| Canadian Capital and Equity: An Overview |
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| Saturday, 02 February 2008 07:36 | |
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Introduction The purpose of this paper is to examine what Canada has to offer to the private equity market. What is meant by this is that this paper will examine the characteristics of Canada that make the country so inviting for private equity firms from around the world. In performing this analysis, a variety of economic indicators will be provided to show how Canada has a strong economy and innovative industries that are a good source of investment for individuals in the private equity market and for venture capitalists. At the same time, comparisons will be made to economic factors in the United States to show the relative strength of Canada. Besides the actual strength of the Canadian economy, this paper will also examine the ability of companies that have been funded by private equity and venture capital togo public in the country. This examination will discuss the ease and reduced cost of going public in the country, as well as the strength of going public on the Toronto Stock Exchange because of its rules governing smaller companies. Comparisons will also be made between the rules and financials of going public in the United States as compared with going public on the Toronto Stock Exchange. It should be noted at the outset that this report will contact several charts and graphs showing economic indicators and making comparisons with the United States. One reason for this is to show the strength of Canada against the United States. The other reason is to show the general strength of the Canadian economy. As an economy grows, the amount of venture capital and private equity that is invested in that economy typically increases (Vance 2005, 142). This information will be important to explain what Canada has to offer those looking to invest in private firms, and especially those who hope to take their investments public in the future. Foreign Investment in Canada An important cliché in the world of venture capital is that success breeds success, or perhaps more accurately: money brings money. People who are looking to make investments in private companies will often go where others are making investments because this is seen as a sign of strength at the present time, and growth for the future (Bartzokas & Mani 2004, 222). In the past few years, the amount of foreign investment in Canada as a percentage of the total venture capital in the country has risen from 3% in 1998 to 23% in 2005 (Sheahan 2005, 50). Figure 1 shows the yearly investments from venture capital in the country and the amount of foreign investments in venture capital.  What is also interesting is that the venture capital market in Canada has not grown much in the past few years. There have been years when the amount of venture capital invested was higher, but overall the market has remained fairly stable. However, the amount of foreign venture capital into the country has increased. What this indicates that is foreign investors are looking to Canada and its private companies as a way to grow their money. One of the reasons for this interest by foreign investors in Canada is that the country offers prospects for growth that are not necessarily available in countries like the United States or European nations (Johnson 2007, 24). Investors looking to make money have largely tapped out industries in the United States and Europe. Those countries have markets that are saturated with investors who are looking for places to invest their money. Canada, on the other hand, until recently has largely been ignored by the private equity and venture capital markets. This surge in equity investing in Canada will likely continue as there is currently around $600 billion worth of venture capital available in North America. Put another way, there is $600 billion worth of funding that could potentially go to Canada. Obviously, all of it will not go to Canada, but the country does offer companies that are strong and have not yet been discovered by other venture capitalists. While some might argue that simply having the attention of other venture capitalist and private equity investors does not make Canada a strong market, it is clear that people often want to go where the money is. In this case, more and more private equity is flowing into Canada. If nothing else, this will spark even more curiosity to the possibilities of investing in Canada. This can be a good way to at least catch the attention of the world. However, what will keep their attention and create a situation where they will want to invest in Canada is the strong economy of the country. Canadian Economy A recent survey of investment fund managers in Canada found that many fund managers believe that foreign investments are coming into Canada because of the relative strength of the Canadian economy as compared with that of the United States (Lee 2006, 43). Canada is the third fastest growing economy in the world behind Russia and the United States. Between 2002 and 2006, Canada saw an average rate of growth in gross domestic product of 2.7%. This is not far behind the United States that had a rate of real growth in GDP of 3.2% in that same time period (McKinsey & Company 2007, 6). Figure 2 shows the rate of real GDP growth for Canada and the United States over the last nearly 3o Years.  Even more, the year-to-year rate of growth in real gross domestic product has been slightly higher for Canada than the United States at times over the past five to ten years. Within the past two years, Canada’s yearly rate of GDP growth has actually been slightly higher than that of the United States. Overall for the past 25 years, the rate of growth in gross domestic product for Canada was right in line with that of the United States. With Canada’s economy growing every year in line with that of the United States, there are other economic indicators that are inviting to venture capitalists and private equity investors. One of them is the growing strength of the Canadian Dollar versus the U.S. Dollar. In the late 1990s, the Canadian Dollar was only worth about three-quarters of the U.S. Dollar (Canadian Economy Online 2008). This difference in value meant that the cost of doing business in Canada as compared to the United States was greater. Even worth, any money made in Canada by someone living in the United States was worth much less than if that money had been made in the United States. Overall, the costs of making investments in Canada were greater and the rewards were less. Figure 3 shows the value of the Canadian Dollar compared to the U.S. Dollar since 1997.  However, in the past few years all of that has changed. In recent years, the value of the Canadian Dollar has increased sharply in relation to the U.S. Dollar. At the present time, the values of the Canadian Dollar and the U.S. Dollar are nearly equal. For private equity investors and venture capitalists, this equalization of the exchange rate between the Canadian Dollar and the U.S. Dollar takes away some of the uncertainty in making investments in that country. Even more, this equalization in the exchange rate takes away the costs and potential downfalls of investing in Canadian firms. Finally, one other concern for potential investors in Canadian firms is the cost of debt. Many smaller and even medium-sized firms rely on debt to allow the companies the capital needed for expansion. In 2006, the average central bank interest rate in Canada was 4.5%. This is in relation to the average central bank interest rate in the United States of 5.25% at the same time (McKinsey & Company 2007, 6). While this difference might not seem that important, it can add up to a lot of savings or cost for a company. For example, a 5-year loan of $1 million at 4.5% results in total interest payments of $118,581.15. However, a 5-year loan of $ 1 million at 5.25% results in interest payments totally $139,159.03. The savings to a company for this type of loan between the Canadian interest rate and the U.S. interest rate would be $20,577.88. This is money that could be used for expenses incurred by the company rather than paying back a loan (Financial Loan Calculator 2008). The end result in all of this is that the Canadian economy offers several incentives that are not available to private equity investors in the United States. It is cheaper for companies in Canada to borrow money. At the same time, the stronger Canadian Dollar is not a potential hazard for a person or company that would wish to invest in a Canadian firm. What Canada offers to the private equity world is a strong economy where the cost of debt is cheaper than other major nations. At the same time, Canada’s economic growth is equal or even slightly above nation of the United States. Another economic aspect that is worth mentioning is that Canada offers reduced corporate taxes and capital taxes. Canada has gone through a period of reducing corporate income taxes from a high of 28% in 2000 to a low of 23% in 2003. For the private equity world, this means that the companies in which they invest pay less in corporate taxes than their American counterparts. Even within Canada, there has been a reduction in corporate income taxes to encourage growth and investment (Department of Finance Canada 2003). Another rule in Canada that might be of particular interest to private equity and venture capital is the elimination of the tax on excess capital that had previously been in place in the country. In 2003, the government called for the elimination of the federal capital tax over a five-year period for firms that held less than $50 million in capital. The government also began work in that year to completely eliminate the capital tax indefinitely. Canada is offering investors the opportunity to allow more of their investments to work for the growth of their companies rather than paying the money in taxes. These more lenient tax rules that are currently in place over previous years means that companies in Canada truly do save money for themselves. This is especially true with the elimination of the capital tax. Companies can feel more free to hold on to access capital at the present for future uses rather than feeling the need to use the money for fear of paying out excess taxes. Expanding Industries in Canada One of the aspects of Canada that makes it so ripe for foreign investment in the form of private equity and venture capital is the growing industries in that country in innovative sectors. One such sector that is growing in Canada is the environmental technologies industry. Canada is a country that is rich with nature resources. However, in recent years, companies have begun to focus just as much as the development of renewable energies and technologies in the field of renewable energy. This has led to the creation of many companies in the Western portion of Canada that are developing new technologies in the energy sector that are being exported to countries around the world (Affleck & Dunn 2008). This industry in Canada is focusing not only on the creation of new technologies, but also the design of environmental services and analysis of plans and projects for more environmentally friendly organizations. This industry is also working with other industries inside and outside of Canada to educate citizens about renewable and cleaner energies. The companies in this industry are also building partnerships with other companies to increase the importance and knowledge of renewable technologies (Affleck & Dunn 2008). For venture capitalists and private equity, the industry of renewable energy is an untapped and potentially profitable industry in Canada. The reason for noting this is that Canada is not only a country with nature resources. Instead, it is also a country where companies are working to create new technologies to preserve nature resources and to create a cleaner environment. The future of this industry is likely to grow as more and more people become concerned about the state of the environment and the ways in which it can be cleaned up for future generations. Business Regulations and Going Public in Canada One of the concerns of private investors when they step outside of their home country is that the regulations that government corporations will make growth more difficult. This is especially true for private companies where there can be a lot of regulations that have to be followed in order for private equity or venture capitalists to make investments. In many of the provinces of Canada, the rules regarding private investors allows a company to have around 25 investors and to raise less than $3 million in funds before having to register with provincial governments. The registration rules change based on certain characteristics of the companies and the investors seeking to infuse capital into companies (Carpentier, L’Her & Suret 2000, 61). The concern, however, is that the registration rules and other compliance regulations in Canada might cause undue burden upon smaller companies which would prevent their growth. Carpentier, L’Her & Suret (2000, 61) investigated this particular issue. What the researchers found was that various rules in Ontario about financial registration with the Ontario Securities Commission did not cause unnecessary burden on small companies in the province. In the end, it would appear that the rules governing company registration, at least in Ontario, do not prevent companies from raising capital and growing in size. While this one particular study may not provide sufficient evidence to make inferences about business regulations across the country, it does indicate that in Ontario companies have not significantly suffered because of various reporting or registration requirements. This information is important because most private equity investors and venture capitalists invest in companies in any country with the eventual exit strategy of taking a company public (Johnson 2007, 25). If the ability to take a company public is not available, or if the costs are too high, then this is likely to dissuade some investors and venture capitalists from even making investments in the first place. For Canada, the ability for small firms to go public is another strength that is offered to the venture capital and private equity worlds. In the United States, it is difficult for a company valued at under $100 million to issue an IPO. The reason for this is that American stock exchanges have very rigid listing requirements. A company cannot simply expect to offer stock and have that stock listed on a major stock exchange in the United States. Even more companies that are valued between $200 and $300 million, the requirements can be tough to navigate (Panio 2007). The Toronto Stock Exchange has realized the need for easier listing requirements for smaller firms. Rather than having a set of listing requirements that are rigid and must be met, the Toronto Stock Exchange has no listing requirements at all. Instead, the stock exchange uses a system of nominated advisors who are used to determine if a public company should be listed (Panio 2007). The result in this is that smaller firms that show great potential and a solid management team and business plan can compete on an equal level with large firms that are worth billions of dollars. Even more, the Toronto Stock Exchange has a sub-unit known as the TSX Venture Exchange. This is an exchange where smaller companies are able to trade. In offering this variation, the Toronto Stock Exchange provides a place for Canadian companies to go public where equal size American companies would never be able to get listed by a major exchange in the United States. In fact, the average value of companies listed on the Toronto Stock Exchange is $1.35 billion. However, the average value of companies listed on the TSX Venture Exchange is only $29.1 million (Panio 2007). Even for larger companies that wish to go public and get listed on the main Toronto Stock Exchange, there is an advantage over listing on the New York Stock Exchange in terms of cost. The average IPO on the New York Stock Exchange is $470.6 million. This is almost five times the average size of an IPO on the Toronto Stock Exchange of $99.6 million (Shutt & Williams 2000, 2). Again, it is easy to see that even for large firms that wish to go public, there is a distinct size disadvantage of trying to go public in the United States. Only the largest firms are able to meet the listing requirements and compete to be listed on the New York Stock Exchange. Another concern that is present for venture capitalists and private equity investors is the actual cost of going public at all. The cost of going public is typically listed as a percentage of the total proceeds that are raised in an IPO. Because of this, the total percentage costs of an IPO are usually lower for a firm with a larger IPO size. For a firm with an IPO valued at between $10 million and $50 million, the percentage costs of going public on the Toronto Stock Exchange is around 10%. This is less than the 14% costs of going public for the same size firm on the New York Stock Exchange. Even more, the percentage cost of a firm with an IPO of less than $10 million is 12% on the Toronto Stock Exchange and nearly 18% on the Nasdaq (Shutt & Williams 2000, 2). There is no cost available for a firm this sized on the New York Stock Exchange because a firm of this size could not get listed on the NYSE. Figure 4 shows the direct percentage costs of going public for the Toronto Stock Exchange, Nasdaq and New York Stock Exchange.  Finally, investors who are seeking an IPO as an exit strategy for their investments want to have some type of idea of the performance of the larger market upon which the IPO will exist. It must be remembered than an IPO is not merely a short-term exist strategy for a private equity investor or venture capitalist. Instead, an IPO can also be a long-term investment in the company in which the initial investment was made. However, part of this is not only based on the growth and strength of the company that is taken public. Instead, part of the ability to see an IPO grow is based on the relative strength of the larger market on which the company is listed.One of the ways to determine the relative strength of a stock market is to look at the level of volatility and growth over a period of time. Figure 5 shows the level of change in the Toronto Stock Exchange, the Nasdaq, and the New York Stock Exchange. As the figure indicates, all three of the markets have moved with some relation based on larger economic conditions. However, the past three or four years, it does appear that the Toronto Stock Exchange has seen a sharper increase in value over the Nasdaq or New York Stock Exchange.  However, simply looking at straight performance is not enough to determine which market has had stronger growth through various periods over the past 10 years. The reason is that the values of the stock market indices are not standardized. By standardizing the values of the indices, a direct comparison can be made based on the actual levels of growth of each. Figure 6 shows the standardized performance of each of the three stock market indices. It should be noted that each market index was standardized to start at a value of 100 for the month of January 1997.  As the figure shows, the Nasdaq experienced much greater growth around the turn of the century. However, those gains quickly fell in 2001. The Toronto Stock Exchange and the New York Stock Exchange have moved nearly in line with each other for the past 10 years. Specifically, from January 1997 through December 2007, the Toronto Stock Exchange had a 124% increase in its value. During that same period, the Nasdaq had an 92.8% increase in value and the New York Stock Exchange experienced a 123.6% increase in value (Yahoo Finance 2008). The Toronto Stock Exchange was technically the strongest performing stock exchange in terms of returns of all three. However, the difference between the returns for the Toronto Stock Exchange and the New York Stock Exchange were negligible. What is important for the private equity world is that they can invest in Canadian companies and then take them public on the Toronto Stock Exchange for less cost and still expect to see the same rate of growth or even greater rate of growth as the Nasdaq or New York Stock Exchange. Conclusions The purpose of this paper was to show what Canada has to offer the world of private equity and venture capital. What should have been gained from this report is that Canada has a lot to offer private equity and venture capital in the form of a strong economy, increases in the amount of foreign investment coming into the country, a strong currency, and IPO opportunities that are easier and less costly than in the United States. On the surface, it might seem like Canada is merely a smaller economy that must compete with its larger neighbor to the south. However, the information that is available shows that the Canadian economy is as strong, if not stronger in some ways, than the economy of the United States. This means that the potential for growth for small companies is strong. Even more, the ability to take a company public in Canada on the Toronto Stock Exchange is easier for small firms, and is less costly for firms of all sizes as compared to the United States. In the end, Canada can offer private equity and venture capital the ability to know that investing in companies in the country offers the ability to see real growth with reduced taxes, fewer restrictions on small companies being listed on a major stock exchange, and the ability to invest in untapped and unnoticed industries. In essence, what is available form Canada is the ability to invest in industries and companies that have been largely ignored in the past. Rather than investors competing in a country like the United States that is saturated with private equity, these people can look for the best opportunities and the highest potentials for growth in a country where companies have largely grown and expanded on their own until just a few years ago. article by: simon beckel and arjun sethi Full Bibliography & Article Available: Download Here Subscribe to Private Equity Watch by Email |