Canada: North of the wall

It boasts an advanced legal system that honours the rights of creditors. Its proximity to the US allows companies to access a resurgent economy home to some of the globe’s most advanced non-traditional lending houses. Geographically, it’s the second largest country in the world. So why don’t you hear more about Canadian private debt?

“American non-bank lenders come to Canada with a big splash and then they say, ‘Oh gee, this isn’t a very big market’,” says David Alexander, co-founder of Toronto-based firm Third Eye Capital.

He has a point. Although several giants in the private debt space, including most recently Kohlberg Kravis Roberts and Apollo Global Management, have ventured across the border in some form or another over the last year, the country’s economy lacks the size and scope of its neighbour to the south. Even so, Canadian private debt firms do not face a drought in regards to opportunity.

“The Canadian market — in terms of looking at lending opportunities — is fairly robust. There’s a lot of diversity, whether it’s by industry or by region,” says Theresa Shutt of Integrated Asset Management’s (IAM) Private Debt Group. “Economically, the Canadian economy is pretty stable. It’s definitely seen less of the ups and downs you see in Europe.”

Indeed, although annual GDP growth and inflation remain well below where they were prior to the global financial crisis, a steady decline in Canada’s post-2009 unemployment rate has coincided with increases in total investment as a percentage of GDP, which is now tracking above pre-crisis levels, according to International Monetary Fund data.

Private market data is also encouraging.

Canadian syndicated loan volume reached a record high of $236.7 billion in 2013, up 9 percent compared with $217.6 billion in 2012. Average deal size increased by $15 million year-on-year to $488 million in 2013, the second highest average on record, according to a Dealogic report. Canadian sponsor related volume reached the second highest volume on record with $17.4 billion in 2013, up 54 percent from the $11.3 billion borrowed in 2012, Dealogic added.

The recent surge in activity shouldn’t come as a surprise given the Canadian market’s relationship with the US, sources tell Private Debt Investor. Many US companies do business in Canada (and vice versa), which makes it difficult to differentiate cross-border opportunities, says Alexander.

Certain investors no longer group their Canadian or US portfolios separately, instead opting for a broader “North American” classification. Third Eye takes a similar approach – its investment mandate allows it to provide loans to companies with operations in both the US and Canada.

“Economically, as goes the US, [so] goes Canada,” says Alexander. “Canada and the US are so intertwined. You have to think on both sides of the border.”

That being the case, opportunity for private debt investment remains subject to market fluctuations in the US, where a spate of refinancings and recapitalisations led to record highs in leveraged loan volumes last year. Viewed in that context, the recent upswing in activity on Canada’s debt markets makes sense.

A TOUGHER SELL

Although their market is intertwined with that of the US, managers tell Private Debt Investor that selling Canadian borrowers on the concept of private debt is considerably more difficult than it is south of the border.

“The psychology of Canadians, they’re debt averse. Selling them 12 percent money is really hard. The reality is, they’ll do everything they can to avoid it,” says Corry Silbernagel of Bond Capital, a Vancouver-based provider of mezzanine debt.

“The biggest competitors are the Canadian banks, and they’ll just do an extra turn of debt at senior debt pricing. The Canadian buyout funds rarely use a mezzanine structure, they’ll use senior debt and equity,” he says, adding: “The high yield market is a lot less prevalent in Canada than it is in the US. I would venture to say in the mid-market, you take senior debt, you put a slug of mezz in it. It would be very competitive with a high yield note.”

Thankfully for fund managers, that trend is beginning to diminish as private debt becomes more commonplace. IAM’s Private Debt Group, which provides loans to investment-grade borrowers, has seen an uptick in borrower and investor demand investors, particularly as the latter continue to hunt for yield in a low interest rate environment.

“Once interest rates settled where they have, our yield pickup story has continued to attract attention. The wall of growth that we see happening in the private debt land, it’s part of a whole quest for yield and return,” says Philip Robson of IAM’s Private Debt Group “I joined the firm in ’96, and I remember talking to borrowers who were dumbfounded by the concept that they could find someone who would be willing to lend them money, co-habit the relationship with their existing banking lenders, and fix a rate for a term that was perhaps for as long as 10 years, with a longer amortization rate than the bank was willing to offer.”

NEVER FORGET

It’s a trend foreign investors are picking up on. In August, The Financial Post reported that Apollo had hired Joe Mattina to oversee a Canadian credit operation from Toronto. Earlier this year, KKR confirmed that it would open an office in Calgary to pursue energy investments (an industry that will be a key driver of activity for debt managers moving forward, sources say).

As the economic data cited earlier indicates however, Canada was not immune from the fallout of the financial crisis. GDP growth plummeted and unemployment spiked in 2009. Investments made at the height of the buyout boom – such as KKR’s acquisition of Canadian door-maker Masonite – were wiped out completely. As was the case in other parts of the globe, some Canadian managers viewed the banking sector’s sudden withdrawal from the lending market as an opportunity to snap up non-core assets divested by Canadian banks.

Unfortunately, Canadian banks weren’t selling. The end result was a surplus of investment capital dedicated to an opportunity that didn’t materialise.

“If I go back to 2007-2008, there [were] 25-30 dedicated mezz vehicles, be it inside a bank or a dedicated fund,” says Silbernagel. “We would’ve been really small compared to the bunch in Canada, there were $1 billion plus [in] mezz funds in Canada then … Today, we’re probably number three, and [although] we got bigger, we didn’t get a lot bigger. It’s like everyone else fell by the wayside because they probably did some stuff that they wish they hadn’t.

“Guys who went off-mandate or off-core competence, they didn’t survive.”

To avoid another industry shake up in the future, perhaps debt fund managers should take a page from their borrowers’ books and adopt a more conservative approach in their expansion strategies.

“If I were an institutional investor, I’d certainly invest in Canada,” says Alexander. “Typically we’re a little more conservative, so our alternatives would be a little better quality, I would think. But if I was looking at growth, I’d look at Europe … and also the US, where banks are unloading onto the alternatives [firms].”

“Not to be a market forgotten, either,” he says, laughing.