After the feverish pace of 2021, the Canadian private equity
(PE) market cooled down significantly in 2022. Deal activity and
deal values both suffered in comparison to the record highs of the
previous year. Looking ahead, McCarthy Tétrault’s PE
professionals weighed in with observations on 2022 and predictions
on what investors and firms can expect for 2023.
Takeaway 1: A Cooler Market May Persist
Hoping to recover from a tumultuous year, PE firms may
exercise more caution in 2023. Persistent inflation,
rising interest rates and geopolitical events may cause PE firms to
allocate capital more judiciously. It remains to be seen how
Canadian companies will handle these challenges – and
potential new ones – in the coming year. While PE-backed
exits will likely continue their downward trend from 2022, add-on
transactions may grow as firms continue to specialize and build
industry-specific expertise.
Takeaway 2: The Energy Sector Dominates, with IT and B2B in the
Periphery
The energy sector saw a significant increase in invested
PE capital since 2021, despite a lower deal count. As of
December 2022, C$7.2 billion of PE capital was invested in the
energy sector, compared to C$1.45 billion in the prior year. As a
distant runner-up, the information technology sector saw C$2.2
billion of PE capital invested – a 45% decrease from its 2021
figures. Meanwhile, the B2B sector – while leading all other
sectors in overall deal count – saw a 77% decline in deal value
from 2021.
Takeaway 3: The Insolvency Market is Poised to Ramp-Up
For distressed investments, quick execution and creative
approaches will be rewarded. In sales and investment
solicitation processes (SISP), which are often truncated, groups
that are efficient in deploying due diligence teams and making
decisions will have a key advantage over those who are not.
However, since SISP can often face challenges in down markets,
creative restructuring solutions should be reviewed. These may
include traditional compromises, plans of arrangement, and a
variety of insolvency tools.
Takeaway 4: For Lenders, Quality Beats Quantity
In 2023, the pace of acquisition financings have
declined as lenders take a more cautious and prudent
approach. After the red hot markets of 2020 and 2021, and
parts of 2022, lenders are placing more emphasis on familiar
sponsors and high quality credits. Interest coverage ratios and
leverage ratios may come into greater focus, as lenders become
mindful of limiting their exposure and preserving capital. Banks
will also generally take a more deliberate, thorough approach to
due diligence and credit approval processes to ensure their deals
are structured appropriately for the market conditions and will
allow more time for syndication processes to complete.
Takeaway 5: Continuation Funds Have Become Prevalent
Sponsors have caught on to the benefits of continuation
funds. This trend continued in 2022 with sponsors
increasingly using continuation funds as viable alternatives to
traditional M&A and IPO exits given current market volatility,
giving investors an option for liquidity while allowing sponsors to
continue to hold their “crown jewel” assets that may have
further potential for growth. In 2022, secondaries funds continued
to raise capital at historic rates, led by large funds from
traditional secondaries players and many new entrants in the space
– including established managed launching secondaries
strategies. Demand for continuation funds was fueled by these
secondaries funds looking to deploy their increased amounts of
capital. This demand, combined with the benefits to sponsors,
suggests that continuation funds will continue to be a prominent
feature of the private funds landscape in 2023 and beyond.
Takeaway 6: The CRA Clarifies its Position on Loans to Limited
Partners
The CRA has provided long-awaited guidance on the
conditions that must be met for CRA to treat loans from limited
partnerships to their limited partners as loans and not
distributions, but uncertainty still looms. These
conditions include that loans must (1) be in respect of profits and
not represent a return of capital, and (2) be made primarily for
the purpose of mitigating the deemed capital gain (and potential
double taxation) issue that can result from a distribution of
profits in the same fiscal period as the profits are earned. While
this guidance will be welcome to most limited partnerships, the
CRA’s conditions provide for a narrow administrative exception
that will not be available in all circumstances. PE funds should
consider whether any changes are required to their partnership
agreements to facilitate the making of loans that fit within the
CRA’s guidelines.
Takeaway 7: Proposed Amendments May Impose New Withholding Tax
Obligations
These proposed amendments to the
Income Tax Act (Canada) could
impact foreign PE funds with Canadian investors – even when
the fund has no Canadian investments. The Income Tax
Act (Canada) imposes a 25% withholding tax on certain amounts
paid by Canadian residents to non-Canadian residents. Currently, a
partnership is deemed to be a Canadian resident for this purpose to
the extent that such an amount is deductible in computing the
partnership’s income or loss from a source in Canada,
however the proposed rules would deem the partnership to be a
Canadian resident to the extent that the amount is deductible in
computing the share of the partnership’s income or loss that
is allocable to Canadian residents (and certain non-residents
subject to Canadian income tax). This potential change could cause
foreign funds to pass the associated costs to Canadian investors,
or even impact the circumstances in which foreign funds will admit
Canadian investors.
Takeaway 8: Greenwashing – an Unsustainable Practice
Even for voluntary sustainability-related disclosure, PE
firms should be mindful of the potential legal liability against
companies and their directors and officers. Greenwashing
allegations, such as claims of inaccurate or misleading statements
on corporate ESG activities or commitments, may give rise to civil
litigation, class actions and regulatory proceedings. The lack of a
mandatory global standard for sustainability-related disclosure has
created a state of flux over what must be included. In Canada and
elsewhere, this vacuum has spurred a number of well-resourced and
coordinated complaints to competition and securities regulators
relating to sustainability-related disclosures.
Takeaway 9: PE Firms Will Continue to be Significant Players in
the Take-Private Market
Falling public valuations and the pressures of running a
public company present an opportunity for PE firms to lure
companies away from the public markets. PE buyers can also
offer management teams a rollover component to the transaction,
allowing them to remain invested in the target as minority
shareholders. These benefits, among others, often allow PE firms to
offer lower premiums to target shareholders. When these deals are
struck, they are virtually always done through a court-approved
plan of arrangement structure.
Takeaway 10: Despite Uncertainty, PE Firms Should be
Proactive
While it’s not always clear how to respond to
changes in the macroeconomic environment, regulation and public
opinion, PE firms can take proactive steps to get ahead of these
changes. For instance, a fund may benefit from revisiting
its limited partnership agreements to ensure that any provisions
regarding loans to limited partners are aligned with the CRA’s
conditions. It may also wish to scrutinize its ESG strategy to
ensure that any stated goals are backed by actionable, robust
plans.
Discover how our national Private Equity Group can guide you
through 2023 by contacting our presenters below or by reading our
latest report, On Target: 2023 Private Equity
Outlook.
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