For corporations and trusts, the federal government announced its plan to increase the capital gains inclusion rate from 50 to 66.7 per cent on all capital gains realized. This has adversely impacted business investment, including mergers and acquisitions (M&A). Specifically, this has hurt clients who were planning to sell their businesses.
Transaction prices may experience downward pressure as acquirers consider how the higher inclusion rate will adversely impact them when they sell in the future. For example, our back‑of‑envelope calculations indicate an owner looking to sell his or her company with an earnings before interest, taxes, depreciation and amortization (EBITDA) margin of 25 per cent would now need to grow the company’s annual revenues by roughly 20 per cent to increase the company’s valuation, so its owner can keep the same amount of cash after paying more taxes at the higher inclusion rate. As a result, clients will need to consider a wider range of options, and one they should seriously consider is search funds.
Introduction to search funds
The concept of search funds began in 1984 at the Stanford Graduate School of Business. At the time, it was deemed an alternative for aspiring entrepreneurs – from new MBA grads to experienced managers – who wanted to own and run businesses, rather than start them from scratch. This concept is also referred to as entrepreneurship through acquisition.
Search funds are investment pools used to raise capital to acquire private businesses. Entrepreneurs step in as senior executives to operate the businesses they acquire. Search funds seek companies on the lower end of the valuation range. Mario Nigro of Stikeman Elliott in Toronto has advised search funds since 2010, and in recent years, he advised on more than 50 search fund transactions annually. According to Nigro, search fund transactions typically range in value from $10 million to $50 million. Equity financing is traditionally raised from angel investors and private equity funds. They place trust in and provide guidance to entrepreneurs to successfully run the acquired businesses they finance.
Though search funds have been in operation for the past four decades in the United States, they are relatively new in Canada and a growing segment of the Canadian private equity market. According to Nigro, the first Canadian search fund transaction occurred less than 15 years ago, and there are now more than 100 annually seeking to make acquisitions.
Deal closed with Gazelle Capital
Baker Tilly Capital closed a deal in 2022 with a Toronto‑based search fund named Gazelle Capital. Its two founders, Jody Law and Brent Timmerman, were professional engineers who wanted to be entrepreneurs. Despite being MBA grads, neither Law nor Timmerman wanted the challenge of launching a business or turning around a floundering one. Instead, the pair sought to pay a fair price for a great business that fit their competencies.
Though they were living with their young families in Toronto, the deal was for an established, Vancouver‑based HVAC business named Pacific West Mechanical (“PacWest”). HVAC fit their competencies well – they started their careers as electrical engineers at BC Hydro – and they were fond of the idea of relocating to the West Coast, having both lived there during their BC Hydro days. Under the legal counsel of Nigro, the pair closed the deal and returned to Vancouver to run the day‑to‑day operations of PacWest. In these new roles, Law and Timmerman now hold the title of co‑CEO.
Deal risk in proprietary searches
Search funds understandably have more limited resources than, say, an established private equity firm. As a result, they do their best to avoid competitive markets. Gazelle Capital was no different. In their “propriety search,” which included cold calling business owners in search of unrepresented opportunities, Law and Timmerman learned the HVAC industry was highly fragmented and its companies were owned by baby boomers, many of whom had vague succession plans. Though the pair preferred uncovering unrepresented opportunities, so they could negotiate directly with business owners, they let M&A advisors like Baker Tilly Capital know of their plan to acquire an HVAC business to supplement Gazelle Capital’s proprietary search.
In hindsight, the pair appreciated PacWest for retaining Baker Tilly Capital. In a podcast interview (more details below), Timmerman acknowledged it was “really helpful” for the vendors of PacWest to have Baker Tilly Capital advise them on navigating the M&A process, executing best deal practices and negotiating fair or market terms (e.g., valuation, structure).
Some of Gazelle Capital’s search fund peers fail to close deals because vendors often represent themselves. The team at Baker Tilly Capital has heard directly from other search fund operators of deals falling through at the eleventh hour due to vendors getting cold feet. Despite months of negotiation, self‑represented vendors backed out of deals, fearing they were about to give away their businesses to smooth talkers. Despite also paying their lawyers to help write and review the share purchase agreements these vendors negotiated themselves, they abruptly ended all negotiations and communications. After spending months building relationships, parties on all sides were left unsatisfied.
Closing the PacWest deal
Deal risk with search funds tends to be higher due to the fact they generally have more limited resources. Baker Tilly Capital was prepared for this when negotiating with Gazelle Capital. Though the precise details of the deal remain confidential, Baker Tilly Capital focused on the following:
- Background check – This was Law and Timmerman’s first foray into business ownership, so we at Baker Tilly Capital had to make sure Gazelle Capital had the necessary resources to close a deal and abided by confidentiality if a deal failed.
- Building rapport and trust – Gazelle Capital was new to the private equity market, so more time and effort was needed to ensure both sides were speaking the same language and would work well together.
- Negotiating with an open mind – When structuring this deal, we at Baker Tilly Capital understood one party may value some things more than the other. Successfully negotiating these priorities helps increase the size of the pie. Though we are not at liberty to share the details, we can confirm everyone got what they wanted.
Summary
Given the rise in the capital gains inclusion rate, the market for private business will face downward price pressures. When clients decide they are ready to exit their businesses, they should also consider less traditional investors, including search funds. This is a growing segment of the Canadian private equity market for businesses worth up to around $50 million. However, search funds conduct proprietary searches, an approach that can increase deal risk, especially if your client doesn’t have an M&A advisor.
If you have a client who has already been contacted by search funds and/or is open to selling to a search fund, reach out to the team at Baker Tilly Capital. We can work together to ensure a successful deal closing.
Podcast
To learn more about the PacWest deal, listen to episode 109 of the Views from the Market podcast. Host Mario Nigro interviewed Law and Timmerman and Baker Tilly Capital’s Managing Director and CEO, Mike McIsaac.
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