Private equity

Private equity consists in investments in companies that are not publicly traded, or that are publicly traded but are taken off the market. The attraction for institutional and high net worth investors is an equity asset class that is not correlated with the daily valuations of public equities. Non-correlation is the product of a variety of circumstances. One is that valuations are generally annual. Others concern the nature of the various private investments. Venture capitalists invest in startups that they hope will one day be floated on the public markets through an initial public offering or be bought by a publicly traded company. Mezzanine financiers provide loans to late-stage startups or to established private companies that have hit the wall with their traditional bank credit lines in return for subordinated debt that pays a higher interest coupon. With leveraged buyouts, there could be two purposes at work: to take a company private for its relatively stable cash flows, or to restructure it to refloat it on public markets.

All levels of private equity are operative in the Canadian market although, to be successful, Canadian private equity players, some of whom are publicly listed (Onex, Kensington), some of whom are labour-sponsored funds (VenGrowth, GrowthWorks), and some of whom are institutional investors (Ontario Teachers, OMERS), generally require participation from foreign firms, usually U.S. private equity firms.

Venture capital
The late 1990s were the heyday of venture capital, with Silicon Valley financiers raising funds for high-tech or biomedical startups, all the while seeking the next Hewlett-Packard. Venture capital funds are mainly interested in serial entrepreneurs who, having initiated an enterprise and developed it to maturity, are ready to set off on their next project. For Canadian investors, many labour-sponsored investment funds emerged to "catch the wave" of tech investing. But it was not limited to retail funds. Québec's pension fund manager, the Caisse de dépôt et placement, was heavily invested in high-tech and biomedical startups. Nor is Canadian venture investing limited to the hi-tech or biomedical space; many Alberta oilmen are serial entrepreneurs too.

There are roughly four stages in a venture firm. Angel investing gets an idea off the ground and into a prototype. Early-stage investing involves product development and marketing, to get the company to turn a profit. Middle-stage (or second-stage) investors finance the expanded marketing and production of the now-profitable product. Late-stage venture capitalists prepare the company to go public or sell it to a strategic partner, such as a tech or health services company. Along the way, the venture fund supplies not just capital, but access to managers (for accounting, sales, marketing, among others) and strategic advice.

In each stage, there is a round (sometimes several) of financing. With each round, the venture capitalist negotiates an equity stake, based on an appraised value of the company. That appraisal takes into account the valuations fetched by other companies that have made a successful exit. Still, the stock market plays a role here. Successful exits occur in boom times, with IPOs or companies flush with capital buying venture firms by issuing more treasury shares. This was the strategy of Nortel in the late 1990s; it used its own stock market capitalization to make acquisitions, many of which were later written off. Too much money chasing a specific fund is good for the founder; too little dilutes the founder's stake. There is a cyclicality to venture capital, and that affects the returns investors can expect.

The cycle of venture financing is anywhere from five to eight years. Thus a fund that raised capital in a given year will make capital calls on its limited partners for further investments in a portfolio of companies over a set time. Funds are generally organized as limited partnerships so that the tax liabilities are flowed from the general partner to the investment partners. While a fund that is created in one year may not draw down all of its capital in the year of its formation – as it watches over the various steps in a portfolio company's evolution – the year of its formation counts as its "vintage year."

As with wine, some vintage years are better than others.

Mezzanine financing
Mid-stage venture companies – they are profitable – may require money for succession to a new owner, to make an acquisition or to expand. The same factors affect private companies that are not startups, but in fact long established. Rather than suffer a dilution of equity, private companies may turn to private equity funds to find the finance. In a mezzanine deal, the lender supplies subordinated debt that is ranked below senior debt such as bank financing and lines of credits; in return, it receives warrants that are convertible into equity.

In Canada, a number of pension funds, including the private capital divisions of the Ontario Teachers Pension Plan and the Caisse, and some labour-sponsored investment funds, such as VenGrowth and VentureLink – to mention but two – provide mezzanine finance.

Leveraged buyouts
For most Canadians, the attempted takeover of Bell Canada Enterprises (BCE) by the Ontario Teachers Pension Plan is their first experience with a leveraged buyout. The attempt failed, in part because of an actuarial valuation on the worth of BCE should it file for bankruptcy.

Let's consider the investment mechanics. OTPP gathered partners to make a $42.75 bid on shares trading in the low $30s. That was a $57-billion deal, constituting at least half of Teachers assets. But OTPP wasn't planning to become Canada's biggest telecom operator. It was looking for leveraged returns, together with its other partners.

In a leveraged buyout, the acquiring company assumes an equity stake, perhaps as low as 10%, perhaps as high as 30%. But to complete the acquisition, the acquiring company engages a bank or a syndicate of banks to float new debt on the acquired company. These are called leveraged loans that the acquiring company's financial advisor (normally an investment bank) shops as high-yield debt to institutional investors – who seek a steady coupon that may pay a bit more than Canadas or provincials or other guaranteed debt offerings.

LBOs were the subprime mortgages of the 1980s, and when financing came to a halt, there was a hue and cry for the Mike Milkens who offered high-yield debt to pay for their takeovers. Leveraged buyouts involve raising money from various partners to take a company private. The idea is that, with some restructuring, the cash flows from the now private entity will support the interest payments on loans that are not rated triple or double A – the norm for good-quality or investment-grade debt. Sometimes, the company is reorganized and then sold back into the public markets. Onex Corporation has done a number of such deals. But sometimes the purpose is to keep the cash flow private, to fund ongoing pension payouts, e.g., as is the case with Ontario Teachers ownership stake in Maple Leaf Sports and Entertainment, whose revenues are mainly derived from a hockey team as well as a basketball franchise.