Skip to main content

Dry powder abounds among Canadian private equity firms, but don’t expect a quick deployment.

With billions of dollars raised from investors – known as limited partners, or LPs – those firms are ready to scoop up scores of struggling small businesses, helping rescue Canada’s moribund merger and acquisition market. Except they won’t. At least, not in 2023.

Many senior leaders at PE firms across Canada are saying they expect to adopt a cautious approach in the coming year, with plans to keep much of their cash in reserve.

A great deal of the so-called dry powder in private equity right now is what is known as “young capital,” meaning money that has been raised relatively recently. Because PE firms typically have at least five years – and some have a decade or more – to deploy their capital, many are at points in their cycles where the pressure to spend is lowest.

For those nearing the ends of their deployment timelines, the pressure to invest is tempered by the imminent fundraising challenges facing the sector. Many of the larger LPs, generally institutional investors like pension funds, have become more heavily weighted in private equity as the value of their public market holdings has dropped. As a result, many simply lack the capacity to cut fresh cheques to PE firms, making it even more difficult to replenish dry powder once that cash is spent.

“2023 is going to be a very slow year … very few high-quality assets will transact,” said Pascal Tremblay, chief executive and managing partner of Montreal-area private equity firm Novacap. “You have to be very conservative and disciplined in your approach in these kinds of markets.”

According to the Canadian Venture Capital and Private Equity Association, or CVCA, Novacap was among the most active private equity investors of 2022, closing 10 deals worth a combined $833-million. But Mr. Tremblay said 2022 was “actually a slow year for us … we purposely slowed down our investment pace.”

He estimates the firm did at least 30 per cent to 40 per cent less business than it otherwise would have, “if not 50 per cent by the end of the year.”

“It is going to take a while to come back at this point,” Mr. Tremblay said, “that is for sure.”

Lisa Melchior, founder and managing partner of Vertu Capital in Toronto, is more optimistic. While it took months for sellers to stop holding out for a quick rebound to the astronomical valuations of 2021, she said, expectations have moved closer to reality.

“I think most companies were trying to see if it might be a quicker recovery than it appears it is going to be, so they were holding back from accessing any new capital or going to market,” Ms. Melchior said. “The next year or two are going to be excellent times to deploy capital and invest. It will be a great vintage.”

But, as with any great vintage, quality will outrank quantity. Ms. Melchior is among a growing chorus who expect private equity investors to be more judicious about where they spend their money next year.

Rob Normandeau, president of Halifax-based SeaFort Capital, said this increased selectivity will be to his benefit.

“Historically, we have had some challenges competing against bidders who have been very aggressive in terms of their use of debt and were maybe pricing at sometimes very high multiples,” he said. “I think the market will come to us a little bit more next year.”

At Novacap, Mr. Tremblay said, “the callback has already started,” as sellers facing rising debt servicing costs seek out new sources of sustaining capital.

After a frantic period of deal-making during the pandemic that accelerated an already busy market, the latest shift will allow more time for proper due diligence, Mr. Tremblay said.

“Ten years ago, you could get 90 days [of exclusivity], but a year ago or two years ago it was so crazy that you could not get more than 30 days,” he said. “Now it has gone back to 60 to 90 days, which is positive, because if you have a high-quality asset, you don’t need to be in a big rush to get it out the door.”

Ed Bryant, chief executive of Ottawa-based Sampford Advisors, which serves a broker-type role in the private equity sector, said the market has effectively returned to prepandemic levels from the more frenzied pace of the past two years. But he added that now buyers have adopted a “different mentality” toward companies without a clear path to profitability.

“During COVID-19, we were selling businesses that were growing quickly but were losing a lot of money,” Mr. Bryant said. “Those businesses are pretty much unsellable today.”

Many of those businesses are saddled with unsustainably high debt, unclear paths to profitability, or both. Given their increasingly cautious approach, private equity firms are declining to bid for those companies even if the price is right. Many are positioning themselves to wait for higher-quality assets to appear.

“Everyone is saying, ‘Oh, there is so much money, you’ve got to deploy it.’ Well, because it is quite young capital, you actually don’t have to deploy it. It is not burning a hole in anyone’s pocket, that is for sure,” Mr. Bryant said.

Many of those higher-quality companies, meanwhile, are reluctant to come to market unless they can attract market-topping valuations.

“There are still sellers out there who are stuck in 2021 pricing and just won’t sell their businesses,” said Bradley Mashinter, head of private equity for Montreal-based Fiera Capital. “And if you don’t have to sell a business and you can afford to be patient, then people are being patient.”

In Halifax, SeaFort’s Mr. Normandeau has noticed the same trend.

“Quality businesses are still selling at a premium, but businesses that are not achieving their price goals are trying to either reposition or withdraw,” he said. “Anecdotally, we have also seen a higher incidence of busted deals, where buyers and sellers fail to agree on pricing or on adjustments to earnings.”

Part of the reason pricing gaps have remained so persistent, Mr. Normandeau said, is that it takes roughly six months to complete the investment process, from initial expression of interest to a closed deal. Any process that started in May or June, when M&A was still relatively strong, would be nearing completion now, in an environment where buyers are much less willing to pay large premiums.

“People who are having those first meetings now, though, are forming maybe more reasonable expectations, and I think those deals will be more likely to be completed in five or six months,” Mr. Normandeau said.

Meanwhile, the slower pace of deal-making itself has had a proportional impact on the ability of private equity firms to raise more capital. Limited partners need to see returns on their investments before they commit more to the same firm. A slower pace of M&A and public offerings means a slower pace of returns. Even if the deals that are getting done generate solid returns, the process of making LPs whole to the point where they would want to reinvest still takes longer, because the deals themselves are less frequent.

Another factor limiting PE fundraising prospects is what is called the “denominator effect,” which occurs when the public holdings of a major LP, such as a pension fund, go down. For example, if a large institutional investor wants to have 10 per cent of its assets under management allocated to private equity funds and the rest to public markets, then any decline in the overall value of that investor’s public assets increases their proportionate allocation to private assets.

“That is the challenge with the denominator effect, as a lot of LPs are currently over-allocated to the [private equity] asset class,” Vertu’s Ms. Melchior said. “That makes it more difficult for them to allocate new capital to firms that are fundraising.”

Keith Gillard, chief executive of Vancouver-based UpperStage.Capital, said the spring of 2023 is likely to bring yet another barrier that fundraising private equity firms will need to overcome. That is when many firms will release annual reports containing portfolio valuations updated as of late 2022. And with many expected to report declining valuations and lower returns, Mr. Gillard expects investors will be more wary of putting new money into the sector.

“That is going to change LP behaviour, that is going to change sensitivity to valuation and I think, unfortunately, that is going to make the fundraising environment even more difficult,” Mr. Gillard said.

SeaFort’s Mr. Normandeau said the “timing is fortuitous” for his most recent fund raise, which has already closed on $160-million of committed capital and is approaching a $200-million cap. He is also in no rush to deploy those funds.

“I’m glad we are coming to the end of that process,” he said. “We have actually extended our fund life to 12 years, so we have a 12-year base life and the ability to extend that up to 14 years.”