1.1 What are the most common types of private equity transactions in your jurisdiction? What is the current state of the market for these transactions? Have you seen any changes in the types of private equity transactions being implemented in the last two to three years?
The year 2015 was a strong one for private equity transactions in Canada. The 399 deal closings reported by the Canada Venture Capital & Private Equity Association represented a 19% increase in deal volume over 2014 and evidenced continued growth in the industry. Private equity buyout deals continued to be the most common type of transaction with the bulk of Canadian activity occurring in the provinces of Alberta, Ontario and Quebec.
While depressed oil prices have impacted both the volume of deals and the amount invested in the oil and gas industry, overall the current conditions favour a robust private equity market. The decline in the Canadian dollar and the related reduced acquisition costs for foreign purchasers of Canadian companies, make inbound private equity investment particularly attractive at this time.
Notwithstanding a recent rebound in the Canadian IPO market, the IPO market is still relatively slow and M&A exits continue to be more prevalent. Over the past few years, evergreen or ultra-long term funds have become increasingly common, which has likely impacted the number of transactions. Other trends include the increased prevalence of co-investments by private equity funds, and direct investments by Canadian pension funds both locally and abroad.
1.2 What are the most significant factors or developments encouraging or inhibiting private equity transactions in your jurisdiction?
Private equity firms are flush with capital to be deployed and Canada is highly ranked by a number of sources as an attractive country for foreign companies to invest in. The Canadian political scene is stable with a new federal government having come to power in 2015. The legal system is fully developed and similar, in many respects, to the American system. Those factors, coupled with the declined value of the Canadian dollar, have created favourable conditions for private equity activity in Canada.
While the impact of low oil prices was felt in 2015, with a corresponding decline in investments in the oil and gas sector, private equity deal volume and fundraising levels remain robust overall. The declining Canadian dollar has also resulted in improved business outlooks for some industries, notably manufacturing.
2 Structuring Matters
2.1 What are the most common acquisition structures adopted for private equity transactions in your jurisdiction?
Privately held Canadian businesses are generally acquired by private equity buyers either through a purchase of assets or a purchase of shares. Private equity investors will typically incorporate a Canadian acquisition corporation and fund it by way of interestbearing debt and equity on a 1.5:1 basis in order to comply with Canadian thin-capitalisation rules. This acquisition entity then acquires all of the shares/assets of the Canadian target and, in the case of a share acquisition, the acquisition corporation and target are "amalgamated" under the relevant corporate statute.
In the case of foreign private equity investment into Canada, an unlimited liability company ("ULC") is often used as the ultimate Canadian company in the ownership chain. ULCs act as flowthrough vehicles for tax purposes, allowing private equity funds to minimise tax at the portfolio entity level in favour of a structure that results in income for tax purposes being realised at the holding level.
2.2 What are the main drivers for these acquisition structures?
Whether a Canadian acquisition should be completed by purchasing assets or shares is driven by tax and non-tax considerations. The weight given to these factors will depend on the circumstances of the transaction and the parties' ability to leverage their respective positions. From the point of view of a potential acquiror, the greatest benefits of an asset sale are tax advantages and the ability to pick and choose the assets and liabilities that will be acquired. However, asset sales tend to be significantly more complex in larger transactions and can require voluminous third party consents. In contrast, a share sale is relatively simple from a conveyancing perspective. From the seller's perspective, tax considerations generally favour share transactions as individual sellers may be able to utilise their personal capital gains exemptions to shelter a portion of the proceeds. We are seeing an increase in the number of 'hybrid' transactions which involve the acquisition of both shares and assets of a target entity, providing tax advantages to both buyer and seller.
2.3 How is the equity commonly structured in private equity transactions in your jurisdiction (including institutional, management and carried interests)?
Sellers of businesses will, on occasion, take back equity in a corporate purchaser. The precise terms of the equity interests offered to, or required of, continuing management are often a major point of negotiation in transactions. Typical structures include multiple classes of equity with one class designed to pay out investors, such as the fund and any co-investors, in priority over a second class designed to pay out continuing management only if the business is eventually sold for more than a certain threshold value. Stock options or phantom stock options are also commonly granted.
2.4 What are the main drivers for these equity structures?
A number of considerations drive these equity structures including the negotiating power of the management team and their personal tax considerations, as well as the openness of the private equity fund to use structures other than their typical or preferred structure. Aligning the equity interests granted to continuing managers with the continued growth and success of the company is also essential. Whether equity incentives were held by management prior to the private equity acquisition and, if so, in what form, as well as the overall size of the management team, also impact the equity structure.
2.5 In relation to management equity, what are the typical vesting and compulsory acquisition provisions?
In order to align interests, most stock option plans call for options to vest and become exercisable upon the achievement of certain conditions. Those conditions are typically tied to either continued employment and the passage of time, and/or certain performance/ success requirements, such as the achievement of stated financial returns.
Generally, management equity is structured to allow for repurchase by the company upon a termination of employment. Options granted to management may vary on whether they are exercisable following termination of employment based on whether the termination was a "good exit" or a "bad exit". All, or substantially all, of the options granted to management typically vest automatically in the event of a sale of the company by the private equity investor.
2.6 If a private equity investor is taking a minority position, are there different structuring considerations?
Private equity investors taking minority positions, once only common in smaller growth equity deals but now an increasingly popular trend in larger transactions, require private equity firms to consider different structuring issues due to the lack of control. The minority rights stipulated in the shareholders agreement become of primary concern to ensure private equity firms have veto power (or at least significant influence) over critical decisions. Likewise, put and drag-along provisions are key to ensure the private equity investor has flexibility with regards to its exit strategy. A minority interest may also be taken in the form of a convertible debt instrument.
3 Governance Matters
3.1 What are the typical governance arrangements for private equity portfolio companies? Are such arrangements required to be made publicly available in your jurisdiction?
Private equity firms utilise their equity positions, or negotiated minority rights, to assign seats on the board of directors to their principals and nominees. As such, they typically have the authority to run the portfolio company for the period of their investment. In Canada, the names and addresses of private companies' boards of directors are publicly available information. However, the names of shareholders of private companies are not publicly available.
3.2 Do private equity investors and/or their director nominees typically enjoy significant veto rights over major corporate actions (such as acquisitions and disposals, litigation, indebtedness, changing the nature of the business, business plans and strategy, etc.)? If a private equity investor takes a minority position, what veto rights would they typically enjoy?
The default dissent rights provided under corporate legislations are typically supplemented through unanimous shareholder agreements that ensure the private equity investor has ultimate control over the portfolio company. Often, such veto rights cease to apply where a private equity investor's equity interest is reduced below a given benchmark.
Where a private equity investor holds a minority position, veto rights are still typically enjoyed over critical business matters such as acquisitions, changes to the board and management team, the issuance of new equity or debt and the disposition of key assets.
3.3 Are there any limitations on the effectiveness of veto arrangements: (i) at the shareholder level; and (ii) at the director nominee level? If so, how are these typically addressed?
In order for a shareholder agreement that sets forth veto arrangements to be enforceable against a subsequent shareholder, to fetter the discretion of the directors or to supplant the default provisions of corporate legislation where permitted, it must be unanimous in nature. At the director level, only certain director discretion can be fettered by a unanimous shareholders agreement and most notably, the fiduciary duty directors of portfolio companies owe to the company cannot be restrained.
3.4 Are there any duties owed by a private equity investor to minority shareholders such as management shareholders (or vice versa)? If so, how are these typically addressed?
In contrast to some American jurisdictions, controlling shareholders in Canada do not owe a fiduciary duty to minority shareholders.
3.5 Are there any limitations or restrictions on the contents or enforceability of shareholder agreements (including (i) governing law and jurisdiction, and (ii) non-compete and non-solicit provisions)?
A shareholder agreement that is not signed by all of the shareholders of a company is treated as a regular commercial contract. It is subject to the articles and by-laws of the corporation and the provisions of the relevant corporate statute. In contrast, a unanimous shareholder agreement ("USA") is a creature of statute and must be signed by all shareholders. Corporate legislation expressly recognises the ability of shareholders to contract out of certain statutory requirements and fetter certain powers of directors.
To the extent a USA restricts the powers of directors to manage the business and affairs of the corporation, shareholders who are given that power inherit the rights, powers, duties and liabilities of a director under corporate statutes or otherwise.
Canadian courts will not enforce restrictive covenants that unnecessarily restrict an individual's freedom to earn a livelihood. What is reasonably necessary depends on the nature of the business, its geographic reach, and the individual's former role in that business. Canadian courts will not enforce a restrictive covenant that does not contain any time limit.
3.6 Are there any legal restrictions or other requirements that a private equity investor should be aware of in appointing its nominees to boards of portfolio companies? What are the key potential risks and liabilities for (i) directors nominated by private equity investors to portfolio company boards, and (ii) private equity investors that nominate directors to boards of portfolio companies under corporate law and also more generally under other applicable laws (see section 10 below)?
Depending on the jurisdiction of incorporation, the board of directors of a Canadian corporation may be subject to certain minimum residency requirements. Notably, boards of directors for companies incorporated under either the federal or Ontario statute, must consist of at least 25% resident Canadian directors.
In Canada, all directors owe fiduciary duties to the corporation, including a duty to act in the best interest of the corporation. The potential statutory liabilities directors are exposed to can be extensive and the basis for this potential liability varies. Directors may be personally liable for their own wrongdoing or failure, such as breaching the duties of loyalty and of care, or, in other instances, held personally liable for wrongdoing by the corporation. The statutes that impose director liability include those governing corporate matters, securities compliance, employment and labour protection, taxation, pensions and bankruptcy and insolvency.
3.7 How do directors nominated by private equity investors deal with actual and potential conflicts of interest arising from (i) their relationship with the party nominating them, and (ii) positions as directors of other portfolio companies?
Directors of a corporation who are nominees of a particular shareholder are subject to fiduciary duties to act in the best interest of the corporation, not the shareholder who nominated them.
Canadian corporate statutes require directors to disclose in writing the nature and extent of their interest in a proposed material contract or transaction with the corporation. This provision applies whether the director is a party to the contract or transaction personally or is a director or officer of, or has a material interest in, a party to the contract or transaction. As such, all conflicts or potential conflicts the director has, as a result of their relationship with the nominating party and/or other portfolio companies, must be disclosed. In situations of conflict, the statutes require the director to refrain from voting on any resolution to approve the contract or transaction except in narrow circumstances.
4 Transaction Terms: General
4.1 What are the major issues impacting the timetable for transactions in your jurisdiction, including competition and other regulatory approval requirements, disclosure obligations and financing issues?
Aside from the typical due diligence process, the timetable for transactions is often governed by the regulatory approval required under the Competition Act and the Investment Canada Act, where applicable.
In Canada, certain large transactions trigger advance notice requirements under the Competition Act. Such transactions cannot be completed until the end of a review period. Pre-merger notification filings are required in connection with a proposed acquisition of assets or shares or an amalgamation or other combination to establish a business in Canada where thresholds relating to the "size of the parties," the "size of the transaction" and "shareholding" are exceeded.
In addition to competition regulations, under the Investment Canada Act, foreign investments that exceed a prescribed value or that relate to cultural business or national security are subject to Investment Canada Act approval. This allows the federal government to screen proposed investments to determine whether they will be of "net benefit" to Canada.
4.2 Have there been any discernible trends in transaction terms over recent years?
The increase in foreign investment, typically from the United States, has influenced transaction terms which have gradually shifted to become increasingly similar to those in the American market. For instance, the use of pro-sandbagging provisions, common in the United States, is increasingly found in Canadian transactions. Similarly, the size of indemnity caps, while still significantly higher in Canada than in the United States, have trended downwards in recent years.
5 Transaction Terms: Public Acquisitions
5.1 What particular features and/or challenges apply to private equity investors involved in public-to-private transactions (and their financing) and how are these commonly dealt with?
Canadian takeover bids require that adequate arrangements (an interpreted statement) must be made, with the effect that a bid cannot be conditional on financing. Statutory plans of arrangement on the other hand can be conditional in nature and allow for more flexibility to provide collateral benefits to managements, etc. Due to this flexibility, most Canadian privatisation transactions involving private equity investors are completed by a plan of arrangement.
5.2 Are break-up fees available in your jurisdiction in relation to public acquisitions? If not, what other arrangements are available, e.g. to cover aborted deal costs? If so, are such arrangements frequently agreed and what is the general range of such break-up fees?
In friendly acquisitions, break fees are often seen in connection with 'no-shop' provisions. The 'no-shop clause' is typically subject to a fiduciary out, upon which the break fee becomes payable. The break fee is generally in the range of 2–4% of the transaction's value.
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Previously published by Global Legal Group
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
© McMillan LLP 2016