The market for initial public offerings in Canada is usually either feast or famine. And, in 2007, activity was definitely on the lean side.

For the past dozen years or so, this bipolar part of the capital markets has been kept perpetually chipper, thanks in large part to the income trust phenomenon. But, in late 2006, the federal Department of Finance changed the market’s meds by revising the way in which income trusts will be taxed, effectively neutralizing the appeal of the trusts. As a result, 2007’s IPO market suffered from trust withdrawal.

In fact, the Canadian IPO market received a double dose of bad medicine in 2007. Not only was one of its key supports swept away by the evaporation of income trust deals, but the credit crunch that took hold in August 2007 sent the entire securities market into uncertain territory. With equity markets in general disarray, taking a flyer on a speculative new issue was the last thing on many investors’ minds.

Companies looking to raise money were in no better shape. They could hardly feel comfortable pricing a deal in the midst of jittery, volatile markets. The window during which it makes sense to go public in Canada is a very narrow one at the best of times, and the conditions that prevailed in the third quarter of 2007 were certainly not conducive to raising capital.

Investment Executive looks at the Canadian IPO market each year in terms of deals completed within the calendar year. IE counts all the transactions classified as IPOs, including capital pool companies on the junior market and non-traditional deals such as split-share transactions on the senior market. Deal values are based on the final prospectus filed on the System for Electronic Document Analysis and Retrieval. IE also estimates the IPO underwriters’ total annual commissions, based on each transaction’s prospectus and using the bonus credit method (whereby each member of the syndicate is credited with an equal share of the commission proceeds, with the lead underwriter given a double share).

Tallying all the activity for the past year, it emerges that 2007 was a relatively weak year for raising money by going public — and for making a living bringing such deals to market. Activity on the TSX Venture Exchange held up better than activity on the Toronto Stock Exchange, but the contribution of the TSXV deals is fairly minor in the context of the overall market.

The source of the weakness in the senior market was not just a scarcity of deals but the fact that the deals themselves were, for the most part, rather small. With the notable exception of the $1 billion-plus Franco-Nevada Corp. IPO in the fourth quarter, there were no other single deals that raised even $200 million during the year.

Traditionally, large IPOs are relatively rare in Canada. On occasion, a multi-billion-dollar deal will take place, but they are few and far between. Nevertheless, in recent years, there have been numerous income trust and income-fund transactions that have routinely raised hundreds of millions of dollars each. Those deals aren’t there anymore and, apart from the last-second Franco-Nevada issue, there weren’t many large traditional IPOs in 2007 to take up the slack.

Indeed, in 2007, in total, just slightly more than $6 billion was raised via IPOs in Canada. About $550 million of that was generated on the TSXV through 241 deals, including 181 capital pool offerings. That means only $5.5 billion was raised via IPOs on the TSX. That’s down from more than $10.5 billion in the previous year — which was itself a slow period, as the last two months of that year were affected by the income trust decision that took effect on Oct. 31, 2006. The total for 2006, then, represents a notable drop from the $14.4 billion that was raised in 2005. Yet, that already subdued deal total fell by about 40% again in 2007.

That said, the vast disparity in overall capital raised between 2005 and 2007 conceals the fact that this past year actually represented a stronger underlying performance than the situation two years ago. In 2005, the market was almost entirely driven by the huge contribution from income trust-type deals that occurred that year.

@page_break@In 2005, only about $1.8 billion of the IPO activity on the TSX could be classified as “traditional.” (In other words, a brand new company coming to market and raising equity for the first time.) The vast majority of the deal activity was in non-traditional issues, such as income trusts, income funds, split shares and other deals that aren’t plain common equity.

In 2006, traditional IPO activity jumped to about $3.85 billion, but this past year it was back down to $3.1 billion. While this represents a notable drop from the previous year, it’s far from a reversion to 2005 levels. The apparent resilience of the traditional IPO market in 2007 is particularly impressive, considering the paralysing impact of the credit crunch that took hold in the last five months of the year.

Where the shortage of IPO activity was most acute in 2007 was in non-traditional deals. The big reason for that is there simply are no business or resources income trust IPOs anymore. There are still non-traditional IPOs being done; there are still real estate income trusts, which are exempt from the taxation changes, and other offerings that can be classified as income trusts. Indeed, these types of transactions still make up about half of the overall market. But, without business trust offerings, the total value of non-traditional deals is way down.

In 2007, slightly more than $3 billion was raised in non-traditional deals, down from $6.7 billion in the previous year, and well off the $12.6 billion that was raised in non-traditional deals in 2005.

The inevitable consequence of this fall-off in non-traditional deal activity was a commensurate drop in the underwriting commissions earned by Canada’s investment dealers. For 2007, estimated aggregate underwriting commissions were less than $300 million, down from more than $610 million in 2006.

The good news is that the type of deals that remain tend to be those that reward underwriters more handsomely than do the non-traditional deals, which often carry smaller commission rates that are spread across large syndicates. In 2007, for example, the traditional deals on the TSX paid average commissions of 6%, compared with 4.6% commission for non-traditional transactions; the average syndicate for traditional deals included just five underwriters, compared with the 14-member syndicates that often are used to distribute non-traditional deals.

The shifting composition of underwriting commissions also shakes up the industry league tables as a result. While CIBC World Markets Inc. continues to enjoy top spot among the underwriters, the smaller overall underwriting market helps to magnify the effect of standout individual performances. For example, Toronto-based BMO Nesbitt Burns Inc. was able to vault up IE’s ranking into the No. 2 spot largely on the strength of its lead mandate on 2007’s one truly large IPO, the Franco-Nevada deal.

Other firms that ranked well in the business of underwriting traditional IPOs also climbed in IE’s ranking, now that this segment represents a greater share of overall IPO activity. That boosted the competitive position of National Bank Financial Inc., GMP Securities LP and HSBC Securities (Canada) Inc. , in IE’s ranking. At the same time, the dwindling significance of the non-traditional deals has pushed firms that were historically leaders in that area down in the ranking.

Among the junior market deals, Vancouver’s Canaccord Capital Inc. continues to dominate that space, as well as making a strong showing in senior-market deals. And that advantage becomes more significant as the relative size of the two markets tilt in favour of the junior circuit.

The Canadian IPO market is unlikely ever to be a reliable, consistent source of underwriting business. It will always be volatile. The domestic market is too small and too concentrated to be able to deliver a constant flow of sound deals regardless of the shocks it may face.

In the past two years, the overall market has been hit with two negative shocks: the government decision to kill business and energy income trusts, which affected the IPO supply throughout 2007; and the global credit crunch that took hold midway through last year, affecting virtually all aspects of the capital markets.

Neither of those factors is likely to go away in the short run. It’s hard to imagine the feds reversing course on the income trust decision, and it’s similarly difficult to project an imminent end to the credit crunch. So, perhaps the best that can be hoped for in the year ahead is that underwriters can sustain the new-issue market until the next catalyst for a flurry of IPO activity emerges. IE