March 30, 2011

Lower-Middle Men

On a recent trip to Toronto, Graham Winfrey spoke with two Canadian fund managers who (happily) consider their target markets uninteresting to other GPs.

Small and medium enterprises account for nearly half of Canadian GDP – and employ almost 60 percent of the country’s labour force, according to a 2010 study released by the Business Development Bank of Canada. But the bulk of private equity firms that operate in Canada don’t target much of that market segment, focusing instead on servicing a core group of medium-sized companies and leaving a handful of players to tackle the country’s vastly underserved lower mid-market.

Toronto-based Whitecastle Private Equity Partners is one of those firms. It makes initial investments of between $5 million to $10 million in smaller businesses, before scaling up to around $20 million.

We’re talking about companies with EBITDA’s somewhere between $2 million to $5 million dollars,” says Whitecastle managing director Elmer Kim.

The firm’s C$60 million debut buyout fund was launched in 2005 by Whitecastle Investments, the investment office of Toronto’s Diamond family, led by president and chief executive officer Carey Diamond.

Because Whitecastle’s target market lies under the radar of the majority of Canada’s private equity players, the firm frequently has to find its own opportunities.

Half our deals are more proprietary, probably because there aren’t a lot of midmarket advisors at this end of the market,” Kim says.

Another challenge associated with investing in Canada’s lower mid-market – and one which may speak to why more private equity firms aren’t operating in the market segment – is what Kim calls the raw management assistance” that comes with the territory when growing small companies.

There’s a lot more hand-holding, a lot more working with management,” he says. I would suggest that there’s more work involved in the smaller businesses than in the larger businesses.”

One benefit of dealing with companies looking for equity cheques under $20 million, however, is a lack of competition.

In the Canadian context there are probably a handful of competitors in that market,” Kim says. There are very few Americans that come up for that size of a deal.”

While Whitecastle still has dry powder to deploy from its debut buyout fund, the firm plans to spend most of its capital in 2011 on scaling up its current holdings, which include waste recycling company Turtle Island Recycling and food business Bento Nouveau, Canada’s largest seller of sushi. Whitecastle also has an investment in Equity Financial Holdings, a Canadian financial services company.

Few Canadian private equity firms focus on financial services in Canada because of the small number of banks in the country, but one firm with a small focus on the sector is TorQuest Partners, which operates one tier above Whitecastle in terms of market segment.

We think that our space is sort of $25 million to $75 million equity cheques, and to do that you can’t be too big,” says founder and senior managing partner Brent Belzberg. When considering larger transactions, the firm co-invests alongside its institutional partners.

TorQuest closed its most recent private equity fund on C$550 million in 2006 and completed five transactions in 2010, including investments in SCM Insurance Services and fuel management company 4Refuel Canada. The firm’s target market is also underserved relative to the US, Belzberg says.

As the other midsized funds become bigger, they become less interested in the space we have, as they probably don’t want to have 20 transactions in their funds.”

Both Whitecastle and TorQuest say Canada’s lower mid-market presents significant opportunity for returns.

We just think there’s not a lot of competition in that market segment, so we like it,” says Kim.

It requires people who have relationships in Canada,” Belzberg adds, and I think that’s why we’ve succeeded.”