Originally published in Blakes Bulletin on Business Law, October 2007
Crisis for some is quite often opportunity for others.
Record-breaking levels of Canadian M&A activity in 2006 had continued through the first half of 2007. However, since the onset of the credit squeeze in the summer, there has been a marked decrease in the number and, in particular, the size of Canadian M&A transactions.
Today, purchasers with cash on hand, readily available credit or their own shares issuable as consideration may find targets available with less competition or at lower prices than before the advent of the credit crunch.
In recent years, the proliferation of private equity buyers with access to what seemed unlimited amounts of credit at low rates had radically altered the deal landscape. In competitive auction situations, it would not be uncommon for eight or nine bidders to be active in the due diligence process. Typically, only two or three would be "strategic buyers" (companies looking to expand their businesses) and the balance would be "financial buyers" (private equity players who would finance a significant percentage of the purchase price with debt). The result of this level of interest by financial buyers was that in many cases strategic buyers were edged out by financial buyers. Now the tables have turned somewhat and many strategic buyers have access to credit and shares as acquisition currency. In the last number of weeks, there has been a noticeable increase in the number of acquisitions by strategic buyers as a percentage of transactions.
Even with the recent tightening of credit, private equity funds remain active purchasers, although at diminished levels. New funds continue to be formed, including the USD 21.7-billion fund, the world’s largest, raised by The Blackstone Group in early August. Moreover, many private equity funds continue to have significant uninvested cash raised from investors prior to the credit squeeze. The typical horizon for a fund to invest money raised from investors is a year or more. Many private equity players are revising their strategies until credit markets normalize. One practical result in Canada has been fewer mega-deals and more mid-market acquisitions of both public and private companies by private equity buyers that do not require as much credit leverage. Other private equity funds are focusing on distressed targets in sectors under pressure.
A new focus of attention is "sovereign wealth funds" or funds owned by sovereign states that purchase and operate businesses instead of merely taking small portfolio stakes in them. Many are from Middle Eastern states seeking to invest surplus petrodollars, but there are many diverse countries of origin, including China, Singapore and Norway. A Canadian example is the recently announced CAD 4.5-billion acquisition by Abu Dhabi National Energy (commonly known as TAQA) of PrimeWest Energy Trust. The Canadian government has declared that it is considering possible amendments to the Investment Canada Act to address national security and reciprocity concerns arising from investments by sovereign wealth funds.
A key area of heightened concern in the due diligence process is the impact of the credit crunch on potential targets. The obvious first question in the Canadian context is the extent to which the target is exposed to the asset-backed commercial paper (ABCP) market. If the target relies upon the market to fund any portion of its business, has it been able to replace that source of credit with other sources of credit? Will the target be embroiled in the ongoing process to sort out the ABCP situation?
The next line of inquiry is whether the target (or perhaps its pension fund) holds ABCP of other issuers. Many companies have invested some portion of their cash in (traditionally highly rated) ABCP. A potential purchaser will need to consider how significant that holding is compared to all of the target’s other cash assets and evaluate the impact of the holding on the business as a whole. Potential purchasers should consult their accounting advisers about whether the target has properly and adequately accounted in its financial statements for the ABCP it holds in accordance with generally accepted accounting principles. Given the quarterly reporting cycle of public companies and the onset during the summer months of the credit crunch, upcoming quarterly and annual reports will bring more information about the extent of the impact of the credit situation on a wide variety of issuers.
The attention paid to material adverse change provisions, commonly referred to by the acronym "MAC" or "MAC out," has also increased. For deals that have already been signed, parties are parsing their terms to understand their rights and obligations. The typical MAC provision states that a material adverse change, when used in connection with any person, is any change, effect, event, occurrence or state of facts that is, or would reasonably be expected to be, material and adverse to the business, operations, results of operations or financial condition of that person and its subsidiaries, taken as a whole. There are then typically carve-outs from this standard that are expressed not to constitute a MAC (and which are typically also not to be taken into account in determining whether there has been a MAC), such as, for example, a change, effect (whether alone or in combination with other effects), event, occurrence or state of facts resulting from the announcement of the transaction, changes in generally accepted accounting principles, the commencement, occurrence or continuation of any war, armed hostilities or acts of terrorism, or changes in applicable law. Of particular relevance in the circumstance of the credit crunch are carve-outs that relate to markets and economic circumstances. Examples include:
- "changes in general economic or political conditions or securities or banking markets in general" and
- "changes in factors generally affecting the industries or markets in which the target and its subsidiaries operate"
It is then quite common for the carve-outs to be limited in their application by an overarching proviso that certain carve-outs shall not include any change "which disproportionately affects that person and its subsidiaries, taken as a whole."
The merger agreement will generally provide that the purchaser shall not have an obligation to proceed with an acquisition if the target suffers a MAC that is not remediable or has not been remedied within a fixed number of days.
The bar to a purchaser relying upon a MAC out as a means of avoiding the obligation to complete a transaction when all conditions to closing have been satisfied is a high one and is rare in Canadian M&A experience.
In some acquisitions involving, in particular, private equity purchasers, there are provisions in which the purchaser is required to pay a fixed fee (referred to as a "reverse break fee") if the transaction is not completed because the purchaser is unable to complete the debt financing for the purpose of paying the purchase price. The interplay between the various MAC and remedy provisions in agreements, including whether the parties have provided for the payment of the reverse break fee by the purchaser as the exclusive remedy, or whether specific performance of the agreement may be ordered by a court, will determine if a purchaser is able to escape the obligation to close.
In light of the relative dearth of Canadian case law on the operation of MAC provisions, parties are following developments in the U.S. closely, where purchasers in an increasing number of mergers are alleging a MAC as the ground for terminating a merger agreement.
Credit markets will normalize over time. Until that happens, there will be opportunities for a variety of players who have greater access to cash and credit, and who have shares to issue as consideration, to prevail as acquirers over players who are not similarly situated.
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.