Canada: 2018 Legal Trends: Private Equity

Sellers' Market

While overall year-to-date 2018 deal value has been propped up by a small number of megadeals, there has been considerable deal volume in transactions under C$100-million, according to the CVCA Venture Capital and Private Equity Canadian Market Overview H1 2018.

Irrespective of deal size, it is clear that the seller-friendly dynamics that have been so pervasive in recent years are continuing in full force in 2018, even at the smaller end of the market. With the significant amount of private equity and pension fund dry powder available for deployment, we see no signs of these seller-friendly conditions letting up any time soon.

Near the top of these seller-friendly conditions is the high frequency — and now near-routine nature — of auction sale processes. It is becoming increasingly common to see sellers, even in lower value deals, engaging sell-side financial advisers. Further, the auctions themselves are intensifying with greater bidder participation, both foreign and domestic, and increasingly demanding bid requirements.

In higher value transactions, it is now common to see multiple bidders advance through numerous auction stages, including negotiations of potentially binding transaction agreements, all before a successful bidder is selected. This is driving up the "cost to play" and squeezing bidders not just on price but also on transaction terms.

Examples of the impact on transaction terms can be seen among the post-closing protections that buyers are able to obtain from sellers:

Baskets & Caps

In deals where the seller agrees to provide an indemnification package, deal agreements have continued to predominantly include the more seller-friendly form of basket — a deductible instead of a threshold. This is consistent with the findings in our 2018 Canadian Private Equity Deal Study (Deal Study) in which 64 per cent of deals with indemnification packages included deductibles, as compared to 35 per cent of such deals which carried thresholds.

Similarly, consistent with the decline in retentions under representation and warranty (R&W) insurance policies, we have seen a trend towards lower basket sizes, typically 50 per cent of retention amounts. The same type of decline has been seen in general representation and warranty liability caps, which we believe is indicative of both the seller and auction pressure for bidders/buyers to offer lower post-closing exposure for sellers, and the proliferation of R&W insurance policies, which customarily set the cap for general representation and warranty breaches at the retention/deductible under such policies.

Escrow

As documented in our Deal Study, there was a sharp drop in escrow size in 2017 as compared to the preceding three years (from medians of approximately five to six per cent of purchase price in 2014-16, down to a median of approximately one per cent of purchase price in 2017) and there has similarly been a steady year-over-year decline in escrow hold periods from 2014 (median of 21 months) to 2017 (median of 14 months).

In 2018, the drop in escrow size and decline in escrow period appear to be changes reflective of a shift in the market rather than a temporary anomaly. With sellers eager to reduce the portion of their proceeds that are tied up for significant periods in escrow, it is not surprising they are putting direct pressure on bidders to minimize their escrow "asks".

These declines are also reflective of the fact that sellers are actively encouraging bidders to use R&W insurance policies as the primary source of post-closing recourse, reducing the need for bidders to rely on and thus negotiate for extensive escrow shelters.

Fewer Standalone Indemnities for Unknown Liabilities

We are noticing a continuing trend away from deals including standalone indemnities for unknown liabilities. In line with the theme of sellers aiming to minimize their post-closing exposure and obtain clean exits, these standalone indemnities — which in some industries may have traditionally been common sources of buyer protection (e.g., an environmental indemnity in a sale of a manufacturing target) — have become decreasingly available to bidders.

Such unknown risks are now to be factored into bid prices, captured by representations and warranties (and potentially protected under R&W insurance policies) or just absorbed by bidders as another of the new costs of playing in this space.

Shorter Survival Periods

The market position for the survival of general representations and warranties in Canadian private M&A, and in private equity deals specifically, appears to have roughly settled at 18 months (with minor variances). An interesting feature of 2018 deals has been the ongoing acceptance by bidders of finite and in fact increasingly shorter survival periods for fundamental representations and warranties. In our Deal Study, 31 per cent of deals had a fixed survival period on fundamental representations and warranties, and we expect this percentage to grow in 2018.

Similarly, whereas traditional Canadian M&A practice would see a fraud claim related to a breach of a representation or warranty surviving indefinitely — in line with findings in our Deal Study — we are increasingly seeing breaches of representations and warranties due to fraud being treated the same as any other breach of representations and warranties. In 44 per cent of the deals in our Deal Study, a breach of R&Ws arising from fraud was not afforded any special or different treatment as compared to any other breach of such R&Ws.

Representation & Warranty Insurance

Both our Deal Study and our more recent private equity transaction experience have shown that R&W insurance has become a staple in Canadian private equity transactions and that the market for this type of insurance product continues to rapidly evolve. The current "sellers' market" has required buyers to find means of distinguishing themselves from their peers by offering limited post-closing exposure to sellers, similar to public company style transactions.

This trend, coupled with heightened competition among insurers jockeying for increased market share, has led to decreased retentions and premiums, the rise of no-seller recourse policies and an expansion of the coverage offered under R&W insurance, making R&W insurance more accessible and attractive.

Retentions and Premiums Decreasing

Data set out in our Deal Study and sourced from R&W insurance brokers BFL Canada, Marsh LLC and Ethos Insurance Partners Inc. has shown that the policy premiums have steadily declined year over year to settle between 2.77 per cent and three per cent of the policy limit for 2017. Our recent transaction experience shows that this downward trend continues in 2018.

Similarly, retention amounts (or deductibles) under R&W insurance policies have also followed this downward trend, dropping well below two per cent of the policy limit for 2017, and some R&W insurance brokers have indicated that retentions have averaged one per cent of the policy limit for 2018.

No-Seller Indemnity Policies

Another bi-product of the competitive Canadian private equity M&A marketplace and more robust competition among providers of R&W insurance policies is the increased use of no-seller indemnity R&W insurance policies.

While traditionally sellers would generally share the burden of the retention amount or deductible under the R&W insurance policy — such that they would continue to have some "skin in the game" for a limited period of time following the closing of the transaction — the current sellers' market has fuelled the need for buyers to distinguish themselves from their competition and led to more frequent use of no-seller recourse R&W insurance policies. Under this construct, the sellers do not share in any portion of the retention amount resulting in an exit that, subject to a few exceptions, is similar to a public company style deal by offering a clean break with little to no residual post-closing liability for sellers.

R&W Scope Expansion

One other trend that we have noticed over the course of 2018, which likely results in part from the more competitive R&W insurance landscape, is that the scope of representations and warranties covered by R&W insurance has steadily expanded. While certain matters such as pre-closing taxes and environmental matters were typically excluded from R&W insurance — often because the quantum of the liabilities that flow from such matters is difficult to compute and may be material — we've seen a steady trend towards such matters now getting coverage under R&W insurance policies and fewer exclusions from policy coverage.

Industry Trends

Private Plans of Arrangement Transactions

We have also seen increased private equity interest in the technology and software sectors, principally from technology-focused private equity funds based in the United States. Unlike Canadian businesses in traditional industries where equity is often concentrated in the hands of key management members and institutional investors, many technology-based businesses — and particularly those that have been through a start-up phase — offer equity to employees and consultants as a primary form of compensation. Due to the meaningful lifetime capital gains exemption available to individuals under Canadian tax laws and to the more straightforward nature of share transactions as compared to asset transactions, most securityholders of Canadian companies will wish to undertake a sale of their securities as opposed to selling the assets of the company.

Accordingly, private equity buyers seeking to acquire such businesses will often need to contend with lengthy shareholder and optionholder lists and the practicalities of having all such securityholders participate in the transaction.

In such circumstances, private equity buyers must choose between entering into a multiparty securities purchase agreement with all securityholders or acquiring the securities of the target company through a plan of arrangement transaction in which the shareholders of a target company will pass a resolution approving the transaction, and the target company and the buyer will seek a court order conveying or otherwise dealing with the target company's shares and options on terms and conditions agreed between the target company and the private equity buyer.

Both approaches come with drawbacks. While a purchase agreement will be familiar to private equity buyers and offers the most transactional flexibility, ensuring that every single securityholder actually executes and delivers the primary purchase agreement can be practically challenging and can afford a "holdout" securityholder a disproportionate amount of leverage. In turn, a plan of arrangement transaction entails a greater number of steps and complications relative to a purchase agreement transaction, including the following:

  • A plan of arrangement and arrangement agreement
  • Court materials and shareholder meeting materials, which often include shareholder lockup agreements obliging key shareholders to vote in favour of the arrangement and a detailed management proxy circular to be circulated in connection with the special shareholders meeting
  • Court orders approving the shareholder meeting and the completion of the arrangement following a successful shareholder vote.

These additional documents and steps generally lead to significantly increased transaction costs for the private equity buyer and the target company, as well as a lengthier timeline to closing.

Moreover, as private plan of arrangement transactions remain relatively uncommon and the arrangement structure is more conventionally used to acquire public companies, care must be taken when drafting the plan of arrangement transaction documents so that typical private company deal terms that private equity buyers are accustomed to receiving — such as post-closing indemnification obligations, working capital and price adjustment provisions, and third-party escrow provisions — are properly reflected and implemented. Once drafted, these provisions must also be accurately described in the shareholder meeting materials so that shareholders can fairly determine whether to vote in favour of the transaction and must also be described to the court when seeking the court orders needed to effect the plan of arrangement.

Widely held private companies can take the following steps to both avoid the need to utilize a plan of arrangement structure and ameliorate the practical challenges entailed in a multiparty purchase agreement:

  • A shareholders' agreement with properly drafted and robust drag-along provisions obliging all shareholders to transfer their shares to a buyer once certain conditions are met can provide comfort to a private equity buyer that there won't be any "holdout" shareholder issues
  • A properly drafted option plan that both expressly addresses the sale or surrender of the options in a sale of the company and grants broad powers to the target board of directors or a committee of the board of directors to administer the plan and options may avoid the need for optionholders to be made party to the purchase agreement

Private Equity in Canadian Energy

After seeing increases in private equity activity in the upstream oil and natural gas sector after the immediate fallout of the late 2014 oil price crash, activity in 2017 was more muted and 2018 continues to show reduced transaction activity.

The initial shock of the dramatic decrease in commodity prices in 2014 and 2015 led to considerable acquisition and investment opportunities as companies sought to manage their debt and bolster their balance sheets by selling non-core assets.

Through 2017 and into 2018, higher international oil prices, together with leaner Canadian exploration and production (E&P) and energy services companies, have provided enhanced stability to the Canadian energy industry. The industry continues to face challenges, including regulatory uncertainty and operational issues arising from limits on oil and natural gas transportation capacity that has led to record price discounts for Canadian energy products compared to international oil prices. Accordingly, the seller-friendly trends visible in the rest of the Canadian private equity universe have largely not carried over to the Canadian oil and gas space. R&W insurance remains rare in the Alberta market, and general deal terms follow a unique model. Buyers often have the upper hand in negotiations in the current environment, although each transaction will vary depending on the specific deal dynamics.

Still, industry and private equity players do recognize the potential for investment and acquisition opportunities. Strategic acquirers, including those that have made large acquisitions from U.S. majors leaving the Canadian industry in recent years, are likely to look to continue to divest non-core assets to further improve their balance sheets. This will provide experienced management teams with private equity backing with opportunities to start new portfolio companies or expand existing ones.

The relatively low asset valuations and Canadian dollar exchange rate present a potentially attractive investment for private equity firms and their portfolio companies, with tremendous potential upside once transportation capacity and regulatory questions are resolved.

The recent positive final investment decision by the LNG Canada consortium to proceed with the construction of a liquefied natural gas (LNG) export terminal in British Columbia is expected to attract investment and development of the long-suffering Canadian natural gas industry.

Finally, there is continued interest in midstream, transportation and other infrastructure opportunities, in light of the need that oil and gas producers have to move their increased production to market or find alternative uses and markets for their products.

For permission to reprint articles, please contact the Blakes Marketing Department.

© 2018 Blake, Cassels & Graydon LLP.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions