As the global financial storm subsides, Canada's economy is commanding unaccustomed attention and some new-found respect. A solid regulatory system and strong demand for Canadian resources and commodities have kept the country in the business headlines for all the right reasons. In the M&A sector, there is every indication that the rebound experienced in 2010 will continue in 2011, as market players continue to adjust and adapt. We believe that each of the trends identified below will play a part in shaping the market – whether it's creative methods of financing, more realistic valuation methods, adjustment to deal terms or regulatory developments in the areas of foreign investment, taxation and securities law.
1. Investment Canada: Business as Usual for Foreign Investors in 2011
What a difference a year and one transaction can make. In 2010, the Government of Canada's decision that BHP Billiton's proposed US$38.6 billion unsolicited bid for PotashCorp was not in Canada's national interest effectively ended the bid and generated considerable international attention. As a consequence of the Potash transaction, the Government of Canada has indicated that it will conduct a review of the entire Investment Canada Act.
In spite of the publicity generated by the Potash case, we believe that the situation was an anomaly rarely to be repeated. Canada remains open for business and in 2011 it will be business as usual for most foreign acquisitions of control of Canadian businesses. This belief would be in line with the current federal Government's stated position on foreign investment in Canada. The reality is that only two acquisitions have been rejected by the Government in over 20 years.
Foreign investment review thresholds continue to rise. At the beginning of 2010, we anticipated the Government would implement the proposed higher thresholds for review and approval of foreign acquisitions of control of Canadian businesses in bi-annual stages to C$1.0 billion in 2015, based on "enterprise value" of the business. Currently the review and approval test is C$299 million based on book value of assets, subject to certain exceptions. We would anticipate that in the near term (particularly in light of the Government's proposal to review the entire Act) the review threshold will be increased in the normal course by annual cost of living indexing to approximately C$310 million. In addition, as we reported last year, the lower review thresholds of C$5 million have been repealed for the sensitive sectors of financial services, transportation services and uranium mining, leaving only cultural businesses subject to the C$5 million asset threshold for direct acquisitions of control and special review by Heritage Canada.
2. Canadian Poison Pills Gain Strength: Just Saying No May Be Getting Easier
Canadian regulators have opened new room for debate in one area of Canadian securities law that had long been considered settled – the role of poison pills in defending against a hostile take-over bid. In contrast to Delaware practice, Canadian shareholder rights plans have traditionally been strictly limited to the single purpose of helping the board "buy time" to seek out improved or alternative offers. Once that purpose has been served, Canadian securities commissions would routinely "cease trade" poison pills, sending whatever offer was on the table to a shareholder vote. It was widely accepted that, under such conditions, a "just say no" defence was dead in the water in Canada. This position was consistent with National Policy 62-202, which clearly states that the main objective of take-over bid regulation is to protect the bona fide interests of the shareholders of the target.
In two recent decisions, however, the Alberta Securities Commission (Pulse Data) and the Ontario Securities Commission (Neo Material) refused to cease trade shareholder rights plans, even where the target's board had not solicited other bids. In both decisions, the Commissions acknowledged the fact that poison pills had been strongly endorsed by the shareholders and, in the latter decision, that tough economic times and the possibility of coercive bids might justify keeping the pill in place. In Neo Material, the OSC also placed considerable reliance on the reasoning of the Supreme Court of Canada in the BCE decision that the board of directors duty is to the corporation as such, rather than specifically to the shareholders.
The Neo decision was recently considered by the Ontario Securities Commission in the Baffinland Iron Mines Corporation decision. In Baffinland, the OSC issued an order cease‑trading the shareholder rights plan on the basis that the rights plan had provided a sufficient time for the Baffinland board to obtain a competing offer from ArcelorMittal SA and that the plan had accomplished the objective of stimulating an auction by obtaining a competing offer. The Baffinland board recently approved a new rights plan and the transaction is ongoing.
3. The Commodities Sector: No End in Sight to Foreign Demand
Continuing demand by foreign investors for Canadian natural resources is almost a certainty in 2011. The most prominent recent example was BHP Billiton's abortive bid for PotashCorp. A key development is that this sector is seeing more creative and strategic-based structuring for effecting transactions, not just conventional going-private transactions and take-overs. Alternative transaction structures in the mining sector, for example, include acquirors taking toe-hold positions in a target, coupled with a joint venture arrangement to provide for off-take, supply or other strategic agreements. Another well publicized creative structure occurred in the acquisition of a 51% stake in TSX-listed Uranium One by Russia's ARMZ, which included an asset "vend-in" by ARMZ involving that company's stake in two Kazakh uranium mines.
4. Financing and Valuation: Techniques for Bridging the Gaps
Notwithstanding increasing confidence in the Canadian economy, acquisition financing is still not always easy to arrange and residual economic uncertainty continues to produce many real or perceived value differences between buyers and sellers. We anticipate the continued use of various techniques for bridging gaps in financing and/or valuations. These include earnouts, seller financing (typically secured and subordinated), seller rollover equity and the seller receiving buyer stock (often accompanied by mutual "puts" and "calls", to ensure an ultimate takeout). Other more creative techniques – all of which have been used in the Canadian marketplace – include:
- Structured equity whereby the seller receives equity which provides a back-end payment tied to a hurdle rate of return – if the buyer achieves such target over a period of time (usually three to five years), the seller participates in any upside.
- "Loan to own" strategies or a creeping takeover in distressed situations where a potential buyer makes a secured loan to a troubled target (possibly accompanied by warrants) and in the event of default, the secured lender is in a very strong position in any insolvency proceeding to "foreclose" on the target and own all or a significant portion of the equity.
- Contingent value rights ("CVRs") which are a form of transferable, earn-out security sometimes used as partial acquisition currency in the purchase of a public company. For example, CVRs have been used to guarantee the value of buyer's stock for a period after closing.
- Standby equity distribution agreements ("SEDAs") have recently provided increased flexibility to issuers in raising financing in Canada. SEDAs provide that one or more investors contractually agree to purchase, upon demand of the issuer, unissued shares of (smaller) publicly-traded companies in one or more tranches at a small discount from market (usually 5% or less) over a period of time (usually two years, with right to renew for a year or two).
For a more comprehensive consideration of earnouts and other bridging techniques please see the publication "M&A Trends and Opportunities in a Downmarket" by Richard Clark, presented at the Canadian Institute's National Summit on Private Equity in September 2010.
5. Hedge Funds, Pension Funds and Other Pools of Capital
As always, the adage "follow the money" applies. Hedge funds, pension funds and other pools of capital have increasingly been taking active positions in public companies or participating in Companies' Creditors Arrangement Act ("CCAA") or other distressed transactions. Sovereign Wealth Funds ("SWFs"), State-Owned Enterprises ("SOEs") and hedge funds have also been active in the natural resource and oil and gas industries, both in Canada and abroad. In addition to Canadian pension funds, another emerging source of investment is coming from U.S. state pension funds that are creating new independent firms – such as the South Carolina Retirement System Investment Commission – to oversee their funds' private equity holdings (similar to the direct investment funds created by two of Canada's biggest pension plans, the Ontario Teachers' Pension Plan and the Canada Pension Plan Investment Board). We believe that the Canadian M&A market will see increasing volumes of direct investment in 2011 by large pools of capital that have not traditionally participated in such transactions. The key message here is that this market is prepared to go where the cash is – whether it's with private equity firms, hedge fund investors, pension fund investment vehicles or otherwise.
6. Growth of a Domestic High-Yield Debt Market: A Positive Result of Low Interest Rates
Credit markets are starting to open up; the taps are flowing again. 2011 will see greater transactional leverage in Canadian mergers and acquisitions. As we move into 2011, the emergence of a high-yield debt market in Canada is a strongly positive development for Canadian M&A. Commencing in 2009, a Canadian market began to develop, as issuers including Russel Metals accessed the high-yield market in Canada to raise the funds for potential acquisitions, among other things. In 2010, companies such as North American Energy Partners, Videotron and Corus Entertainment continued to issue Canadian dollar-denominated, non-investment grade debt as investors hungered for higher yields. Income trusts, which have been the principal Canadian issuers of high-yield debt, will likely retain their taste for high-yield debt as they restructure as corporations, providing new impetus to the high-yield market in the corporate sector. In the Canadian M&A market, certain transactions, such as the acquisition by RTL-Robinson Enterprises Ltd. of Westcan Bulk Transport Ltd., have already successfully used a high-yield debt issue as a financing mechanism. Over the coming year, as the domestic high-yield market continues to develop, we expect that high-yield debt will increasingly factor into M&A transactions, especially if, as expected, interest rates remain at near-historic lows.
7. Going With the (Cash) Flow in Valuations
In order to obtain more deal certainty on value, several Canadian institutional investors have begun to favour a multiple of "free cash flow" to value target companies in certain industries. Previously, potential acquirors had typically relied on some variation on the target's multiple of earnings – in which the earnings figure may be derived from net income, from "EBIT" (earnings before interest and taxes) or from "EBITDA" (earnings before interest, taxes, depreciation and amortization).
The progression from net income to EBIT and EBITDA can be seen as an attempt to climb higher on the income statement to get a number closer to cash flow. We are now seeing the free cash flow ("FCF") method used with increasing frequency as an alternative way to achieve a valuation that reflects cash flow. FCF is generally defined as follows:
FCF = [Net Income] + [Depreciation and Amortization] – [Changes in Working Capital] – [Capital Expenditures]
As this suggests, there are two fundamental differences between FCF and an alternative such as net income when it comes to valuation. First, the net income approach uses depreciation, while FCF measures the last fiscal period's net capital purchases, such that capital spending is in current dollars (although a disadvantage is that capital investment is discretionary and can be sporadic). A second difference is that FCF deducts increases in net working capital, while the net income method does not.
FCF is basically the cash flow available for distribution to all holders of security, including equity holders, debt holders, preferred stockholders and convertible equity holders. It represents the cash that an entity is able to generate after expending the funds required to maintain and expand its asset base, thereby allowing the company to pursue opportunities that enhance shareholder value. Some investors, concerned that income can be clouded by accounting practices, believe that cash flow is much harder to obscure and that FCF gives them a much clearer view of the ability to generate cash (and thus profits).
8. Income Tax: Recent Developments Generally Positive for M&A
As the economy continues to improve and cross-border M&A activity increases, a number of recent amendments to the Income Tax Act (Canada) and some longstanding structures and techniques will have even a greater impact:
- The repeal of withholding tax on most cross-border interest payments should continue to facilitate accessing the most favourable sources of acquisition debt financing outside of Canada.
- The repeal of the infamous "Section 116" compliance and withholding regime on cross-border equity dispositions (except where the equity effectively constitutes a real property interest) will facilitate the sale by foreign investors currently holding the shares of Canadian companies and encourage new foreign investors contemplating an exit strategy which is devoid of most administrative hurdles.
- As purchase prices increase, the use of "exchangeable shares" may become more prevalent, in order to provide a rollover for capital gains purposes for Canadian shareholders of a Canadian target where the consideration includes, in whole or in part, stock of a foreign acquiror.
- Recent administrative rulings appear to have softened the harsh impact on Unlimited Liability Companies (ULCs) of the anti-hybrid rules contained in the 5th Protocol to the Canada-U.S. Tax Convention, which had negatively impacted the payment of dividends and return of capital, among others, to the U.S. ULCs have been used as tax-flow-through vehicles (so called check-the-box) for U.S. tax purposes in many cross-border structures.
9. Structuring Investments in M&A Transactions: Bilateral investment Treaties
As a global leader in mining, resource and energy finance, Canada and its investors are increasingly recognizing the importance of bilateral investment treaties ("BITs"). BITs permit investors to seek monetary damages from foreign governments that violate their treaty obligations, as do the investment chapters of many free trade agreements, including Chapter 11 of NAFTA. The private, investor-state dispute mechanism typically allows foreign investors to bring claims for damages before independent arbitral tribunals in the event that foreign governments take harmful actions that violate BIT obligations, including those that prohibit discriminatory or unfair treatment or expropriation without adequate compensation.
In structuring investments and M&A transactions we have traditionally been highly conscious of the implications of tax treaties and possible claims by indigenous peoples, but it is becoming equally important that investment into less stable countries are structured through a country that has a BIT with the host country (in conjunction with a favourable bilateral tax treaty). In light of this, we anticipate that the Canadian government will continue to work toward the implementation of BITs in order to preserve Canada's leadership role in global mining and resources financing.
In August 2010, Canada's federal government announced a C$130 million settlement of a Chapter 11 NA FTA claim by AbitibiBowater Inc. arising out of the expropriation by the Government of Newfoundland & Labrador of certain water and timber leases held by Abitibi in that province. This is just a reminder of the importance of bilateral investment treaties not only in Canada, but also in making investments in other countries around the world.
10. Infrastructure: One of the Hottest M&A Tickets for 2011
Infrastructure has been one of the most robust trends throughout 2010 as pension funds and large private equity groups acquire infrastructure-focused companies and infrastructure assets. Examples include CPP Investment Board's October 2010 investment of C$894 million for a 10% stake in Ontario's Highway 407 Express Toll Route (ETR), soon to be supplemented with the additional 30% of 407 ETR that CPPIB will acquire as a result of its purchase of Intoll, an Australian company, for approximately C$3.6 billion. In 2011, we expect to see continued growth in acquisition and joint venture activity relating to transportation and energy infrastructure projects, including co‑generation, nuclear and hydro. In our view, infrastructure-related M&A activity will remain a major theme in 2011, as stimulus spending continues and governments increasingly look to public-private partnerships (PPP) to bridge the gap between scarce public funds and public infrastructure needs – an important example being the recently concluded deal between Infrastructure Ontario and Windsor Essex Mobility Group to develop and maintain the C$1.6 billion Windsor-Essex Parkway. This was the first civil infrastructure PPP in Ontario and also the largest PPP in value in the province to date.
11. Deal Terms in Canada and the U.S.: Similarities and Differences
In 2011, we will see a continuation of themes that have emerged over the past two years, namely back to basics with cautious buyers; the return of more controlled auctions and the re-emergence of more strategic buyers (as distinct from financial buyers); the return of traditional bank financing (highly negotiated positive and negative covenants – no "covenant-lite" loans).
In Canadian M&A, we are seeing a continuing influence of U.S. practices, although there continue to be a number of marked differences within the North American marketplace for negotiated M&A transactions. The recent ABA 2010 Canadian Private Target Mergers & Acquisitions Deal Points Study published by the M&A Committee highlights some of the similarities and differences (compared to the ABA 2009 U.S. Private Target Study):
- Canadian transactions appeared to involve far fewer earnouts than U.S. transactions (29% in U.S. versus 3% in Canada).
- The concept of a Material Adverse Effect (MAE), as a defined qualifier of representations and warranties and/or conditions of closing was defined in fewer purchase agreements in Canada than the U.S. (92% in U.S. versus 73% in Canada).
- The general survival period for representations and warranties was longer in Canada than in the U.S. (75% of Canadian deals specify 24 months or less, as compared to 88% in the U.S.).
- "Baskets" (threshold or deductible for claims) as a percentage of transaction value totalled 69% for Canadian transactions for a basket of 1% of total value or less (U.S., 89%).
- More interestingly, the cap on indemnity claims was the "purchase price" in 45% of the Canadian transactions (U.S., 5%) with only 17% of the Canadian transactions having a cap of 15% or less of purchase price (U.S., 64%).
- Only 26% of Canadian transactions had an escrow or holdback component (U.S. figure not given; previous studies suggest that the figure in the U.S. is more than double that in Canada).
- Finally, in Canada, provisions relating to sandbagging are found less frequently than they are in the U.S. (31% vs. 47%), and, surprisingly to us, where they are found in Canadian agreements they are much more likely – by 21% to 10% – to be anti-sandbagging than pro-sandbagging (the reverse being the case in the U.S., where anti-sandbagging provisions were found 8% of the time vs. 39% of the time for pro-sandbagging provisions). Pro-sandbagging provisions are express statements that the buyer can seek indemnification for breach of warranties, notwithstanding knowledge of breach. Anti-sandbagging clauses can be dangerous for a buyer since, if not properly qualified, they invite the "you knew" defence for almost every claim.
* * * * * * * * * *
We would also note that due to the existing volatility in the Canadian capital markets and the continuing disparities in valuations, investors in Canadian companies are increasingly using dual-track (IPO and M&A) exit structures to effect liquidity. See Curtis Cusinato's article "M&A transaction or IPO: Why not pursue both?", in Stikeman Elliott's M&A Update, April 2010, available at www.stikeman.com or via the firm's securities law blog, www.canadiansecuritieslaw.com.
All in all, we expect a good year for M&A activity in Canada.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.