SME Financing in Canada, 2002 — Part I: Other Sources of Financing

Quasi-equity financing

Quasi-equity financing, often referred to as mezzanine financing or subordinated debt, involves a mix of the characteristics of debt and equity. As an investment it provides the cash flow of term lending along with the capital gains of share ownership. According to Macdonald & Associates Limited,^{Footnote 43} it is generally defined as including subordinated convertible debt and yield-based preferred shares, often structured with warrants or options. This type of financing tends to be an attractive financing option for companies that prefer not to relinquish full or partial control of the business by selling shares. The equity component allows investors the ability to achieve a higher rate of return depending upon the success of the company, while the debt element entails a premium price contributing to the overall return of the investor. Unlike term or demand debt, this type of financing is more flexible and is constantly evolving to respond to emerging market needs. This market segment has seen recent growth since it was introduced by a few financial institutions in the mid-1990s.

In the first nine months of 2001, $234 million of quasi-equity was disbursed in 337 transactions. This is 9 percent higher than during the same time period the previous year.^{Footnote 44}

Figure 25 – Quasi-equity Investment by Sector, First 9 Months of 2001

Traditional sectors received the majority (64 percent) of financing in the first nine months of 2001, unlike the same period in 2000 when 54 percent flowed to technology sectors during the same period.

Consumer products (at 52 percent) was by far the sector of choice among quasi-equity providers, followed by communications and networking, which received 21 percent of the total amount invested.

The Business Development Bank of Canada (BDC) is the largest provider (almost three quarters) of quasi-equity to companies in traditional sectors, a large increase from 56 percent one year earlier. The BDC directed almost half (48 percent) of its disbursements to consumer-orientated firms, and 26 percent to manufacturing firms.

Quasi-equity providers have traditionally provided financing to companies in the expansion stage, as shown in Figure 26. In 2001, firms at this stage accounted for the largest proportion (53 percent) of total financing in the first nine months of 2001, and 83 percent of all deals. This focus is similar to what was seen in 2000.

Figure 26 – Quasi-equity Investment by Stage of Business, First 9 Months of 2001

The BDC provided 74 percent of its quasi-equity funds to expanding companies.

Quasi-equity activity during the first nine months of 2001 was more polarized between large and small deals, with the heavy focus on deals of less than $1 million. Ninety-four percent of quasi-equity transactions involved $1 million or less, although as shown in Figure 27, large deals of over $5 million do absorb the lion's share of capital invested (60 percent).

Figure 27 – Quasi-Equity Investment by Deal Size, First 9 Months of 2001.

The overall increase in quasi-equity activity is impressive given the relatively weak economy in 2001. The first three quarters of 2001 saw an increase in the number of transactions (439 in 2001 versus 227 in the first nine months of 2000), as well as in total capital provided ($234 million versus $214 million) relative to the same time period in 2000.

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43. See http://www.canadavc.com

44. Macdonald & Associates Limited, Quasi-Equity Activity, prepared for Industry Canada, 2001.