Contributed By Fasken
Steady Deal Flow
With record-high private equity deal activity in 2017, and a continued strong showing in 2018, the Canadian market continues to be an attractive jurisdiction for M&A private equity activity in 2019. Canadian private equity deal flow has been steady, seeing continued high prices (with a slight tapering off compared to last year), high multiples and continued strength (with a slight increase) in deal volume. Add-on acquisitions have been frequent.
However, private equity funds have, in some cases, been patient with exit strategies, preferring to hold on to assets or roll them into successor funds rather than selling in less than optimal conditions. Private equity exits in Canada have been fewer thus far in 2019 than in the past two years.
One notable trend in Canada in 2019 has been the creation of specialised, industry-specific funds, in addition to the continued maturation of more traditional private equity funds. Over the past year, structuring and fundraising efforts have been deployed for funds focused on sectors ranging from real estate, insurance, and financial institutions to agro-food, cleantech, cannabis and life sciences. Private equity players are also exploring alternative funds focused on distress financing and credit and other flexible capital, as a complement to M&A activity.
It will be interesting to see how the development of these alternative vehicles impacts the transaction landscape – for example, in attracting a broader range of entrepreneurs to consider private equity partnerships or exits, or by creating increased competition from more private equity buyers. The heightened level of understanding and sophistication a specialised fund develops within a particular industry may also lead to more obvious front-runners in auction processes (if the price is right) and large-scale consolidation activities in previously fragmented industries.
Continued Adoption of Representation and Warranties Insurance (RWI)
Canada has also experienced an increase in cross-border activity, in particular with the USA. Canadian private equity deals continue to be cross-pollinated by American deal terms, both for Canadian private equity buyers and sellers, with a view of creating a more competitive process. In particular, representations and warranties insurance has become commonplace in Canadian transactions. In competitive auction processes, the use of insurance is no longer perceived as an advantage, but a requirement. Canadian bidders have been adopting this framework to provide a competitive edge (or to ensure they do not lose one to their US competition), and have become comfortable and familiar with the mechanics. Insurance providers in Canada, too, have become more aggressive in promoting the product and have made adjustments in the product to ensure it is an attractive solution for M&A.
Continued Focus on Privacy, Cyber Risk and Anti-corruption
Additional trends seen in 2019 in Canada include the consideration of specialised insurance for known risks, as well as a heightened sensitivity to privacy, cyber-risk and anti-corruption risks. There has been increased diligence and more thorough representations and warranties on these matters over the past year (in addition to a continued focus in more traditional zones of risk such as environmental and intellectual property).
Deal flow in Canada continues to be dominated by traditional sectors such as industrial and manufacturing, and technology. Financial institutions and the more specialised sector of payment processing has seen increased activity following global consolidation trends in the industry. Agro-food deals may be more uniquely Canadian, and there has been an uptick in this space from private equity players in 2019.
Enhanced Rules Pertaining to Protection of Personal Information
The protection of personal information in Canada is governed by the Personal Information Protection and Electronic Documents Act (PIPEDA) and by substantially similar legislation in certain provincial jurisdictions. In addition to strict provisions as to the collection, use, and disclosure of personal information, and record-keeping, effective as of 1 November 2018, PIPEDA now includes a mandatory requirement for organisations to give notice of information breaches.
Notice must be given to affected individuals (unless prohibited by law) and to the commissioner about data breaches where it is reasonable to believe that the breach creates a “real risk of significant harm to an individual”. “Significant harm” includes humiliation, damage to an individual’s reputation or relationships, and identity theft. A “real risk” requires consideration of the sensitivity of the information, the probability of misuse, and any other prescribed factor. The notice to individuals and the report to the commissioner must be given in the prescribed form “as soon as is feasible” after it is determined that a breach occurred. The commissioner may publish information about such notices if it determines that it would be in the public interest to do so.
Avoiding data breaches is of paramount importance to the businesses in which private equity funds invest. Understanding and complying with the evolving legal landscape on privacy matters is a top priority for private equity investors across a suite of industries.
New Free Trade Agreements
Canada is a trading nation and is an active promoter of trade agreements. The country has recently signed two important agreements (USMCA and CETA) fostering continued business activity between some of its largest trading partners.
The United States-Mexico-Canada Agreement (USMCA) updates a more than 20-year-old North American Free Trade Agreement (NAFTA). The 'New NAFTA', as it is known colloquially, was signed on 30 November 2018, and is intended to replace NAFTA once all three countries have ratified it. While Mexico has ratified the agreement, electoral politics and trade tactics have, to date, stalled the approval processes in both Canada and the USA.
With some important exceptions, the scope and content of USMCA generally reflects that of NAFTA, so for the most part it is expected that it will be business as usual for most private equity portfolio companies. Notable changes that may impact future private equity strategies in specific industries are (i) the requirement for significant North American content in automotive sector and minimum wage requirements; and (ii) the granting of increased access to US dairy farmers to Canada’s lucrative dairy sector.
Government procurement rules have also been eliminated, resulting in suppliers who enjoyed privileged access to prepare for heightened competition from the other two countries in this regard. The broad investor protection measures found in NAFTA have also been eliminated, such that US and Mexican investors in Canada will lose their right to use international arbitration to challenge Canadian measures. They will, however, retain their right to challenge Canadian measures in Canadian courts. Finally, the new agreement bans restrictions on data transfers across borders, meaning that Canada can no longer require companies based in the USA or Mexico to store data within Canada.
The Comprehensive Economic and Trade Agreement (CETA), the trade agreement between Canada and the European Union, came into force provisionally on 21 September 2017, and immediately eliminated 98% of customs tariffs. Within seven years, 99% of customs tariffs on qualifying goods will be duty-free. Under CETA, Canadian suppliers enjoy privileged access to the huge EU public procurement market, from the EU institutional level down through national and provincial governments to public institutions at the municipal, academic, school board, and health sector levels. Given CETA’s massive scope and coverage and enough time for its full benefits to be realised, CETA may prove to be the most significant trade agreement Canada has signed since (the original) NAFTA.
Private equity funds with investments or opportunities in specific industries (for example, agro-food or automotive manufacturing) will want to carefully understand how the target businesses’ market share may be impacted by these changes, and consider new opportunities abroad in industries benefiting from advantageous trade arrangements.
Proposed Changes to Stock Option Tax Treatment
Stock options have historically been used by private equity firms in Canada as an effective means of incentivising management teams. In Canada, stock options are considered part of employment income, and taxed accordingly. Further, they are taxed at time of exercise, not grant. Given these attributes, stock option plans have been widely used within portfolio companies. Proposed amendments to the taxation regime for stock options should therefore be followed carefully.
In its 2019 Federal Budget, the Canadian government outlined its proposal to introduce a CAD200,000 annual limit on employee stock option grants for employees of “large, long-established, mature firms”. The government explains that the current regime disproportionally benefits executives of large, mature companies who take advantage of the rules as a preferred form of compensation instead of achieving the policy objective of supporting younger and growing Canadian businesses. The new draft legislative proposals will apply to employee stock options granted on or after 1 January 2020.
Under the current stock option rules, a taxable benefit is added to the employee’s taxable income at the time of exercise, to the extent the fair market value (FMV) of the underlying shares exceeds the exercise price specified in the option agreement. However, the employee is entitled to claim a deduction in the amount of 50% of the taxable benefit provided that at the time of the grant, the options are not in-the-money and, generally, common shares are issued upon the exercise of the options.
If enacted as proposed, the legislation would impose a CAD200,000 annual vesting limit on employee stock option grants (based on the fair market value of the underlying shares at the time the options are granted) that could be entitled to receive the 50% deduction. This vesting limit would not apply to employee stock options granted: (i) Canadian-controlled private corporations (CCPCs); and (ii) non-CCPCs that meet certain prescribed conditions (yet to be released).
The federal government is currently seeking input on the characteristics of companies that should be considered “start-up, emerging, and scale-up companies” for purposes of the prescribed conditions as well as views on the administrative and compliance implications associated with putting such characteristics into legislation. Given an upcoming federal election and this ongoing consultation process, it is unclear if or how these provisions will ultimately be implemented.
The legislative proposals also introduce a tax deduction for an employer who grants non-qualified securities to its employees, with the amount of the deduction in a given taxation year being equal to the amount of taxable benefit its employees in respect of non-qualified securities. An employer would be entitled to claim such deductions where:
Shareholder Register Disclosing Ultimate Controlling Shareholder(s)
As of 13 June 2019, companies governed by the federal statute in Canada, the Canada Business Corporations Act (CBCA) are required to maintain a detailed shareholder register that reflects all individual shareholders having significant direct or indirect control over the corporation. This obligation extends beyond the previous corporate obligation (to maintain a list of registered holders only). The purposes of this reform, like its counterparts in the EU and the UK, is to provide greater transparency in corporate ownership and help combat tax evasion, money laundering and other smokescreen operations. Practically speaking, private equity funds often hold controlling positions (in terms of percentage owned or in fact through shareholder arrangements) in their portfolio companies governed by the CBCA and should therefore be prepared to provide additional information about their own controlling interests. Provincial and territorial finance ministers have agreed to follow the federal lead in this area, although the timing of them doing so is uncertain.
Diversity and ESG
While currently just good policy and not statutorily required practice in Canada, there has been heightened attention on diversity for board and management composition and on environmental, social and governance (ESG) criteria. These factors have been edging their way through limited partner investment criteria and into requirements imposed on portfolio companies themselves as they carry out their business plans in 2019 and beyond.
M&A activity in Canada is governed by federal and provincial corporate statutes, provincial/territorial securities laws, and, where applicable, stock exchange rules. The Competition Bureau is responsible for antitrust considerations in Canada through the application of the Competition Act and foreign investment is monitored by the Minister of Innovation, Science, and Economic Development through the application of the Investment Canada Act, both key considerations in private equity backed transactions.
Residency Requirements and Language Laws
The federal statute as well as certain provincial laws (Alberta, Saskatchewan, Manitoba, Ontario, Newfoundland and Labrador) impose minimum Canadian residency requirements for board composition (25% resident Canadian, or at least one board member if board is composed of less than four members) which sometimes influences jurisdiction of formation of purchaser companies by foreign private equity investors. Remaining provinces and territories, notably British Columbia and Quebec, do not have such limitations.
Businesses operating in Quebec must respect the Charter of the French Language (colloquially known as 'Bill 101'), which requires companies to meet French language requirements in various settings (including with employees, contractual undertakings, and on websites and advertising). Foreign investors are sometimes mystified by this law. However, acquiring an existing Quebec operation has a distinct advantage over growing the business organically in the province in this respect, as the local operation should already be familiar with the Charter requirements and have measures in place to ensure compliance.
Canada has no federal securities law or federal securities regulator. Securities laws are covered by ten provincial and three territorial regulators, although the applicable authorities are generally substantially equivalent in regulating securities matters across the country.
The Competition Act prescribes a “transaction-size” threshold and a “party-size” threshold for acquisitions in Canada. If both thresholds are exceeded, a transaction is considered “notifiable” and it triggers a pre-merger notification filing. Transactions exceeding such thresholds cannot close until notice has been provided and the statutory waiting period has expired or has been terminated or waived.
The “transaction-size” threshold is subject to annual adjustment. The 2019 transaction-size threshold requires that the book value of assets in Canada of the target (or in the case of an asset purchase, the book value of assets in Canada being acquired), or the gross revenues from sales in or from Canada generated by those assets exceeds CAD96 million.
The “party-size” threshold remains unchanged from 2018, requiring that the parties to a transaction, together with their affiliates, have assets in Canada or annual gross revenues from sales in, from or into Canada, exceeding CAD400 million.
Pursuant to the Investment Canada Act (ICA), an acquisition of control by a non-Canadian of a Canadian business, and the establishment by a non-Canadian of a new Canadian business, is subject to notification or to review and approval according to a “net benefit to Canada” test where a specified threshold is exceeded. Factors to be considered under this test (as enumerated on the government of Canada website) include:
For 2019, the applicable thresholds are as follows:
If the applicable threshold for a net benefit to Canada review under the ICA is not met or exceeded, the acquisition of control of any Canadian business by a non-Canadian entity is subject to a relatively straightforward notification, which can be made either before or within 30 days after closing.
Separate and apart from the net benefit to Canada review process, the ICA also contains a mechanism to allow the Canadian government to review a foreign investment on national security grounds. There are no thresholds for such national security reviews; rather, they can be initiated at the discretion of the government.
As Canada relies heavily on its trading partners and is generally supportive of foreign investments that do not raise national security concerns, “net benefit to Canada” approval under the ICA, where required, is seldom denied.
Comprehensive due diligence is customary for a private equity transaction in Canada. Financial, tax, operational, environmental and general business diligence (including key partner, client and customer audits and meetings) is conducted with the private equity deal team for a new platform investment, and through a combination of the private equity deal team and existing management for add-on acquisitions. Consultants may be engaged to cover environmental risks, client audits or other industry-specific considerations.
General legal diligence will include a combination of review of publicly available documentation (websites, CIM, public disclosure documents, if available), preparing a detailed list of standard questions to be answered in writing by the target and its counsel (including topics covering corporate history, shareholder arrangements, material reorganisations, acquisitions and divestitures, commercial agreements, debt arrangements, IP/IT, privacy and cyber-risk, environment, real estate, regulatory compliance, litigation, labour, employment and benefits, tax), review of a data room and other materials provided in response to the diligence questions, and follow-up calls with relevant members of management on specific areas of interest. Key areas of focus will vary depending on the industry in which the target operates.
Vendor diligence reports are not customary in Canada. Legal advisors rarely provide reliance on their buy-side diligence reports to other third parties other than their private equity clients and the portfolio companies in the case of add-on acquisitions.
Unless there is a significant known liability that needs to be carved out through structuring as an asset sale, the vast majority of private equity transactions in Canada are completed via share purchase agreements.
Where the target has multiple shareholders or significant restructuring of equity plans or other specific challenges in obtaining all required corporate approvals, and in case of public-company targets, a plan of arrangement may be used. An arrangement is a court-sanctioned agreement (similar to the UK scheme) that can accommodates various structures (share purchase, amalgamation) and complex capitalisations. Although a plan of arrangement can be more costly and take slightly longer than a simple share purchase, it is an efficient way to clean up messy capitalisation, providing certainty to the buyer in the court’s seal of approval.
Very few private equity deals are conducted by way of takeover bid (whether friendly or hostile) in Canada. Regulatory hurdles, complex and extensive requirements for non-Canadian bidders to comply with, as well as delays and costs associated with possible second step ('squeeze out') transactions are major deterrents.
Terms of the purchase agreement can vary significantly depending on the private equity player backing the purchaser and the strategic importance of the acquisition to an existing portfolio or the creation of a new platform, as applicable. In a competitive auction, the terms tend to be more balanced and seller-friendly provisions (for example, shorter duration and smaller amount of indemnification holdback, acceptance of more pervasive qualifiers in the representations and warranties, shorter lists of closing conditions, and a more limited indemnification regime) and the use of representation and warranties insurance are more prevalent.
In Canada, a private equity backed buyer will rarely be party to the purchase agreement directly. Where a newly-created 'shell' company is the purchaser, a fund may concede to providing a limited guarantee as to the funding of the acquisition, but this is more likely to be provided as a stand-alone undertaking as opposed to the fund intervening to the purchase agreement directly. In the case of public company targets, the board will require debt and/or commitment letters, as applicable, before signing off on definitive agreements (even where there is no formal 'funds certain' statutory requirement to do so, as this obligation only applies to takeover bids in Canada).
With respect to exits, as most private transactions are structured as share purchase agreements in Canada, it is customary to have all shareholders (including the private equity players) execute the sale agreements, with indemnification obligations being individually (and not jointly) allocated proportionately amongst the various sellers.
Funding of private equity backed M&A in Canada varies from transaction to transaction. Certainty of funding is only required under Canadian legislation for a takeover bid. As mentioned earlier, equity commitment letters are often provided by the private equity fund, particularly in competitive auction processes, with more sophisticated sellers and in the case of privatisations, to provide vendors with comfort that funding will be available for the transaction.
The financing of an acquisition varies from one fund to the next, both in terms of debt/equity combinations (or cash on hand, in the case of add-on acquisitions within a platform). Financing for these deals usually involve a minimal equity commitment by the private equity fund, with the remainder of the funds being provided by traditional bank debt and other mezzanine lenders. Credit has been readily available in the market with a range in financing from three to five-plus times EBITDA for secured financing depending on the type of industry and assets available for security.
Private equity funds may invest in majority or minority positions, although it is typical in Canada for the private equity fund to hold effective control over the target business.
Deals involving a consortium of private equity sponsors are common in Canada, particularly in light of the role public-sector pension plans and other quasi-governmental vehicles play in private equity.
It is not uncommon for a lead private equity investor to have provided for co-invest rights to its limited partners, or to partner with other private equity funds. In such cases, detailed shareholder rights are negotiated concurrently with the acquisition in a shareholders agreement for the platform company(ies). Introducing additional investors following the initial investment is also considered, although such circumstances require a careful review and often lengthy renegotiation of the shareholders' agreement already in place.
Consideration structures in Canadian private equity transactions continue to be predominantly based on closing date financial statements – that is, an estimated purchase price is paid at closing, subject to a working capital adjustment (and possible other adjustments depending on the business) upon completion of financial statements as of the effective time. In the case of privatisation transactions, fixed price agreements dominate.
Earn-outs and deferred consideration are relatively uncommon in private equity deals in Canada. With high valuations, vendors are expecting to receive close to full consideration at closing. Furthermore, private equity funds may themselves be reticent to provide for such provisions in light of the additional complexity added to negotiating the purchase agreement and the increased possibility of disagreement arising from the interpretation of such clauses.
Private equity sellers will tend to limit any recourse post-closing to the purchase price consideration by using representations and warranties insurance or very time-limited indemnities and escrows. This approach differs from a typical strategic corporate seller who may entertain an escrow and longer indemnities.
Private equity buyers are increasingly relying on representations and warranties insurance to provide vendors with full consideration with minimal escrow and indemnification provisions. Although many deals continue to provide for indemnification escrows and robust indemnification clauses, the duration and scope have been diminishing in recent years. In fact, in competitive situations, vendors have benefited from public company-style representations and warranties packages with zero recourse after closing. This is not typical for a strategic corporate buyer.
Locked box structures are uncommon for private equity funds in private M&A in Canada, who continue to favour a traditional working capital adjustment as of the date of closing.
A detailed dispute resolution mechanism with respect to purchase price adjustments is a standard provision in a Canadian private equity share purchase agreement, whether on the buy side or the sell side. Traditional features of this provision include the appointment of an independent third party who evaluates only the specific items identified in the disagreement, and the terms upon which the selling and the buying party are to interact and share information with this independent third party. Typically, this party’s decision is binding.
Dispute resolution on other deal terms is typical through recourse to the courts. Arbitration (binding or not binding) is rare in Canadian private equity deals.
Conditions precedent to the closing of a private equity transaction vary considerably from one deal to another. Regulatory approvals (including the Competition Act, and the ICA, where applicable) and required board and shareholders approvals are nearly universally imposed. In the case of other third-party consents (eg, material customers, landlord etc), the conditionality of such provisions (required, best efforts, reasonable commercial efforts, no obligation) varies depending on the comfort level the private equity buyer has obtained in its due diligence, its familiarity with the other parties and its general operating practices. Financing conditions are less common and are typically found when the private equity buyer has substantial bargaining power over the target. Finally, a stand-alone condition that there be no material adverse effect between signature and closing is relatively common for a PE buyer to require.
A 'hell or high water' undertaking is sometimes accepted in private equity deals in Canada where there is a regulatory condition; this provision is negotiated and ultimately depends on the nature and regulatory sensitivity of the deal.
Break fees are rarely accepted by private equity backed buyers in private transactions. Where such provisions are accepted, it tends to be in a privatisation context and countered with a reverse break fee (or at a minimum, a reimbursement of expenses clause).
Reverse break fees do arise if the transaction is conditional on financing, thereby limiting the private equity firm’s exposure if financing doesn’t take place.
In a friendly public take private transaction, a reverse break fee is typically payable to the purchaser in connection with the exercise of a fiduciary out by the target board for a superior proposal.
Purchase agreements structured as two-step (sign and then close) transactions typically provide for termination in the case of (i) mutual agreement, (ii) termination by the buyer (provided the buyer is not in default of its obligations) where the obligations of the seller cannot or has not been satisfied by an outside date, and (iii) by the seller (provided the seller not in default of obligations) where the obligations of the buyer cannot or has not been satisfied by an outside date. The failure to obtain regulatory or government approvals, third-party consents or appropriate financing are the most frequent obligations triggering these termination rights.
Private equity buyers are not sympathetic to assuming risks related to business before they become owners. They adopt the principle of 'your watch/our watch' for all matters. However, risk allocation can be more tempered in a competitive auction process, and depending on the nature or extent of diligence conducted and the comfort level with (or pricing adjustment in light of) known risks.
Sellers in Canadian private equity transactions seek to limit liability through the use of materiality thresholders and knowledge qualifiers in providing representations and warranties, the application of baskets and deductibles (ie, imposing minimum thresholds that must be obtained before they are out of pocket), shortened durations for representations and warranties, and reducing the cap on indemnification.
The duration of representations and warranties in a non-insured deal typically range from 12-24 months (with carve outs for fraud or specific representations such as fundamental representations, which can have a longer period). Following US trends, whereas fundamental representations used to be provided for an indefinite term, these are also restricted in time, although often longer than the general duration for other representations. As a result, sophisticated private equity purchasers have sought to expand the definition of fundamental representations beyond what was covered historically (share ownership and authority to sell) to include core zones of risk, such as intellectual property, with varying levels of success.
Indemnification provisions in private M&A in Canada range anywhere between 25% to 100% of the purchase price and may even go uncapped. However, in private equity transactions caps are typically under 25%, with more and more deals following US trends of a lowered cap to 10% and below.
In Canada, who gives the representations and warranties in a private sale transaction (whether the target company/management or the shareholders/private equity fund) is not a crucial argument given that indemnification will come from sellers irrespective of who gives the warranties. As an institutional investor, the private equity fund will typically represent as to its share ownership, capacity and due authorisation to sell the shares, as well as antitrust thresholds, where applicable, and will work closely and diligently with management to ensure the company provides wholesome operational representations.
A private equity seller will necessarily seek to limit liability as much as possible, thereby maximising returns to its investors within a shorter time period. However, as sophisticated buyers, funds are also accustomed to accommodating relatively robust representations and warranties on the target company, including accuracy and completeness of financial statements, no undisclosed liabilities, list of material contracts, insurance coverage in place, warranties provided to customers, material compliance with applicable laws for a limited lookback period, pending and threatened litigation, relationships with material customers and suppliers, material compliance with employment and benefits laws, list of required consents, notifications and regulatory approvals, list of owned and leased real property, compliance with environmental laws and availability of environmental reports, breaches to privacy, cyber-risk, anti-corruption policies and laws, IP ownership and infringement, and status of IT and information systems. Private equity sellers will conduct a thorough disclosure exercise with management and external counsel to ensure all statements in the representations can be confirmed, and to identify all carve outs, or disclosures required to limit the scope of the representations given in light of all known facts.
As mentioned above (in the absence of representation and warranty insurance), a private equity seller’s representations will be limited by pervasive qualifiers, both in time (12-24 months), and by capping the indemnification (as low as possible, commonly below 10% of the purchase price).
The contents of a data room are not used in Canada against representations and warranties; instead, a disclosure schedule that lists relevant items from the diligence conducted is annexed to and forms an integral part of the purchase agreement.
As indicated above,representations and warranties insurance has become commonplace in Canadian transactions, whereas it was still a foreign concept less than five years ago. Canadian bidders have been adopting this framework to provide a competitive edge (or to ensure they do not lose one to their US competition), and have become comfortable and familiar with the mechanics. Insurance has provided an attractive option to private equity purchasers purchasing companies from management sellers who remain engaged in the business post-closing, as the tension of possible claims is effectively eliminated and shifted to the insurer.
Indemnification provisions are used in the absence of representations and warranties insurance, or as a 'first recourse' before accessing the policy (insurance providers were initially requiring the seller to have some 'skin in the game' before the policy would kick in, although this approach is falling out of fashion). Specific indemnities for known risks are also considered, although sometimes dealt with in pricing negotiations upfront if material.
As a seller, a private equity player will try to avoid or reduce the duration and amount in escrow. In competitive processes with representations and warranties insurance, we have seen private equity buyers prepared to accept a 'no indemnification' regime beyond the policy itself, with no exceptions. While Canadian practice in the adoption of representations and warranties insurance is still behind European and American trends, it has become relatively common, although not adopted in all circumstances. The size, speed and level of sophistication of the seller are taken into account in turning to representations and warranties insurance. Insurance is most common in cross-border acquisitions and sales between two private equity (or private equity backed) players.
With the widespread adoption of representations and warranties insurance, there has been a trend towards smaller or absence of indemnification escrows. However, purchase price adjustment escrows continue to be used
While litigation does arise in private equity M&A, Canada is not as litigious in approach as its neighbours south of the border. In Canada, the court can generally order that the losing party pays the litigation fees to the winner, which in itself is a deterrent. The most common disputes pertain to purchase price disputes, where the dispute procedure is via an independently appointed accounting firm and is generally settled before recourse to the courts. Warranties and indemnification clauses pertaining to third-party claims also lead to quite a bit of litigation (before the courts or an arbitrator as opposed to an accounting firm).
Private equity companies consider both public and private targets in Canada. There is considerably more volume in private company targets than public. This may be due to the relative number of attractive targets, the level of comfort the private equity has in the privatisation model and the additional level of complexity and uncertainty required in obtaining requisite shareholder approvals, and fiduciary out provisions elevating deal risk in public company transactions. Where public to privates by private equity firms do occur, they are rarely done on a hostile basis. Generally, the negotiations are friendly and the transaction ultimately supported by the target board (and significant shareholders, where possible).
Holders of over 10% of the equity of a public company in Canada triggers the filing of an early warning report which provides public disclosure of the shareholdings of the holder. The use of derivatives and options to increase economic exposure is a key consideration when determining if a private equity firm has triggered a public disclosure obligation.
The threshold for triggering Canadian takeover bid rules is the acquisition of a 'bright line' 20% test. If a purchaser acquires 20% or more of a class of voting securities of the target – whether alone or working in conjunction with other parties (a purchasing group) – the purchaser will be required to offer to purchase the shares of all of the registered shareholders of the same class unless an exemption is available.
Both cash and share deals (or a combination thereof) can be used as consideration. Issuance of shares, however, is most common where the purchaser is a public entity itself as valuation is facilitated with public share prices. As such, private equity transactions tend to be cash deals.
Takeover bids in Canada can be subject to conditionality, but cannot be conditional on financing. Unlike the UK, for instance, conditions beyond regulatory approvals may be negotiated.
Other privatisation structures can be presented to shareholders at a meeting, and if the requisite approvals – 66.66% (two-thirds), as well as any “majority of minority” that may be required – are obtained, the transaction may proceed in accordance with the terms of the negotiated agreement. In some cases, this is done pursuant to a court-sanctioned plan of arrangement (similar to the UK scheme); in other cases, it is completed by an amalgamation.
A number of privatisations completed by private equity backed buyers in Canada are for issuers that have not conducted lengthy strategic processes and where the shareholders have a general appetite to exit quickly. In such cases, the purchasers may succeed in obtaining more favourable (and more certain) protections including reverse break fees, force the vote provisions, non-solicitations and the right to match any unsolicited superior offer. However, in more competitive processes where the public target is known to be 'in play', the seller may push to have protections of its own.
In Canada, there is a 50% minimum tender requirement for all formal bids. Bids must be open for a minimum of 105 days (subject to the target’s ability to shorten the period under certain circumstances). If at the expiry of the initial bid period the minimum tender requirements and all other conditions of the bid have been satisfied or waived, the purchaser must extend the period for at least ten days to allow additional shareholders to tender. At the expiration of the bid period, the purchaser takes up the shares and pays the tendering shareholders. If 90% of the shares have been tendered and taken up, the shareholders of the remaining 10% can be forced to tender their shares.
Where fewer than 90% but more than 66.66% (two-thirds) of the shares (or 75% in the case of some British Columbia corporations) have been taken up, the purchaser must proceed to a second-stage 'squeeze-out' transaction to purchase the remainder, which generally requires the approval of two-thirds (or 75% in the case of some British Columbia corporations) of the shareholders and possibly a majority of the minority shareholders.
It is common (and in the case of private equity backed privatisations, nearly always a prerequisite) to obtain lock-ups from principal shareholders, if accessible. Undertakings may be 'hard' (no out) or 'soft' (out for superior offer) for major shareholders, although it is more difficult to obtain hard lock-ups in competitive processes. As private equity backed privatisations tend to be 'friendly', directors and officers will also be asked to execute soft lock-ups.
Hostile bids are permitted in Canada although not commonly used by private equity firms
Equity incentive plans are commonly used in Canadian private equity investments. Stock option plans are most frequently implemented (with straight time vesting provisions and/or performance vesting criteria). The option pool is typically anywhere between 5% and 20% of the outstanding common equity.
As noted above, stock options have historically been used by private equity firms in Canada as an effective means of incentivising management teams. Therefore, recent proposed amendments to the taxation regime for stock options should be followed carefully.
Most private equity investors in Canada focus on strong management teams in identifying attractive targets. Where a management group is included in the selling parties, rollover arrangements for a minority position are considered and such members execute a shareholders' agreement with the private equity and any other institutional investors.
Investments may be in the same category of shares as the institutional investor, or distinct, and may be voting or non-voting. Notwithstanding scenarios where existing management continues to hold a significant stake in the company, private equity investors will typically impose or structure the management investment so as to facilitate decision-making and approvals required to proceed with the private equity fund’s expansion strategy without management consent or blocking such decisions. These mechanics may include non-voting shares, shareholders agreement undertakings, and the appointment of agent or proxies for such management shareholders.
Leaver provisions are negotiated and different private equity funds take different approaches to management equity in cases of termination and departure. Leaver provisions are nearly universally found in stock option plans, but more nuanced and negotiated in the case of shareholders agreements.
Generally speaking, unvested stock options will terminate concurrently with the last date of employment, whereas vested stock options will remain exercisable for a period of time following the last date of employment (unless the employee has been terminated for cause). Management employees may, in such circumstances become shareholders subject to the shareholders agreement in place, but the company may also have the right to 'call' such shares in the case of the employee leaving the company, using a predetermined pricing arrangement equal to the fair market value, or some discount thereon depending on the circumstances of departure.
Similarly, although less consistently, the shareholders agreement may provide the company with the right to 'call' any shares held by management in the case of termination or departure using predetermined pricing arrangements (again, varying depending on the circumstances of departure). In some cases, particularly where management continues to hold a significant stake in the company, management shareholders may negotiate the right to 'put' their shares, forcing the company (or other shareholders) to redeem or purchase the holder’s shares in certain cases of departure, using predetermined pricing arrangements. In the absence of specific leaver provisions, management shareholders are bound by obligations of (and benefit from rights accorded to) other shareholders, irrespective of their status as an employee.
Vesting provisions vary from one stock option plan to another, with time vesting over a period of up to five years being most common. However, performance vesting criteria (based on EBITDA, for example) are also applied. Typically, unvested options will be accelerated upon the occurrence of a liquidity event.
Non-competition covenants are enforceable in Canada, if crafted appropriately as to scope and territory. Non-solicitation covenants and non-disparagement undertakings are also customary.
In an employment agreement, the upper limit for a top executive in terms of a non-compete is typically up to two years. A private equity purchaser will often seek to obtain a seller non-compete from exiting management shareholders, and/or non-competition undertakings from existing or continuing management shareholders, in order to extend the scope of protection, as non-competition undertakings in connection with actual financial gain are enforceable for longer time periods than covenants tied to employment.
Management shareholders do not typically benefit from robust minority protection, though they will typically have some limited protection under corporate statutes through majority and supermajority shareholder approval requirements as well as remedies in the face of oppressive conduct against the corporation.
Anti-dilution protection (pre-emptive rights) may or may not be accorded to all shareholders on a pro rata basis, although this is the most likely to be accommodated by private equity partners.
It is rare for a minority management position to have vetoes; vetoes are typically in favour of the private equity investor and any other institutional investors holding material positions. If a founding member of management continues to hold a substantial percentage of equity, there may be certain vetoes that are granted, but such vetoes are highly dependant on the circumstances.
Similarly, whether or not a management team (either collectively or certain executives) has board appointment rights is dependent on the proportionate control of the management stake. Where management is on the board, this is most commonly tied to the position of the CEO.
The same is true of exit rights. It is rare to see management have any right or control of the private equity exit. The shareholders agreements tend to be crafted to provide for a 'drag' provision for all shareholders. A management shareholder would need to have a considerably large percentage of the company for a private equity to entertain providing management with this power.
Private equity funds typically seek maximum control over its investment, both in terms of board oversight and vetoes. The board is customarily controlled (majority composed) by the lead private equity investor. Vetoes requested can include a variety of items, including consents required as to any proposed corporate restructurings, acquisitions or divestures, incurrence of additional debt, issuance of additional equity, budget approvals, changes to key management, change to head office location.
Information rights are also regularly provided for to institutional investors, including quarterly financial reporting, management reports and forecasts, details on pending or threatened litigation and any other data required for the fund’s tracking.
Absent very unusual circumstances, courts in Canada will generally not pierce the corporate veil. Circumstances would be those of use of the company to shield against illegal or fraudulent acts.
Where specific investment criteria or restrictions on operations are imposed on the private equity fund, these requirements will carry through to the portfolio companies and its activities. However, there is no direct adoption of the same compliance policies in place within the private equity fund. Private equity funds will often impose a form of delegation of authority or authorisation policy to ensure decision-making throughout the various levels of the organisation are conducted in a controlled manner and with agreed-upon thresholds.
Holding periods can range from as short as a few of years to more standard seven to ten-year life cycles. With some of the large pension funds and other quasi-governmental agencies acting as private equity investors, the strategy can be longer term and they are willing to reinvest upon exit if the opportunity is available to them. More traditional private equity funds with multiple funds also regularly evaluate transferring investments to successor funds in the wake of attractive additional expansion projects, or to wait out market downturns.
Sales to foreign (mostly US) private equity firms have dominated recent exits in Canada. While dual-track processes are sometimes considered, private equity funds have been opting for faster exits with immediate liquidity; without the leeway required to set up for a public offering. The appeal of an IPO exit continues to be a top priority to certain private equity players but the sheer availability of private capital has somewhat thwarted the public market exits.
Private equity funds regularly provide for drag mechanisms in their shareholder agreements. However, in practice, these provisions are rarely used directly, with the private equity funds relying instead on the cooperation and willingness of minority investors to support the strategy and sign-up required documentation accordingly.
Tag rights are often granted to minority shareholders (including management) in the case of change of control transactions.
In addition to any escrows that may be required by the applicable stock exchange on which the target is to be listed, the underwriters will typically request lock ups from private equity shareholders who do not sell concurrently with the IPO for a period of 120 days following the offering. Arrangements are sometimes implemented to provide for board nomination rights and registration rights.