds
raised, $42 billion has been invested over the past 5 years,
$22 billion going to Canadian Portfolio Companies and $20
billion going to foreign Portfolio Companies. Canadian
Portfolio Companies also received $5 billion from foreign
investors. Exhibit 3 below describes the flow of money from
foreign and domestic sources to Portfolio Companies in
Canada.
Exhibit 3: The Flow of Money from Sources to Uses of Capital in Canada (Since Inception)
Source of capital
Assets under management
For
e
cap ign
ital
$20 billion
Uses of capital (capital invested)
eign
ts
For stmen
e
v
in
Canadian PE Funds
$66 billion since inception
Foreign
Portfolio
Companies
$20 billion
($10 billion raised in 2006)
Dom
inve estic
stm
ent
s
c
esti
Dom tal
i
cap
$45 billion
• Includes VCs, buyouts,
$22 billion
Mezzanine funds
$5 billion
10
Canadian
Portfolio
Companies
Foreign PE
fund
investments
in Canadian
PC’s
3.0 Overview of the Canadian PE Industry
The buyout segment of PE accounted for most of the growth,
with $38.2 billion of capital under management in 2006, up
a substantial 28% from 2005. (Exhibit 4)
Exhibit 4: Capital Under Management by Canadian Private Equity Firms by Market Segment; 2006
Percent
100% = $ 65.5 billion
Mezzanine
8
100% = $ 45.9 billion
Mezzanine
Venture Capital
7
34
Buyout
58
Total Capital Under Management
Venture Capital
40
Buyout
53
Canadian Capital Under Management
Source: Thomson Financial; McKinsey Analysis
11
3.0 Overview of the Canadian PE Industry
3.2 Who Provides all that Money?
Foreign investors contribute a significant amount of capital,
providing almost one-third of the capital raised by private
equity in 2006. Of the remaining capital raised, Canadian
pension plans and individuals contribute more than half.
(Exhibit 5)
Exhibit 5: Sources of Private Equity Funds Raised: 2006
Percent
100% = $ 10.3 billion
Government
Pensions
4 1
20
Other
Foreign Sources
29
15 Individuals
31
Corporations
Source: Thomson Financial
12
3.0 Overview of the Canadian PE Industry
The positive impact of PE on the
‘Hollowing out’ of corporate Canada
‘Hollowing out’ is the notion that Canada is steadily
losing corporate headquarters and high value jobs
due to foreign takeovers of Canadian companies
and the moving of corporate bases abroad. It has
been suggested that the Buyout industry has been
contributing to this phenomenon.
However, while the net loss of headquarters and
jobs is an issue of some debate, the Canadian
Buyout industry actually plays a positive role that
counteracts the effect. Analysis reveals Canadian
Buyout firms have been far more active buying
American companies than vice versa. Over the last 5
years (2002-2006), Canadian Buyout firms executed
buyout deals in the US valued at approximately 3X
the value of US buyouts of Canadian firms.
Pension Funds
Canadian pension funds contributed $2 billion in 2006, a
20% share of the capital raised by private equity funds. In
total, the top 10 pension funds have some $41.5 billion
invested in private equity worldwide, approximately 6.5% of
total assets. Over the past five years, investments in private
equity have returned over $10 billion dollars to Canada’s
pension funds and their millions of beneficiaries, 30% more
than if that money had been invested in the TSX 300.
However, Canadian pension funds under-invest in PE compared to the US, with only 0.8% of capital allocated to PE vs.
2.1% in the US, for Pension funds between $1-$5 Billion
AUM (Exhibit 6).
Exhibit 6: Pension Fund Allocations to Private Equity
(% of Total Assets, Actual) by Fund Size,Canada and the United States, 2005
Corporate Pension Funds*
>$5 BIL
$1 BIL - $5 BIL
$501 MIL - $1BIL
< $500 MIL
Canada
1.8%
0.6%
0.1%
0.3%
US:
5.8%
1.8%
0.8%
0.2%
>$5 BIL
$1 BIL - $5 BIL
$501 MIL - $1BIL
< $500 MIL
Canada
3.4%
0.8%
0.2%
0.0%
US:
4.2%
2.1%
1.4%
0.7%
Public Sector Pension Funds
Source: Greenwich Associates, 2006
* Does not include pension funds of Canadian subsidiaries of American corporations.
13
3.0 Overview of the Canadian PE Industry
Individuals
3.3 Who Manages All That Money?
Individual Canadians invest in private equity alongside
institutional investors and corporations, enjoying the
returns and diversification benefits provided by this asset
class. More than half of individual investments are made
through retail funds accessible to all Canadians, with the
remainder coming from wealthy individuals.
The industry managing this capital consists of over 200 venture capital, buyout, and mezzanine investor groups, out of
which 55 are buyout firms. The majority of the buyout industry is located in the major metropolitan areas of Toronto and
Montreal, with significant clusters around Vancouver.
(Exhibit 7)
Foreign Sources
Canada's private equity market comprises a diverse mix of
fund types – Independent Funds, Retail Funds, Pension
Funds, Government Funds, and Corporate Funds (Exhibit 8).
By contrast, the US industry is dominated by Independent
Funds. These account for close to 80% of PE activity in the
United States but less than 50% in Canada. In addition,
retail funds represent over 21% of Canadian private equity
funds and are directly accessible to ordinary Canadians
through shares listed on stock exchanges. Exhibit 8 shows
the classification of private equity fund types by assets
under management. A description of the various fund types
follows the exhibit.
American and other foreign investors were integral sources
of capital in 2006, contributing over $3 billion to Canadian
private equity funds. This far surpassed activity in previous
years, with foreign sources contributing only $676 million in
2005.
Corporations, Government, and Other
Corporations invest substantial capital in private equity. The
majority of this capital comes from financial corporations
such as insurance companies, mutual funds, and investment banks, with a small portion coming from industrial
corporations. A few government programs invest in private
equity). The remaining portion of capital invested in private
equity, classified as Other, comes from endowments, foundations, and other such programs.
14
3.0 Overview of the Canadian PE Industry
Exhibit 7: Geographic Dispersion of Canadian PE Firms (Shading TBD)
Northwest
Territory
Nunavut
Yukon
Territory
Nunavut
Northwest
Territory
British
Columbia
Newfoundland
Quebec
Manitoba
Alberta
Ontario
Nova Scotia
New
Brunswick
Saskatchewan
Exhibit 8: Types of Private Equity Funds Based in Canada by Assets Under Management
Percent
100% = $ 65.5 billion
Independent
100% = $ 45.9 billion
Corporate Government
5 3
Independent
18
Corporate
Government
7
4
27 Pension
44
38
Retail
21
32
Pension
Retail
Total Capital Under Management
Canadian Capital Under Management
Source: Thomson Financial
15
3.0 Overview of the Canadian PE Industry
Independent Funds
Pension, Corporate, and Government Funds
The majority of Independent funds raise their capital directly from institutional investors (such as pension funds, insurance companies and endowments), corporations, foreign
investors, governments and individuals through a limited
partnership structure. Several Canadian funds, such as
Onex Partners, raise capital both directly from LPs and by
listing partnership shares on public stock exchanges.
(Assets under management sourced via public stock
exchanges are included under retail funds).
These funds differ from the traditional independent limited
partnership and retail funds in that all are entities of a larger parent organization and use their own capital as opposed
to raising capital from limited partners or the public. Funds
organized in this manner are generally referred to as captive
funds.
Retail Funds
Retail funds are funds available in the retail, or public, market and are accessible to ordinary investors through shares
traded on public stock exchanges. While a portion of this
capital is the publicly traded interests of independent limited partnerships, the majority of these funds represent
Labor-Sponsored Venture Capital Corporations (LSVCCs) and
Provincial Venture Capital Corporations (PVCCs). These
funds are created by government statutes and individuals
are eligible for investment tax credits, to incent them to
invest in these vehicles. The first fund of this kind, the
Solidarity Fund created in 1983 by the Quebec Federation of
Labor, was created to allow workers access to the attractive
returns offered by private equity and to fund businesses
that would add jobs to the economy. Retail funds today continue this tradition, with economic development a principal
goal alongside profitability.2
1. Pension Funds
These funds are managed inside Canadian public and
corporate sponsored pension plans. These captive funds
are significant participants in the private equity industry.
For example, Teacher’s Private Capital, managed by the
Ontario Teacher’s Pension Board, participated in the
mega-buyout of Yellow Pages in 2002.
2. Corporate Funds
The majority of the funds in this segment are the strategic venture investment arms of industrial corporations.
These funds generally partner with early-stage companies or products that complement parent corporation initiatives. Telus Ventures, the investment arm of telecommunications company Telus, is one example. The remainder of this group comprises investment subsidiaries of
financial institutions such as insurance companies and
investment banks. Manulife Capital, with $500MM AUM
(or capital under management), is one of the largest participants.
Pension, Corporate, and Government Funds
3. Government Funds
These funds differ from the traditional independent limited
partnership and retail funds in that all are entities of a larger parent organization and use their own capital as opposed
to raising capital from limited partners or the public. Funds
organized in this manner are generally referred to as captive
funds.
This segment represents government-owned private
equity funds, usually organized through a federal or
provincial agency or crown corporation. These funds are
focused on providing capital to small and medium sized
business. The Business Development Bank of Canada
(BDC) is one of the better-known funds of this type.
2 The federal LSVCC tax credit was introduced in 1986 to provide individual investors with a tax credit equal to 20% of the net cost of their LSVCC shares and
up to $700. In 1992, the maximum federal LSVCC tax credit increased to $1,000. In 1996, the tax credit was reduced from 20% to 15% of LSVCC shares with a
maximum credit base of $525. However, in 1998, the credit limit was increased to $750.
Some provinces including Nova Scotia, New Brunswick, Quebec, Ontario, Manitoba, Saskatchewan and British Columbia offer provincial LSVCC tax credits in
addition to the federal credit. Like the federal regime, certain provinces reduced the tax credit from 20% to 15% of LSVCC shares in 1996. More recently, in 2005,
Ontario announced that the LSVCC credit would be phased out (by lowering the tax credit rate by 5% a year beginning in 2009) and eliminated by 2011.
Currently, Quebec remains the largest jurisdiction that has maintained its LSVCC tax credit system, and in 2007 accounted for 82% of the labor-sponsored
fundraising.
16
3.0 Overview of the Canadian PE Industry
Exhibit 9: Largest Canadian Funds and Deals
Largest Canadian Buyout Fund s Raised 2002-06
Fund size
CAD Millions
Firm name
Year
Onex Partners II LP
3,900
Onex Partners I LP
2006
2003
2,200
Birch Hill Equity Partners III LP
850
2005
EdgeStone Capital Equity Fund Ill LP
800
2006
RCL Private Equity LP no. 2
720
2006
ONCAP LP II
575
2006
Tricor Pacific Capital Partners Fund IV
555
2006
TorQuest Partners Fund II LP
550
2006
Macquarie Essential Assets Partnership
460
Tricap Restructuring Fund
417
2004
2002
CAl Capital Partners and Company III LP
375
2003
Largest buyout* deals**
Deal size
CAD Millions
Bell Canada Enterprises
48,800
Fairmont Hotels & Resorts Inc.
3,900
Four Seasons Hotels Inc. (NYSE:FS)
3,700
Masonite
Yellow Pages
3,100
1,890
Teacher’s Private Capital, Providence Equity,
Madison Dearborn
Colony Capital, Kingdom Hotel Investments
Cascade Investment, Kingdom Hotel Investments
KKR
KKR, Teacher’s Private Capital
* Includes re al e state and energy buyout deal s
** Includes announced deals
Source: Thomson Fi nancial
17
4.0 How private equity firms add value to portfolio
companies and the broader economy
4.1 Overview of Value Added by PE
Buyout firms create value for Portfolio Companies by pulling
strategic, operational, organizational and financial levers.
Though public companies can also employ these levers,
Buyout firms are more effective because they have stronger
governance, challenge conventional wisdom of management teams and encourage long-term mindsets.
As Buyout activity increases and performance improvements driven by Buyout investments touch a greater portion
of our economy, the competitive standard for all market participants is increased. The resulting growth fuels increased
demand for raw materials, end products and jobs and thus
benefits the economy as a whole.
An Ernst & Young study examined 2006 Buyout exits and
found that on average Buyout firms increased the value of
Portfolio Companies by 83% in the US and 81% in Europe
over an average hold period of 3 years. By comparison, public companies increased their value by only 33% and 23% in
the US and Europe, respectively, over the same hold period.
Exhibit 10: How Private Equity Firms Create Value
Value Adding Levers
Strategic
Operational
Organizational
Financial
Common to PE firms
and public companies
18
Enablers
1
Align incentives
2
Turbo charge governance
2a
- Active board
2b
-Enhanced mgmt team
3
Instill new mindsets
3a
- Execution focus
3b
- New perspectives and
approaches
3c
- Long term perspective
Unique to PE
Increase in Value
Increased
revenue
Increased
margins
Increased
productivity
of capital
4.0 How private equity firms add value to portfolio
companies and the broader economy
4.2 Value Adding Levers
Strategic Levers
Strategic levers can include expanding markets, increasing
share in existing markets, growing through acquisitions and
refocusing through divestitures. Expanding the market
means either introducing new products to existing markets,
or using the same products and expanding into new markets. For example, when EdgeStone bought Hair Club for
Men, the product offering consisted only of toupees for
men. During its hold period, EdgeStone worked with management to add new product for existing markets, such as
surgery and shampoos, as well as expanded into new markets with a new product line targeted to women.
A Buyout firm’s ability to grow share in existing markets
means increasing sales relative to competitors in the same
market. One common strategy used by Buyout firms is to
either expand the market or grow market share by pursuing
new channel strategies (e.g., selling insurance online as
opposed to door-to-door), new partnerships (e.g., joint venture agreements with foreign companies to sell Canadian
products abroad), and acquisitions of complementary businesses. For example, when the leading windows manufacturer in Eastern Canada, Farley Windows, was taken private
it was merged with the leading one in Western Canada
(Gienow), after which the combined company IPO’d and
increased market share significantly.
19
4.0 How private equity firms add value to portfolio
companies and the broader economy
Constellation Software: The Creation of a Canadian Multinational
On
May
18th,
2006,
Constellation
Software Inc. completed a successful
initial public offering on the Toronto Stock
Exchange.
Constellation Software
Vision
software businesses that develop
The company’s story began
specialized, mission-critical software
over a decade earlier in 1995 when a
solutions to address the specific needs of
venture capitalist recognized the value of
our particular industries.
creating a permanent and professional
owner for a group of niche vertical market
software companies.
Since then, the
Location
growth, into Canada’s second largest
independent software company.
Constellation Software is not the large
private equity backed turnaround story
commonly seen on the front page of
Toronto; with offices located in North
America, Europe, and Australia
company has grown rapidly, though a
combination of acquisitions and organic
To acquire, manage and build market-leading
2007 Revenues
$226,800,000
Employees
1,600
Investors
Ontario Municipal Employees Retirement
System; Birch Hill Equity Partners II, L.P.
business publications over the past
several years; however, the story is illustrative of how private equity creates value. Through multiple equity investments over an extended period of time, Constellation Software and its private equity partners were able to expand
a successful business model, significantly increasing its geographic and industry coverage.
At Constellation’s inception, the vertical market software industry was fragmented. Companies in the industry
were typically small and were often run as lifestyle businesses. While the businesses were inherently attractive,
some owners were risk-averse, while others were comfortable with “good enough” performance. The founder
approached the Ontario Municipal Employees Retirement System (OMERS) with the idea that the application of
best practices to these businesses, coupled with modest economies of scale, could create an enduring and profitable enterprise. In 1995, OMERS committed to invest C$23.75MM in the business. A further C$60MM was invested
in 2000 by a syndicate including OMERS and Birch Hill Equity Partners.
Constellation Software’s first acquisition was Trapeze Software Inc., a provider of route-scheduling software for
public transit authorities. Trapeze has since expanded into additional geographic and industry sectors through
multiple acquisitions and a green-field start-up.
20
4.0 How private equity firms add value to portfolio
companies and the broader economy
From 1996 to 2006, Trapeze Group grew revenues at an average rate of 24% per year, 14% of which was organic
growth. In addition to Trapeze, Constellation has 5 other significant operating groups, providing software to
more than 20 additional vertical markets.
Constellation’s business has generated phenomenal results. Since 1996, Constellation has achieved revenue
growth averaging 36% per year, with organic growth averaging 8%. In addition, operating margins increased
from 6% in 2001 to 15% in 2006.
The Creation of a Canadian Multinational
Constellation Software, in partnership with a talented and resourceful
group of private equity investors, has created a market leading
multinational corporation with annual revenues of a quarter billion
dollars in just over a decade. The company, headquartered in Toronto,
Canada, employs 1,600 people and has over 40 offices in North
America, Europe, and Australia.
It is difficult to imagine the creation of Constellation Software without
private equity involvement. Even if existing companies like Trapeze
realized the structural opportunity present in their niche markets, they
would not be capable of raising the required capital to execute the
strategy in debt or public equity markets. Building a company like
Constellation required a long-term focused investment and consistent
execution.
Constellation Software’s private equity partners were
“We could not have built
the company without the
help of our private equity
partners. Our business
plan required investing
our profits back into the
business to fund growth.
We needed patient investors whose interests and
beliefs were aligned with
ours. We found that in our
private equity partners.”
-Mark Leonard, CEO
experienced investors, capable of providing sound strategic guidance
to the founder. Most importantly, the investors had the patience to
allow Constellation to use their investment to grow the business without the need for a short-term return on
their investment. OMERS held their investment for almost 11 years before generating a significant return, while
Birch Hill Equity Partners held for 6 years.
Public markets value Constellation Software at approximately C$500MM, more than six times the capital
invested in the business. Constellation’s remaining private equity investors still retain a significant ownership
stake in the company, confident that the business they helped to build will continue to grow and create value.
21
4.0 How private equity firms add value to portfolio
companies and the broader economy
Operational Levers
Operational levers improve margins, or profitability, of the
Portfolio Company and can be broadly grouped into two categories: instituting more efficient operations and reducing
input and intermediary costs (cost of goods sold).
Often, companies attempt to create a culture of entrepreneurship and performance to drive employee productivity.
Rewarding top sales executives for a job well done or fostering innovation through consistent company problem solving
sessions are examples of such strategies.
Financial Levers
Reducing cost of goods sold is often undertaken as a productivity enhancing mechanism. Depending on the type of
industry, COGS can vary from services (e.g., accounting firm)
to raw materials (e.g., clothing company). Strategies to
reduce COGS include better purchasing and pricing. For
example, securing bigger volume discounts through better
negotiations with suppliers and/or reducing the number of
suppliers results in COGS reduction.
Instituting more efficient operations is another mechanism,
as removing operational inefficiencies is typically an easy
means of improving profitability. This is accomplished
through consolidation, lean production practices, automation and moving low value added production to lower cost
geographies. For example, Hair Club for Men is a Canadian
Portfolio Company that achieved operational efficiencies by
moving its production from China to Indonesia. This resulted in lower input costs for the companies, an ability to grow
market share and lower prices for consumers.
Organizational Levers
Organizational levers can include structure, systems, people and culture management. Enhancing management practices is a key lever that Buyout firms use to add value.
Research suggests that effective management is a key lever
in improving the productivity of labor and capital. A joint
McKinsey, Stanford University and LSE study assessed 4000
manufacturing companies in North America, Europe and
Asia across 18 management indicators (e.g., talent management, performance tracking) to create an “Assessed
Management Practice Score” for each company. The score
was compared against a range of corporate performance
indicators and revealed the impact of good management on
both labor and capital productivity, as well as sales
growth.4 (Exhibit 11)
Larger levels of debt allow Buyout firms to purchase portfolio companies with lower amounts of their own equity. Over
the life of the investment, the debt is paid down and more
value is allocated to the equity holders.
Portfolio Companies benefit from borrowing because they
gain access to lower cost capital, which results in the
Portfolio Company being able to expand and grow operations. Debt is lower cost than equity because it has a priority claim against the income and assets of the business. The
flip-side is that more debt also increases the risk that the
equity holders will receive lower returns than if less debt is
borrowed, since the equity holders are subordinate to debt
holders. For that reason, the level of borrowing by any company is influenced by management’s perception of shareholder expectations. In a public company, for example,
management is less likely to borrow as much as a sophisticated group of shareholders of a private company that is
prepared to tolerate the higher risk to which their equity is
exposed. For these aforementioned reasons, buyout firms
are willing to allow higher levels of debt and accept the correspondingly higher risk.
Though this is the most frequently cited and often criticized
value adding strategy of Buyout firms, McKinsey research
shows that debt is the main value adding lever for only
~30% of deals. (Exhibit 12)
In addition, once the Buyout firm buys the Portfolio
Company, it often restructures its debt and strengthens the
financial position of the portfolio company during the holding period. This could include replacing more expensive
debt (e.g., high yield) with less expensive debt (e.g., revolving credit facility), thereby reducing interest payments of
the Portfolio Company.
4Management Practice & Productivity: Why they matter. Centre for Economic Performance – London School of Economics, McKinsey & Company, Stanford
University, July 2007.
22
4.0 How private equity firms add value to portfolio
companies and the broader economy
Exhibit 11: Impact of Effective Management on Company Productivity
7
Labour productivity
6
5
4
20
20
1
2
3
4
5
Assessed management practice score*
ROCE (Percent)
Sales growth (Percent)
15
10
5
15
1
2
3
4
5
Assessed management practice score*
10
5
1
2
3
4
5
Assessed management practice score*
Firms are grouped in 0.5 increments of assessed management score
ROCE- Return on Capital Employed
* Joint McKinsey, Stanford University and LSE study assessed 4,000 companies in North America, Europe and Asia across 18 management indicators (e.g., talent
management, performance tracking) to create an “Assessed Management Practice Score” for each company
Exhibit 12: Primary Sources of Buyout Value Creation
100% = 60 deals from 11 leading US private equity firms
Other
5%
Market/sector
appreciation, plus
financial leverage 32%
63%
Company
out-performance
Source: The McKinsey Quarterly, Volume 1, 2005
23
4.0 How private equity firms add value to portfolio
companies and the broader economy
4.3 Enablers
1 Align incentives through the organization
Buyout firms use substantially different compensation
structures from public companies in order to better align
incentives in the organization. As part of the total compensation package, Buyout firms tend to give more equity (e.g.,
stock options) to management compared to public companies. Senior managers of a Buyout owned portfolio company typically own 2-10% of the company. This is critical as it
translates into a substantial wealth creation opportunity for
management, but only if management is able to increase the
value of the Portfolio Company. In addition, McKinsey
reports that successful Buyout firms give leading managers
a system of performance based rewards that usually range
from 15-20 % of the total equity given5. Finally, CEOs are
also required to invest significant sums of their own money
in the Portfolio Company. All of these strategies align the
incentives of stakeholders and ensure a highly motivated
management team.
to focus on company strategy and operations by virtue of
being private. In addition, since the board and shareholders of the Portfolio Company are the same small group of
people, key decisions are made quickly, as opposed to public companies that require separate shareholder approval
and lengthy formal processes.
2b Enhanced management team
As mentioned in the “Organizational Levers” section above,
Buyout firms frequently inject portfolio companies with toplevel talent. McKinsey reports that 83% of the best Buyout
deals had significant board involvement or outside expertise6. This could range from installing new CEOs and CFOs at
the onset of the deal, to providing access to seasoned
experts during the holding period who bring proven track
records of success to the table. By contrast, public companies typically do not do so on a consistent basis.
2 Turbo charge governance
2a Active and engaged board
Buyout managers play an active oversight role with respect
to the activities of their Portfolio Companies, typically
assuming 1-2 seats on their boards. The board is often comprised of 3-4 people, consisting of Buyout managers plus
top management and/or experts, and is obligated to review
and approve any major decision made by the Portfolio
Company. Compared to public companies, these board
members can usually make better informed decisions.
Specifically, board members of public companies have had
to spend an increasing amount of their time dealing with
regulatory and compliance matters and many corporate
directors believe that this has come at the expense of their
ability to focus on providing strategic direction to their
firms. Directors of Buyout funded companies are more able
5Why Some Private Equity Firms Do Better Than Others. McKinsey Quarterly, October 2005.
6Ibid.
24
4.0 How private equity firms add value to portfolio
companies and the broader economy
CNC Global: The Road to Number One
CNC Global is Canada’s leading provider of customized
IT recruitment and resource management solutions
with annual revenues in excess of $250 million.
Essentially, CNC Global is the only single source IT
CNC Global
Vision
Be the undisputed leader in our
chosen markets - and set the
staffing solution for top companies operating across
standard for others to follow -
both Canada and North America.
by redefining what it means to
work with a staffing firm.
In 2004, CNC Global’s situation was quite different.
The company was having limited success as one of
several regional providers of IT staffing solutions, with
Location
Toronto; with offices in Halifax,
revenue of $147 million and uncertain prospects for
Montreal, Ottawa, Mississauga,
future growth. Management recognized the need of
Richmond Hill, Calgary,
national and multinational corporations for a single IT
Winnipeg, Edmonton, Vancou-
staffing provider, but lacked the resources to grow the
ver, and Victoria
business. As such, management decided to partner
with like-minded private equity professionals with the
2006 Revenues
$250,000,000
transform CNC Global into a national player.
Employees
250
In June 2004, TorQuest Partners, Scotiabank Private
Investors
TorQuest Partners Value Fund,
market
knowledge,
resources,
and
capital
to
Equity, and members of the CNC Global’s management
Scotiabank Private Equity
team purchased the company from its existing owners.
Investments
Management’s equity ownership was substantial.
This ownership translated into a substantial wealth
creation opportunity for management, but only if management was able to increase the value of the company.
Having a substantial interest reinvigorated the management team and helped create a culture of entrepreneurship and performance.
From day one the strategy was to transform CNC Global into Canada’s number one provider of IT staffing solutions.
TorQuest introduced management to some of the largest consumers of information technology in North America
and management continually won new business, with organic revenue growth of almost 30% from 2004 to 2006.
In addition, private equity worked with management to identify potential acquisitions that could strengthen the
company’s presence in the Ottawa region and within the public sector, completing a successful acquisition in the
winter of 2005.
On May 1st, 2006, CNC Global was sold to the North American division of Vedior NV, one of the world’s largest
staffing companies. During the period of private equity ownership, CNC’s annual revenues increased from C$147
million to C$250 million. The company grew from 180 to 250 employees and opened two new offices in Halifax
and Richmond Hill.
25
4.0 How private equity firms add value to portfolio
companies and the broader economy
CNC GLOBAL
Before and After Private Equity
Employees
Revenue
$ Millions
250
10
250
8
180
147
2004
26
2006
2004
2006
2004
2006
4.0 How private equity firms add value to portfolio
companies and the broader economy
3 Long-term mindset
3c Long-term thinking and sustainability
3a Execution focus
A 2005 study by the U.S. National Bureau of Economics
Research (NBER) states that more than 50% of CFOs would
cut a value-creating project in order to meet short-term
earnings targets8. In contrast to public companies, Buyout
Buyout managers bring an execution mentality, For example, during the first 100 days of purchase, buyout managers
often meet daily with top executives, to establish relationships, detail responsibilities and set corporate strategy.
Once a plan is developed, it is subject to continuous review
and revision, and progress is monitored closely through a
set of key performance indicators to ensure successful
implementation. McKinsey reports that in successful Buyout
deals performance management and monitoring systems
were implemented 92% of the time. 7
3b New perspectives and approaches
Buyout firms continuously challenge the plan of the management team and develop their own well-researched and
thought-out viewpoint on what the key value drivers are. The
combination of the experience of incumbent management
and new views from the buyout investors create new but
practical approaches to move a company forward. The
process has some critical elements. One is external benchmarking through a range of key performance indicators
(KPI’s) and processes (e.g., overhead costs, utilization of
assets) that may identify best practices to emulate. The
process also provides independent verification of key
assumptions about the business, such as the outlook for
the industry and the competitive position of the portfolio
company. Publicly held companies can and should undertake similar intensive assessments. However, since these
assessments are time consuming, expensive and require an
outside perspective, they are usually not performed to the
same degree.
owned Portfolio Companies do not have to “manage to earnings”, a term that describes a public company’s obligation
to report quarterly earnings. This typically allows Portfolio
Companies owned by Buyout firms to reinvest profits to
grow the business as required.
Most importantly, Buyout firms give Portfolio Companies a
sustainable competitive advantage that can be observed
long after the Buyout firms sell their investments. Research
demonstrates that companies sold by Buyout firms tend to
do better in the market than companies that were never
owned by Buyout firms. Specifically, a 2007 University of
Florida study looked at 500 private equity led IPOs over a
22-year period, and it showed that LBO exited IPOs consistently outperformed other IPOs and the market as a whole.9
7Ibid.
8The Economic Implications of Corporate Financial Reporting. National Bureau of Economic Research (NBER), January 2005.
9Professor Jay Ritter. University of Florida, 2006.
27
4.0 How private equity firms add value to portfolio
companies and the broader economy
Yellow Pages: Growing Canada’s Largest Directory Publisher
The private investment arm of the Ontario Teachers’ Pension Plan (OTPP), Teacher’s Private Capital, and Kohlberg
Kravis Roberts & Co (KKR) purchased the Yellow Pages Group in November 2002 for $3 billion. At the time, the
acquisition of Bell Canada Enterprise’s telephone directory business represented the largest buyout deal in
Canadian history. Of course, this record has since been eclipsed, most notably by the proposed acquisition of
Bell Canada Enterprise itself for $48.8 billion by an investor group led by Teacher’s Private Capital. While at first
glance a telephone directory business doesn’t seem very exciting, the Yellow Pages story is an example of how
private equity intervention can completely alter the trajectory of a mature and relatively low growth business.
Prior to Yellow Pages acquisition in 2002, the company’s
revenue growth over the previous decade averaged less than
3% per year. This is not to say that Yellow Pages was not a great
business. With recurring revenue streams and high profit
margins, these businesses have always been a favourite
TRACK RECORD OF GROWTH
2002-06
$ Millions
Adjusted revenues
division of telephone companies. The difference is that private
+23%
equity investors recognized untapped potential for growth.
1,390
Yellow Pages is an essential link between Canadian small and
medium sized businesses and their customers. By expanding
the reach of this platform both online and through other print
channels, KKR and Teacher’s helped Yellow Pages grow
revenue an astonishing 23% per year since their initial invest-
613
ment.
Recognizing an opportunity is one thing, but executing a new
strategic plan is quite another. From day one, Yellow Pages’
private equity partners devoted substantial resources to
improving the business. The new owners assembled a talented
executive team within four weeks of completing the purchase.
2002
2006
Adjusted EBITDA
Considering the boards of public companies typically debate
the hiring of new senior executives for months, this was quite
+22%
748
an accomplishment. In addition, KKR engaged Capstone to
work directly with senior management to improve operations.
341
2002
28
2006
4.0 How private equity firms add value to portfolio
companies and the broader economy
During the period of private equity ownership, Yellow Pages increased operating profit margins almost eight
percent.
The Yellow Pages Group completed an IPO in August 2003, selling approximately 30% of the company to the
pubic, with KKR and Teacher’s private capital retaining 70% ownership. At that time, the market valued Yellow
Pages at $4.7 billion dollars. In a little over year, private equity investors increased Yellow Pages value by an
impressive $1.7 billion, providing their limited partners and the OTTP pensioners a significant return on investment. KKR and Teacher’s continued to be owners of the business until June 2004 and OTTP still retains a large
number of shares in the company. Since the IPO, shares in Yellow Pages Group Income Fund have performed
well, returning an annualized 14.4% to investors.
4.4 How PE Firms Add Value To The Broader
Economy
In addition to adding value to Portfolio Companies, Buyout
positively impacts the broader economy by increasing productivity, adding to GDP, creating jobs and improving capital markets. In the section that follows, we discuss the
impact of these measures.
1 Productivity Impact
In section 4.3, we examined how Buyout firms build
stronger, more productive Portfolio Companies. This issue is
particularly relevant for Canada given that lagging productivity has been a source of concern for executives and policymakers alike for several years. A comparison of Canada
against other developed countries highlights this point.
(Exhibit 13)
Exhibit 13: Canadian Productivity Compared to Rest of World
National output per employee hour, 2006
Purchasing power parity dollars
Norway
3,1
73
France
51
US
51
Germany
43
Canada
40
35
Of greater concern
than Canada’s ranking
is the improvement in
5,1 productivity over the
last 6 years, with only
3,8
a 0.5% improvement
per year compared to
4,4
over 3% for other
devel oped nations
3,4
47
UK
Japan
Change in output per hour, 2000-2006*
Percent
0,5
3,5
* Manufacturing
Source: Bureau of Labor Statistics
29
4.0 How private equity firms add value to portfolio
companies and the broader economy
Buyout firms help address the issue in Canada as the
improvements in both labor and capital productivity at the
Portfolio Company level ripple through the economy
through an aggregation of the increased productivity of all
companies. Specifically, the improved productivity of the
Portfolio Companies sends signals along the value chain to
suppliers, and raises the bar for competing companies to
improve their own performance so that they can compete
with the Portfolio Companies.
2 GDP Impact
Broadly defined, GDP is a measure of the size of an economy’s annual activity. Technically, GDP is the sum of all value
added by firms at different stages of the industry production
and service process. In other words, it is the sales in an
economy minus costs of intermediary goods and services.
Buyout firms add to GDP in three primary ways: increasing
growth of the Portfolio Companies which impacts the economy through the multiplier effect, creating economic value
from the management fees paid to the GPs, and through
higher wealth resulting from higher returns (Exhibit 14)
2a Portfolio company growth
Buyout controlled Portfolio Companies typically have higher
sales growth than their industry peers. Research suggests
that the cumulative effect of the increased sales of Portfolio
Companies adds between $20 and $25 billion to Canadian
GDP, ~ 0.4% of total Canadian GDP over the last five years.
This estimate is based on measuring the increase in sales of
all Buyout controlled companies in Canada over the past five
years, and determining how much of this increase is attributable to Buyout ownership. The analysis examines the outperformance of Buyout controlled firms compared to industry peers and quantifies net incremental economic output,
controlling for industry growth and captured market
share 10 .
The direct impact on GDP comes from the increased output
generated by growing Portfolio Companies. This output
grows GDP through the multiplier effect, i.e., not only directly from Portfolio Companies but also from suppliers who
must grow to meet demand. As the sales increase at different stages of the value chain, profitable companies will add
value at each stage and simultaneously require more workers to fill new orders, thereby raising national GDP.
A similar study looked at Buyout investments’ annual economic impact on GDP was commissioned by the California
Public Employees’ Retirement System pension fund
(CalPERS). Although the methodology11 was different, it
also found that Buyout contributed positively to GDP12.
2b The growth of the Buyout industry
In addition, the small but rapidly growing Buyout sector
itself added $1.3 billion to GDP by virtue of being a new component of the financial services industry. This increment to
GDP is based purely on the additional management fees
that are charged by the GPs. These fees help cover basic
expenses for operating the Buyout firm and also multiply
throughout the economy through spending on office space
and equipment, outside research, utilities, etc.
2c Increased wealth
As Portfolio Companies increase in value, investors in
Buyout funds obtain a higher return on their investment.
More often than not, this return is higher than traditional
returns in Canadian stocks. Not only does this increase the
wealth of the investors but it in turn flows into the economy
through two separate mechanisms:
First, the tax paid by the LPs and GPs when returns are realized serves as a new income stream for the Canadian government, enabling the government to increase its spending
or cut taxes. In the last five year period (2002-2006), such
increase in government fiscal room raised the Canadian
GDP by $1.9 billion.
10Captured market share simply transfers output from one producer to the next. Net incremental output is over and above the expected production level;
typically through entry into new markets, or the launch of higher value products and services.
11This is not the marginal impact versus a non-PE investment scenario, but the economic impact of private real estate assets held by that pension fund.
Furthermore, these impacts do not represent all PE firm impacts on California, but simply those impacts from CalPERS. For more information see; The Impacts
of CalPERS Investments on the California Economy. CalPERS and Applied Research Center, September 2007.
12The Impacts of CalPERS Investments on the California Economy. CalPERS and Applied Research Center, September 2007.
30
4.0 How private equity firms add value to portfolio
companies and the broader economy
Exhibit 14: Buyout’s Positive Impact on GDP
PE ADDED $25-$30 BILLION TO GDP OVER LAST 5 YEARS, ~0.4% OF
TOTAL NATIONAL GDP
To tal cumulative GDP impact 2002-2006
Billions CAD
25
3
2
30
5
5
25
20
PC
performance
Description
• Portfolio companies
outperfor m the growth
of their industr y peers
(range due to
different assumptions
on market
cannibalization)
PE as an
industry
Wealth effects
• Management
• Incr ease in PC
fees to PE fir ms
represents a
new revenue
stream
Total
valuations compared to
mar ket average results
in higher levels of wealth
and taxable capital gains
Buyout’s positive impact on government tax revenue
In section 4.2 we mentioned that the Buyout firms often borrow to acquire Portfolio Companies. Interest paid on
these debts is generally tax deductible against the earnings of the companies business. The flip side is that lenders
to these businesses are taxable on the resulting interest payments. In addition, the investments are designed to
help businesses grow, generating additional payroll taxes, goods and services taxes, provincial sales taxes, and
income taxes on employment and business earnings.
Portfolio companies: Once the debt has been paid down over the hold period (typically ~ 5 years), the Portfolio
Company is set on a higher growth trajectory and pays more in corporate taxes for subsequent years. Further, while
the tax shield applies to just the Portfolio Company, suppliers along the value chain who experience growth along
with the Portfolio Company also pay greater taxes on their increased earnings. Lenders are also taxable on the interest earned on monies loaned to the Portfolio Company.
31
4.0 How private equity firms add value to portfolio
companies and the broader economy
Secondly, the higher returns increase investors’ levels of
wealth, which in turn are closely associated with higher consumption levels. Separate studies by the Federal Reserve
Bank and McKinsey estimate that for every $1 increase in
equity, 1-3 cents is spent in the economy13. This suggests
that the portion of the Buyout return that was over and
above TSX 300 returns alone led to an increase in GDP of
$1.3 billion.
3 Jobs Creation
Associated with each of these increases in GDP is the creation of new employment. Overall, an estimated 114,000
jobs (or 0.5% of the total gross jobs created) were added to
the Canada economy by Buyout firms over the last five years
(Exhibit 15).
The jobs are created throughout the economy in both manufacturing and services and can be mapped to the economic impact with which they are associated. (Exhibit 15).
The growth of Portfolio Companies results in increased
demand for labor in the Portfolio Company itself as well as
along its value chain and through the multiplier effect. The
Buyout sector itself generates employment in financial services and, finally, increased spending by governments (from
higher tax revenues) and investors (from higher returns)
boost demand for goods and services in the economy.
Alberta offers an excellent example of job multipliers with
only 75,000 -200,000 jobs in the energy industry creating
almost 10X the jobs in the economy overall.
Exhibit 15: Positive Impact of Buyout on Job Creation
OVER ONE HUNDRED THOUSAND JOBS ADDE D TO THE ECONOMY OR
0.5% OF TOTAL JOBS ADDED OVER THE LAST 5 YEARS
114
To tal cumulative additional employment impact 2002-2006
Thousands
25
87
PC
performance
Descriptio n* • Jobs created for
PCs and PC
suppliers
resulting from
extra spending in
their industries
2
PE as an
industry
• Jobs created
for PE firms
and PE
suppliers
* Methodol ogy to de ri ve numbers d escri bed i n app endix
Wealth effects
Total
• Higher government spending
results in more jobs for
health, education,
government services, and
transportation
• Higher induced spending
contributes to employment in
a myriad of consumer
industries
13The Coming Demographic Deficit: How aging populations will reduce global savings. McKinsey Global Institute, 2005; The Wealth Effect in Empirical LifeCycle Aggregate Consumption Equations. Federal Reserve Bank of Richmond Economic Quarterly, Spring 2001; Are Wealth Effects Important for Canada?
(Working Paper 2003-30). Bank of Canada, 2003.
32
4.0 How private equity firms add value to portfolio
companies and the broader economy
Given the focus of the Buyout industry on higher value
added sectors of the economy these jobs tend also to be
disproportionately higher value jobs. This is particularly
salient to Canada as it moves further away from being a natural resource dominated economy.
Each job generates incremental income and payroll taxes,
including Canada Pension Plan contributions, Employment
Insurance premiums, and numerous provincial levies
including Quebec Pension Plan contributions, Quebec
Parental Plan Insurance premiums, and various Provincial
health taxes and levies.
This is in line with other studies, such as the 2007 AT
Kearney report that found that over the last four years
Buyout has added 600,000 jobs in the US and one million
jobs in Europe.14
Example of How Buyout Firms Help Certain Sets of Individuals
Canadians
Benefit from larger number and better quality of jobs, higher returns on their
investments and over the long run, an improved standard of living
Union members
Can benefit from stronger pension funds to make future payouts
Governments
Gain from increased tax revenues paid by better performing companies and higher
overall productivity
14Creating New Jobs and Value with Private Equity: All companies can learn from the strategies employed by PE firms. AT Kearney, 2007.
33
4.0 How private equity firms add value to portfolio
companies and the broader economy
4 Capital Markets
In addition to the quantifiable benefits to the economy private equity has a positive impact through its strengthening
of capital markets. Buyout creates new investment opportunities and diversification benefits while also acting as a catalyst for increased market sophistication and stability.
Buyout funds provide an attractive alternative to institutional investors who have been shifting away from portfolios
comprised of only conservative investments. For example,
mounting pension obligations for retirees have forced pension funds to seek higher return assets. Private equity
investments meet this need because they provide important
diversification benefits that increase the value of the pension portfolio and therefore, benefit pensioners.
The existence of private equity creates a new asset class in
which institutions and individuals can invest. This offers
portfolio diversification benefits for investors, not only for
the traditional Buyout funds but also for newer types of
investments such as transportation infrastructure funds. In
the absence of Buyout firms these types of assets would not
be widely available for investment (nearly $40 billion raised
globally in 2007 alone).
How Buyout Benefits Diversification
Diversification allows investors to earn higher levels of return by spreading risk across sets of investments.
Because there is a wide range of potential returns for different investments (private company A vs. private
company B) and different investment classes (private companies vs. shares in public companies), establishing a
diversified investment portfolio helps that portfolio absorb sudden shifts that may be idiosyncratic (e.g., due to
specific investments).
Private equity investments meet this need for diversification by offering potentially higher returns that are not
correlated with returns of traditional asset classes like stocks and bonds.
Leveraged loan correlation with major asset classes:
34
Equities
Investment Grade Bonds
High Yield Bonds
0.13
0.08
0.50
5.0 Implications and conclusions
Canada’s Private Equity industry has grown significantly in
recent years and has now assumed a prominent role both
within the financial services industry and in the broader
Canadian economy.
This Study was prepared to raise awareness of the nature,
structure, functioning and growth of Canada’s relatively new
Private Equity industry and particularly its Buyout component. The study’s principal findings from both a macro and
a micro perspective point to an overriding conclusion,
namely: a vibrant, well-functioning Private Equity industry is
an indispensable motor of Canada’s economic growth and
corporate renewal.
The hyper-competitive global economic world of the 21st
century means that individual countries need to embrace
change, internalize the process of industrial and commercial transformation and continuously re-invent themselves.
The alternative is to be at the mercy of outside events and
external forces.
The Buyout industry’s very nature and core mission – to
grow companies – can be a fundamental competitive advantage to a country that seeks to determine its own future
rather than have its fate decided by others. A strong Buyout
industry can play a vital role in a modern economy’s selfrenewal.
Some observers compare the Buyout industry’s role with
respect to the health of companies with that of the medical
profession. The Buyout industry performs necessary diagnostic, and remedial tasks with the express purpose of
improving companies’ well-being. It identifies industries
and companies whose health can be improved. It prescribes
improved strategy, improved operations, improved financing and improved organization.
This individual company by individual company activity
results in significant, tangible economic growth and job creation. Just as importantly, the process involves continuous
self-improvement that is hard-wired into the DNA of companies long afterwards. As detailed in this study, companies
that have received Buyout firm investment have continued
to perform better than those that have not.
Canada's economic performance in recent years provides
cause for celebration and for concern.
The celebration comes from strong economic growth in the
midst of global competition and rising uncertainties. That
strong economic growth can be ascribed to several factors
ranging from heightened demand for commodities to governments' improving financial positions. This study shows
that the Canadian Buyout industry is also making a considerable contribution to the country's positive economic performance.
The concern stems from the recognition that Canada cannot
afford to rest on its laurels and that there are looming
issues, which if not addressed, will compromise its economic performance going forward. Notable in this regard is
Canada's productivity performance that continues to lag
that of its main competitors. It has been estimated that
Canadian productivity is roughly three quarters that of the
U.S. and productivity improvements have not been as
robust as those south of the 49th parallel. Thus, in 2007,
labor productivity in Canada increased .5 per cent versus 1.9
per cent in the U.S. There are likely many factors at play to
account for this relatively poor productivity performance.
One of the key, albeit little-known, factors is the relative size
of the Buyout industry here and abroad. Canada still only
accounts for less than six per cent of global private equity
capital under management, despite the healthy growth of
recent years. In other words, Canada's competitors are
increasingly turning to their buyout industries as a key driver of corporate renewal and re-invigoration. We need to promote the growth and development of Canada's Buyout
industry in order to sharpen our competitive edge.
35
5.0 Implications and conclusions
The next imperative is to establish and maintain an environment where the Buyout industry can outgrow its own international comparators and in so doing provide Canada with
the necessary tools to outperform its global competition.
That environment would include:
• A tax regime designed to foster Private Equity fund
growth and provide a comparative advantage vis-à-vis
Canada’s main international competitors15;
• Effective measures to ensure the free flow of capital
into private equity funds from abroad;
• An improved system of securities regulation in Canada
by the establishment of a single national securities
regulator;
• Removal of inter-provincial trade barriers that are
constraining company growth.
In conclusion, much has been accomplished as the Private
Equity industry has grown but much more needs to be done
to build on the solid foundation that has been established.
15Global Trends in Venture Capital 2007 Survey. Deloitte Touche Tohmatsu, December 2007.
36
6.0 Appendix
6.1 Methodology to Calculate impact of
Buyout on Canadian GDP and Employment
The impact of Private Equity on Gross Domestic Product
(GDP) was calculated by determining the increase in sales
for Canadian portfolio companies attributable to Buyout
intervention. Sales impact was transformed into GDP impact
using an industry weighted StatsCan GDP multiplier. The
study considers the impact of investments in Canadian companies by both Canadian and foreign Buyout firms.
Employment numbers were also derived using an industry
weighted employment multiplier.
To measure the sales impact, a survey of Buyout firms was
conducted to determine sales at the time of investment and
exit for every company in the Buyout firm’s portfolio. This
change in sales was then divided into three slices; sales
growth that would have occurred without any Buyout intervention, sales growth that came through market capture
from other firms16 and the balance to sales attributable to
The wealth effect of increased government spending was
calculated by taking the capital gains tax differential
between PE returns vs. the TSX 300 assuming a typical PE
hold period of 5 years. The additional taxes paid on the
lagged returns of PE were assumed to be spent in the year
realized given a balanced government budget. These additional taxes were translated into GDP and jobs through a
synthetic multiplier created to reflect the proportional destinations of government spending (health, education, etc).
Additional wealth effects on GDP and jobs due to induced
consumption was calculated by taking the additional wealth
created from PE multiplied by an induced consumption rate
consistent with Canadian and US studies on increased stock
market wealth.
Buyout control (Buyout driven sales).
The Buyout driven sales for every Portfolio company over
the 5 year horizon was aggregated for all Portfolio companies and all surveyed Buyout firms to arrive at total incremental sales over 5 years. This total sales number attributable to the survey respondents was extrapolated to the entire
Buyout Industry. The result represents the total incremental
sales driven by the Buyout Industry in Canada. Through the
application of an industry weighted GDP multiplier this was
transformed into the net impact on GDP.17
16To calculate GDP impact only net new sales can be considered. Stripping out sales generated through market capture is essential since a transfer of sales
from one company to another adds nothing to GDP
17National Income and Product Accounts: Canada 2002-2004. Statistics Canada, 2006; Since multipliers are industry specific the multiplier used was weighted to accurately reflect the balance of industries found in the survey
37
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