The private equity industry in Canada and globally hit a turning point in 2008, and will undergo a fundamental reconfiguration as it emerges from the financial crisis, a new report from McKinsey & Company Canada argues.

The report, released by the management-consulting firm on Thursday, outlines the impact of the financial crisis on the private equity industry, including damaging effects on fundraising, investments, exits and returns.

It notes that PE deal volume sunk to a five-year low in 2008, with global buyout activity plunging 70% to US$170 billion from 2007. Canada fared slightly better than the global average, but still saw volume fall 45% in 2008. The report notes that throughout the year, many buyout firms scrambled to extract themselves from deals that no longer made economic sense, including the failed BCE acquisition.

The financial industry was one sector to experience a boost in the concentration of deals last year, as PE firms sought to capitalize on the depressed multiples, the report notes. It says more than 30% of total deal volume was attributable to the financial sector.

Capital managed by Canadian PE funds in 2008 was estimated to be $84.7 billion, up from $79.5 billion in 2007. Buyout and other PE funds captured most of the new dollars, managing $58.4 billion in 2008, up 23% from the year before. This segment’s share of the overall market was a record 72%, according to the report.

Foreign LPs were the leading source of funds flowing into Canada’s buyout and mezzanine segments, accounting for $3.2 billion in new commitments, up from $606 million in 2007.

Venture capital activity dropped 21% in 2008, with fund managers disbursing $1.2 billion to 473 deals.

The report points out that the challenging environment is not expected to materially improve in 2009, setting the stage for another difficult year.

“Various economic scenarios point to a weak economy that will inevitably affect existing portfolio companies and a weak credit market that will undoubtedly place continued pressure on new deal origination,” the report says.

But McKinsey & Company disagrees with arguments that the private equity industry has been irreparably damaged and will not survive.

“The inherent advantages of the PE model – rigorous governance and value creation – are more important than ever, and PE stakeholders could take a number of actions that would help them survive in the short term – and thrive in the long term,” the report says.

Even once the economy recovers from the current slump, the downturn will have long-lasting impacts on the PE industry, according to McKinsey & Company.

“The economic downturn has also triggered a number of structural changes that will continue to shape the PE landscape long after the short-term cycle rebounds,” the report says.

For instance, the company expects to see tighter regulations amid the ongoing debate about how to best regulate the systemic risk of financial institutions. The report notes that the European Commission has already issued proposals that would see the industry regulated to the same extent as banks.

In addition, the shifting balance of power between LPs and GPs is likely to lead to longer-term changes in the terms and conditions governing their relationships, as well as GPs developing more tailored approaches to serve the LPs’ varying levels of sophistication and their fast-changing needs, the report says.

McKinsey also expects several potential new entrants to provide a hefty injection of new capital to PE funds in the near term, including sovereign wealth funds and several Canadian pension plans.

Looking ahead for the Canadian PE industry, McKinsey notes that the largest institutional investors remain bullish on private equity.

IE