Small and Medium-sized Enterprise Financing in Canada — Part IV: Profile of Risk Capital Financing

5. Quasi-Equity Financing

Quasi-equity financing (also known as mezzanine financing or sub-ordinated debt) is another form of financing frequently used by SMEs. It typically involves a mix of debt and equity financing, which allows investors to achieve gains through capital appreciation and interests on debt-repayment. Quasi-equity financing is often more attractive to companies with more limited growth potential and/or companies that prefer not to relinquish full or partial control of the business by selling shares.

The Canadian quasi-equity market is still relatively young and small. However, total quasi-equity investments grew by 77 percent, from $208 million invested in 347 companies in 1999, to $369 million invested in 583 companies in 2002. In 2002, the quasi-equity market remained vigorous, and a number of new mezzanine investors emerged in most Canadian regions, which may have contributed to increased activity, including:

• $369 million in total investments (compared with $292 million in 2001)
• 583 firms financed (compared with 550 in 2001)
• large deals ($5 million and over) captured $233 million, or 63 percent of all investments (compared with 51 percent in 2001)

According to some observers, recent market uncertainties may have encouraged industry players to focus their investments in well-established private companies in the mid-sized market.¹²⁴ Furthermore, fast-growing high technology firms may have decided to delay their exit, instead waiting for more favourable IPO conditions. These firms have created a greater demand for subdebt financing as an interim financing option. Investments in the $5 million and over bracket increased by 55 percent from 2001 to 2002, which could signal investors' appetites for larger investments.

Regional Perspective
In 2002, Ontario-based companies replaced Quebec-based firms as the primary recipients of quasi-equity investments, with $166 million (45 percent of total quasi-equity financing) invested in 182 firms. In 2001, Quebec firms attracted 27 percent of sub-debt investments. In terms of the number of financings, however, companies in Quebec were the most successful in attracting quasi-equity financings, with 277 firms financed (or 39 percent of the total). By contrast, the amount invested in Atlantic Canada decreased by 92 percent.

In 2002, quasi-equity investments reached:

• $166 million (45 percent of total) in Ontario, compared with $76 million (30 percent) in 2000
• $68 million (19 percent) in Quebec, compared with $79 million (27 percent) in 2001
• $53 million in British Columbia (14 percent), compared with $11 million (4 percent) in 2001
• $78 million in the Prairies (21 percent), compared with $42 million (16 percent) in 2001
• $3.5 million (0.9 percent) in Atlantic Canada, compared with $49 million (19 percent) in 2001

Investments flowed to:

• 182 firms in Ontario (compared with 196 in 2001)
• 227 firms in Quebec (compared with 211 in 2001)
• 75 firms in British Columbia (compared with 47 in 2001)
• 78 firms in the Prairies (compared with 108 in 2001)
• 20 firms in Atlantic Canada (compared with 23 in 2001)

Figure 64
Quasi-Equity Investment by Region, 2001-2002

Investments were concentrated in the consumer products sector
As was the case in 2001, the Canadian quasi-equity industry focussed on expanding investments in mature mid-market sectors such as consumer products and services and manufacturing. In 2002:

• consumer products and services attracted $195 million (53 percent of total investments) to 366 companies
• manufacturing captured $67 million (18 percent) in 78 companies
• technology sectors captured the remainder of 21 percent (or $79 million), spread across information and communication technologies, with $50 million (13 percent) invested in 67 companies
• life sciences, with $29 million (8 percent) invested in 11 companies

Quasi-equity investments concentrated in large deals
Large quasi-equity financings ($5 million and over) accounted for $233 million (63 percent of total quasi-equity investments) in 21 companies in 2002, compared with $150 million invested in 9 firms in 2001, for 51 percent of total subdebt investments. Large deals averaged $11.1 million in 2002 compared with $11.5 million in 2001.

Mid-sized transactions ($1–5 million) provided 37 firms with $55 million, or 15 percent of total quasi-equity investments in 2002, compared with $52 million invested in 37 companies, for 18 percent of the total in 2001. The average deal size was $1.5 million in 2002, compared with $1.6 in 2001.

Small transactions ($1 million or less) continued to attract investors' interest, with investments totalling $81 million (22 percent of the total) distributed to 529 companies, or 90 percent of the companies that received quasi-equity funding in 2002. In 2001, these transactions accounted for $90, or 31 percent of the total, invested in 510 firms. As in past years, smaller-sized deals (under $500 000) captured the majority of quasi-equity investments in the under $1 million size category, with $63 million (or 78 percent) invested in 498 companies; in 2001 these companies attracted $66 million (73 percent) in 475 companies. In 2002, the average small financing in the under $500 000 category was $126 000, and the average under $1 million financing was $152 550.

Role of the Business Development Bank of Canada (BDC)
The BDC is the largest provider of quasi-equity financing in Canada, and tends to focus on transactions under $1 million, carrying on its leadership role in this deal size category. In 2002, BDC:

• invested $107 million in 523 companies
• was responsible for $72 million (89 percent) of the industry's total investments in the small deal bracket (under $1 million)
• was regionally diversified, investing across the country
• dedicated 88 percent of its investments to traditional sectors

Figure 65
Quasi-Equity Investment by Sector, 2001-2002

Conclusion

On a relative basis, the Canadian economy has enjoyed virtually the same level of risk capital and VC activity as the American economy. Nonetheless, some relative regional VC investment gaps exist, notably in the Prairies and, to a lesser extent, in the Atlantic provinces. These gaps, which will require further examination, may be explained by the nature and operation of VC investment processes and by the structure of regional economic activity. The low survival rate of small businesses involved in IPOs also needs to be further explored, as this tendency could potentially hinder the Canadian economy's development and growth. A number of questions will need to be addressed in light of the findings highlighted above, notably:

• What effect does the poor performance of Canadian small issues have on market liquidity?
• Should there be a focus on facilitating pre-IPO financing?
• What alternatives can be found to allow IPOs to be deferred until businesses have a reasonable chance to ensure their survival

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124. See Glossary for definition.