Private Equity 2023 Comparisons

2023: A Return to Balanced Deal Making

After a frenzy of private equity transactions and exits in 2020 and 2021, 2022 and the first half of 2023 have seen a normalised volume of activity suggesting greater parity between buyers and sellers of businesses as buyers and sellers grapple with the high interest rate environment and macroeconomic uncertainty.

Deal activity was robust in a record number of deals completed in 2022 but deal value dropped significantly from the levels in 2020 and 2021. Private equity exits remained steady in 2022 coupled with a record number of secondary buyouts in 2022 and zero IPO exits in the Canadian markets.  Private equity exits have been sluggish in the first half of 2023.

High Interest Rates Lead to Cautious Deal Making

The continued increase in interest rates has led to valuation stress between seller’s expectations and buyer’s ability to finance in the current debt markets. This is leading to longer deal negotiations and creativity to find alternative deal structures to bridge the valuation gap between sellers and buyers. We are seeing an increased frequency of higher founder/manager rollover deal terms and creative earn-out provisions. In this environment, existing credit facilities and change of control provisions are key areas of analysis by buyers.

Cleantech deals are leading the pack in 2023 as investors are energised to enter this industry segment given the heightened interest by investors in ESG-related companies. In 2022 and 2023, strength continued in investments in industrials and business product sectors with a corresponding decrease in investment in the information and technology sectors. Small and medium-sized businesses continue to dominate deal-making for private equity activity with a notable lack of mega deals in the market given the financing constraints in the higher interest rate environment.

CRA Transaction Reporting Requirements

On 22 June 2023, Canada enacted new rules requiring taxpayers to provide written notice to the Canada Revenue Agency of certain transactions. Two general categories of transactions are subject to these new rules: reportable transactions and notifiable transactions. Despite lingering ambiguities surrounding the application of these categories, parties who undertake commercial transactions in Canada should be aware of the possible application of the new rules. In particular, any transaction that involves one or more specific steps to address tax planning should be carefully reviewed to assess the applicability of the new rules.

Reportable transactions

A reportable transaction is generally any transaction where:

• one of the main purposes of the transaction is to obtain a tax benefit; and
• one of three “hallmarks” is present in the transaction.

These hallmarks are somewhat complicated but a hallmark will generally be present if:

• an adviser or promotor is entitled to a fee based on the tax benefit realised or the number of people who benefit from the tax benefit (this is generally referred to as the “Contingency Fee” hallmark);
• an adviser or promoter who was involved in the implementation of the transaction has obtained confidentiality protection that prohibits the disclosure of the transaction (this is generally referred to as the “Confidential Protection” hallmark); or
• a party who is involved in the transaction is entitled to insurance or protection against the failure of the transaction to obtain a tax benefit (this is generally referred to as the “Contractual Protection” hallmark).

If the main purpose of a transaction, including one transaction within a series of related transaction, is to obtain a tax benefit and any one of the hallmarks is present, the taxpayers involved in the transaction as well as their advisers must each file a report with the CRA within prescribed time limits (generally 90 days after the transaction was entered into). A failure to do so triggers a number of potential sanctions including monetary penalties, an extension of the tax assessment period and a deemed waiver of certain defences to tax assessments based on the General Anti-Avoidance Rule (GAAR) set out in the Income Tax Act (Canada).

Notifiable transactions

Notifiable transactions are specific transactions that will be identified by the CRA as requiring notification. While the CRA has published statements with a “sample” list of notifiable transactions, a formal list remains outstanding. The consequences of failing to report a notifiable transaction are largely the same as the penalties for failing to report a reportable transaction.

New Supply Chain Reporting Requirements for Businesses

In an effort to combat forced and child labour, the Canadian Parliament has passed bill S-211 An Act to enact the Fighting Against Forced Labour and Child Labour in Supply Chains Act, which imposes an annual reporting requirement on Canadian businesses, including those operating outside of Canada. The initial reporting requirement will be due in May 2024.

The act applies to businesses that are either (i) listed on a Canadian stock exchange; or (ii) have a place of business in Canada, do business or have assets in Canada and meet at least two of the following size requirements based on consolidated financial statements:

• have at least CAD20 million in assets;
• generated at least CAD40 million in revenue; or
• employ an average of at least 250 employees.

In all cases, so long as the businesses produce, sell or distribute goods in Canada or elsewhere or import goods into Canada, the business will be required to submit an annual report that sets out the steps taken during the previous financial year to prevent and reduce the risk of forced or child labour being used in any steps of production. The annual report must be made publicly available, including through publication on the website of the business and, for federally incorporated corporations, distributed to shareholders. Private equity funds will need to consider these new developments in their targets and existing portfolio companies as they require an added level of scrutiny at the diligence level and an increase in the reporting burden.

Sanction Considerations

Russia’s invasion of Ukraine has been met with a flurry of sanctions from Canada, the US, the EU, the UK, Japan and other countries. All these sanctions are similar in structure, in that they will:

• impose asset freezes and dealing prohibitions upon listed persons;
• prohibit activities in certain sectors, such as banking and energy; or
• impose transaction prohibitions involving certain countries or regions (Crimea).

Violations of sanctions laws typically include both civil and criminal penalties, raising the risk of severe business and reputational consequences, multimillion-dollar fines and incarceration. The civil penalties are typically strict liability, meaning that simply violating the law, regardless of intent, may give rise to liability. Criminal sanctions arise when companies wilfully fail to make reasonable inquiries or conduct due diligence into potential sanctioned activity involving, for example, sanctioned buyers, investors or banks. The complexity and expanding scope of sanctions make compliance particularly difficult for companies.

In light of these potentially severe outcomes on company profitability, private equity investors are looking at whether target companies are following best practices in terms of:

• conducting risk assessments of the various sanctions regimes that may apply to their businesses and the risks posed by their customers, the products or services offered, their supply chains and their geographic footprints;
• implementing internal controls to ensure that all entities involved in a transaction are identified and screened, including the beneficial owners of corporations or entities providing financing;
• applying quality written policies that can guide the day-to-day activities of employees and identify clear lines of responsibility for screening and reporting any potential violations;
• training employees; and
• testing and auditing.

The trend over the past five years indicates that sanctions laws will continue to proliferate, increase in scope, coverage and complexity, and assume an increasingly important role in corporate transactions and compliance. The role of sanctions best practices by companies has been “mainstreamed” and is now an indicator of whether a company is practising good corporate governance.

Proposed Changes to Canadian-Controlled Private Corporation (CCPC) Status

The new concept of “substantive CCPC”

Very generally, CCPCs are Canadian private corporations that are not controlled by one or more public corporations or non-resident persons, and are subject to certain benefits under the Income Tax Act (Canada) (ITA). Such benefits include a lower rate of tax on qualifying active business income, enhanced investment tax credits and the potential for shareholders to benefit from the lifetime capital gains exemption on capital gains realised on the sale of their shares.

However, CCPCs are subject to additional taxes on their investment income, which includes income from property and capital gains. Such additional taxes are generally wholly or partially refundable following the payment of taxable dividends by the CCPC. The policy behind the refundable taxes is to eliminate any tax-deferral opportunity on investment income earned in a corporation compared to circumstances where individual shareholders earn the investment income directly.

For CCPCs, the combined federal and provincial corporate tax rate on investment income is therefore approximately equal to 50% (and 25% for capital gains). In comparison, non-CCPCs (such as public corporations or corporations controlled by non-residents of Canada) are not subject to the aforementioned refundable tax on similar investment income, thus resulting in a tax rate of approximately 25% (and 12.5% for capital gains), depending on the province of residency. Planning in private equity sale transactions was developed to take advantage of this discrepancy, and was achieved by signing a purchase and sale agreement pursuant to which a non-resident or public corporation (the “Purchaser”) would acquire a right to acquire control of a CCPC (the “Target”) from Canadian sellers (the “Sellers”), thereby resulting in the loss of CCPC status and a deemed tax year-end for the Target immediately before the signing of the agreement. Prior to the closing of the sale, latent capital gains attributable to depreciable assets would be realised by the Target, thereby resulting in corporate taxes (computed based on the lower non-CCPC rate), and in an equivalent reduction of the purchase price of the Target’s shares for the Purchaser. Such gains would also generate tax attributes which, in some circumstances, could be used by the Sellers to increase the cost of their shares in the Target and thereby reduce the capital gains they might otherwise have realised on the sale of the Target shares. The result was that a significant portion of the gain realised by the Sellers would be taxed at 12.5%, rather than 25%. In addition, the transactions undertaken had the effect of increasing the future amortisable basis of the depreciable assets of the Target, to the benefit of the Purchaser.

In order to eliminate this type of planning, the 2022 federal budget (“Budget 2022”) introduced the notion of “substantive CCPCs”, which are private corporations resident in Canada that are not CCPCs but that are controlled in law or in fact, directly or indirectly, by one or more Canadian-resident individuals. Importantly, a substantive CCPC includes a corporation that would otherwise be a CCPC but for a non-resident or a public corporation having a right to acquire its shares or because it ceased to be a Canadian corporation. Substantive CCPCs are to be subject to the same higher income tax rates and the refundable tax mechanism that is applicable to CCPCs, and the investment income earned by a substantive CCPC is added to its “low rate income pool”, which when paid out as a dividend to individual shareholders is not eligible for the enhanced dividend tax credit. Moreover, substantive CCPCs do not benefit from the other tax advantages usually conferred to CCPCs, such as those described above.

Generally, these amendments apply to taxation years ending after 7 April 2022 (“Budget Day”). However, there is an exception for taxation years ending due to an acquisition of control caused by the sale of all or substantially all of the shares of a corporation to an arm’s length purchaser where the purchase and sale agreement is entered into before Budget Day and the share sale closes before the end of 2022.

Corporate Opportunity Waiver in Alberta

A recent amendment to the Alberta Business Corporations Act (ABCA) may have an impact on the incorporation of private equity-backed corporations in Canada. Under the ABCA, an Alberta corporation may now include a corporate opportunity waiver in its shareholder agreement, whereby the corporation expressly waives any interest (present or future) in a particular business opportunity so that a director, officer or shareholder may participate or pursue such opportunity. This waiver is generally seen as being beneficial to private equity funds that have board representation on multiple corporations competing in the same industry, as it increases certainty for those directors that their actions will not violate fiduciary duties they would otherwise owe to each corporation at common law. As Alberta is currently the only jurisdiction in Canada with a corporate opportunity waiver provision in its corporate statute, it is anticipated that an increasing number of private equity-backed corporations will be incorporated in that province.

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 who have significant direct or indirect control over the corporation. This obligation extends beyond the previous corporate obligation, which was to maintain a list of registered holders only. The purpose 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 smoke screen 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 their doing so is uncertain.

Transparency of Enterprises Registered in Québec

Effective 31 March 2023, Bill 78 An Act mainly to improve the transparency of enterprises, requires any companies that are registered with the Enterprise Registrar of Québec to disclose, when filing an updating declaration, the ultimate beneficiaries of the entity, being a person who:

• is a holder or beneficiary, directly or indirectly, of a number of shares or units of the company conferring on that person the power to exercise 25% or more of (i) the voting rights attached to the shares or units; or (ii) the fair market value of all the shares or units of the company; or
• has a direct or indirect influence that, if exercised, could result in a de facto control of the company.

Additionally, entities must provide, for individuals or entities that are registered in the Enterprise Registrar (directors, officers, three largest shareholders and ultimate beneficiaries), the dates of birth and professional address or domicile of each individual or entity, as applicable, as well as government identification for each director.

French Language in Québec

Businesses operating in Québec 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, in contractual undertakings, and on websites and advertising). Foreign investors are sometimes mystified by this law. However, with Québec accounting for 62% of total private equity deal flow in Canada for 2022, acquiring an existing Québec 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.

Diversity and ESG

While currently just good policy and not statutorily required practice in Canada for private companies, there has been heightened attention on diversity for board and management composition and on ESG criteria, including boards having the ability to take into consideration the interest of a company’s stakeholders rather than solely its shareholders. 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 2023 and beyond. If private equity investors exit their investments by way of an IPO, they will need to take into account disclosure obligations for public companies related to diversity matters, and proposed disclosure obligations for public companies related to climate change matters.

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. Canadian organisations may be subject to multiple Canadian privacy laws, as applicable legal privacy requirements depend on factors such as the geographic location of the individuals concerned and of the business related to the information being handled, as well as the place where the information is collected, hosted and processed.

In the past three years, the provincial and federal governments have noted their intention to reform the Canadian privacy legal and regulatory landscape. While several Canadian jurisdictions are still at the early stage of privacy reforms, Quebec’s Bill 64 was tabled in June 2020 and sanctioned in September 2021. Furthermore, in June 2022 the Canadian government tabled a second attempt to reform federal private sector privacy legislation in Bill C-27.

In Quebec, changes under Bill 64 (now known as Law 25) are coming into force gradually over a three-year period, some of which came into effect in September 2022 and the majority of which will come into force in September 2023. The amendments to the Quebec private sector privacy legislation are inspired by the well-known EU GDPR.

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 (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 (ICA); both are key considerations in private equity-backed transactions.

Residency Requirements and Language Laws

The federal statute and 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 the board is composed of fewer than four members), which sometimes influence the jurisdiction in which purchaser companies are formed by foreign private equity investors. The remaining provinces and territories, notably British Columbia and Québec, do not have such limitations.

Securities Regulators

Canada has no federal securities law or 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.

Competition Act

The Competition Act prescribes a “transaction-size” threshold, a “party-size” and, in the case of transactions involving the acquisition of voting shares, a “shareholding” threshold for acquisitions of operating businesses with assets in Canada. If each of these thresholds is exceeded, a transaction is considered “notifiable” and, subject to certain limited exceptions, 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 otherwise been terminated or waived.

The “transaction-size” threshold is subject to annual adjustment. In 2023, the transaction-size threshold requires the value of assets in Canada of the target (or, in the case of an asset purchase, the value of assets in Canada being acquired) or the gross revenues from sales in or from Canada generated by those assets to exceed CAD93 million.

The “party-size” threshold requires the parties to a transaction, together with their affiliates, to have aggregate assets in Canada or annual gross revenues from sales in, from or into Canada that exceed CAD400 million.

The “shareholding threshold” requires the acquiror to hold at least a prescribed percentage of the target’s voting shares. In the case of private companies, the threshold is more than 35% (or more than 50% if the 35% threshold is already exceeded). In the case of public companies, the threshold is more than 20% (or more than 50% if the 20% threshold is already exceeded).

For the purposes of both the “transaction-size” and “party-size” thresholds, asset values are calculated having regard to the book value of the assets in Canada rather than the fair market value of the assets in Canada.

Foreign Investments

Pursuant to the ICA, the acquisition of control by a non-Canadian of a Canadian business is either reviewable or notifiable depending on several factors, including the structure of the transaction, the nationality of the investor, and the nature and value of the assets or business being acquired.

In summary, the direct acquisition of control of a Canadian business by a non-Canadian is subject to pre-closing review where one of the following thresholds is exceeded:

• CAD1.287 billion in enterprise value for a direct acquisition of control of a Canadian non-cultural business by a WTO investor that is not a foreign state-owned enterprise (SOE);
• CAD1.931 billion in enterprise value for a direct acquisition of control of a Canadian non-cultural business by a “trade agreement investor” (ie, an investor from a country with which Canada has a trade agreement, such as the US or the EU) that is not a foreign SOE;
• CAD512 million in asset value for a direct acquisition of control of a Canadian non-cultural business by a foreign SOE controlled by a WTO member state;
• CAD5 million in asset value for a direct acquisition of control of a Canadian non-cultural business by a non-WTO investor; and
• CAD5 million in asset value for a direct acquisition of control of a Canadian cultural business.

Indirect acquisitions of control of a Canadian non-cultural business by a WTO investor are not subject to pre-closing review, regardless of size. In contrast, indirect acquisitions of control of a Canadian non-cultural business by a non-WTO investor are subject to pre-closing review where the book value of the Canadian business’ assets is at least CAD50 million.

A transaction that is subject to pre-closing review cannot be completed unless the Canadian government is satisfied that the investment is likely to be of “net benefit to Canada”. The government’s net benefit analysis takes into account a number of factors, including:

If the applicable threshold for a pre-closing review of the net benefit to Canada under the ICA is not met or exceeded, the acquisition of control of any Canadian business by a non-Canadian is subject to a relatively straightforward notification, which can be made either before or within 30 days of 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; 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:

• a review of publicly available documentation (websites, confidential information memorandum and 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, and tax;
• a 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. Over the past several years, we have seen private equity buyers have a heightened focus on privacy, cyber and IT diligence conducted by both the operations and legal teams, as well as on sanctions and import/export considerations.

Vendor diligence reports are not customary in Canada. Legal advisers 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, although pressure to conform to European trends has increased in recent months in this regard.

Vendors typically provide a Confidential Information Memorandum (CIM), a detailed financial model, and, depending on the stage and scope of the sale process, populated disclosure schedules based on representations and warranties provided in the vendor draft purchase agreement.

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 there has been significant restructuring of equity plans or other specific challenges in obtaining all required corporate approvals, and in the 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 accommodate 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 through the court’s seal of approval.

Very few private equity deals are conducted by way of a takeover bid (whether friendly or hostile) in Canada. Regulatory hurdles and complex, extensive requirements for non-Canadian bidders are major deterrents, as are the delays and costs associated with possible second-step (“squeeze-out”) transactions.

The 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 (eg, 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 equity commitment letters and causing banks to provide debt commitment letters as to the funding of the acquisition, and would also provide a limited guarantee to fund any reverse break-up fee, as the case may be, but this is more likely to be provided as a standalone undertaking as opposed to the fund intervening in 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.

The 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 in 5.2 Structure of the Buyer, 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. On the debt financing side, the so-called “SunGard/Limited conditionality” provisions have made their way into debt commitment letters. While more often seen in the large-cap space, the provisions are also seen in middle-market transactions.

The financing of an acquisition itself varies from one fund to the next, 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 involves 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. Despite the headwind, credit in Canada continues to be available in the market, with a range in financing from 3.0-5.0+ times EBITDA for secured financing, depending on the type of industry and assets available for security. However, with rising interest rates, financial covenant breaches are now more prevalent in leveraged buy-out financings implemented in the last few years. As such, in several circumstances, lenders were asked to waive or tolerate financial ratio breaches, leading to flexing the terms and conditions of such financings. The flexed terms often include an increase in their pricing and the tightening of certain negative covenants such as incurrence of debt, permitted acquisitions and investments and sometimes introducing a capital expenditures cap.

As for the leveraged buy-out financings being implemented in 2023, the deal terms have tightened up in certain circumstances and lenders may require a higher percentage of equity in the acquisition capital structure (which in turn propels an uptick in rollovers and the use of contingent payment structures). So long as interest rates remain high, lenders have the upper hand in negotiating more restrictive financing terms.

Deals involving a consortium of private equity sponsors are common in Canada, particularly in light of the role played in private equity by public sector pension plans and other quasi-governmental vehicles. “Club deals” with multiple private parties and no clear majority controlling fund involved are less frequent, perhaps due to the relative size of Canadian deals, which tend to be smaller and thus not require the same capital requirements as other markets.

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.

In some instances, the limited partners wishing to participate in a co-investment opportunity may be required to invest through a special purpose investment fund set out and controlled by the sponsors. This allows the sponsors to effect such co-investment opportunity more expeditiously and avoid lengthy discussions, as such co-investors’ entitlements are limited to a participation in a limited partnership controlled by the sponsors.

Consideration structures in Canadian private equity transactions continue to be predominantly based on closing date financial statements (ie, an estimated purchase price is paid at closing), subject to a working capital adjustment (and other possible adjustments depending on the business) upon completion of financial statements as of the effective time that is typically secured with an escrow. In the case of privatisation transactions, fixed-price agreements dominate.

Although earn-outs and deferred consideration have been relatively uncommon in Canadian private equity deals, the falling valuations in 2022 through 2023 have led to a growing number of private equity transactions using earn-outs and management rollover to bridge valuation gaps between sellers and buyers. Certain of these earn-outs were quite substantial relative to the overall purchase price and the terms of these earn-outs are becoming more creative.

Notwithstanding the foregoing, the vast majority of private equity sellers are still relatively resistant to contingent consideration and 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 also 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, there is a growing trend, particularly in competitive situations, of purchase agreements with public company-style representations and warranties packages with zero recourse after closing, although this trend appears to have slowed down in 2022 given recent market conditions. In contrast, transactions with zero post-closing recourse are not typical for strategic corporate buyers.

Locked-box structures are uncommon for private equity funds in private M&A in Canada, which continue to favour a traditional working capital adjustment as of the date of closing. Given the limited sample size, it would be imprudent to comment on what is “typical” in a locked-box structure in this market.

A detailed dispute resolution mechanism with respect to purchase price adjustments is a standard provision in Canadian private equity share purchase agreements, 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, and fees and expenses for the independent third party would be allocated between the buyer and seller in the same proportion that the unsuccessfully disputed amount submitted bears to the total amount of disputed items submitted to such independent third party.

Dispute resolution on other deal terms is typically 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 shareholder 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 standalone condition that there be no material adverse effect between signature and closing is relatively common for a private equity buyer to require.

Prevailing market conditions during the COVID-19 pandemic had the effect of reducing closing conditions to a minimum as buyers were in a situation to require closing certainty. However, since the beginning of 2022, the marketplace is trending back to a more balanced approach.

A “hell or high water” undertaking is sometimes accepted in private equity deals in Canada where there is a regulatory condition related to, for example, the merger review process or the foreign investment review process. As a practical matter, a full “hell or high water” is more likely to be provided in the merger review context than in the foreign investment review context. That said, the scope of “hell or high water” undertakings is negotiated and ultimately depends on the nature and regulatory sensitivity of the deal and business dynamics. For example, in the context of a “seller’s market” and regulatory complexity, such undertakings may involve the sharing of risk (rather than a full “hell or high water”) and/or specific remedial commitments.

Prior to the COVID-19 pandemic, break fees were rarely accepted by private equity-backed buyers in private transactions. The height of the sellers’ market in 2021 saw many private equity sponsors required to provide limited guarantees and equity commitment letters to support break fees being demanded by sellers. 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 does not take place. Many private equity sponsors were required to provide equity commitment letters and limited guarantees to secure a prospective acquisition.

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:

• mutual agreement;
• termination by the buyer (provided the buyer is not in default of its obligations) where the obligations of the seller cannot or have not been satisfied by an outside date; and
• termination by the seller (provided the seller is not in default of its obligations) where the obligations of the buyer cannot or have 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. A typical long stop date (or “outside date”, in Canadian terms) is set on a case-by-case basis, taking into account the anticipated level of complexity of obtaining regulatory approvals (if any) and any other closing deliverables (such as required consents, necessary pre-closing transactions, etc).

Private equity buyers are not sympathetic to assuming risks related to a business before they become owners, instead adopting 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 thresholds and knowledge qualifiers in providing representations and warranties;
• the application of baskets and deductibles (ie, imposing minimum thresholds that must be obtained before 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 ranges from 12 to 24 months (with carve-outs for tax, fraud, environmental or specific representations such as fundamental representations, which can have a longer period). Following US trends, where fundamental representations used to be provided for an indefinite term, these too are 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. However, in a sellers’ market, as has been seen during the pandemic, the success of such an approach was more limited.

Indemnification provisions in private M&A in Canada range anywhere between 10% and 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 recent years, Canada has seen a growing number of transactions involving representations and warranties insurance, especially in transactions involving private equity investors. When first introduced, indemnification provisions in purchase agreements with representations and warranties insurance policies provided a “first recourse” against the sellers (often for a value not exceeding 0.5% of the enterprise value after having applied a deductible – often in the same amount) before accessing the policy. As a result, sellers had some “skin in the game” before the policy would kick in. These limitations did not typically apply to fundamental or tax representations, or to fraud.

While many transactions still reflect this approach (with variations), the growing trend in larger private equity transactions is to have vendors benefiting from public company-style representations and warranties packages with zero recourse after closing, with buyers relying entirely on the representations and warranties insurance policy.

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, as indemnification will come from the sellers regardless 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 comprehensive operational representations.

A private equity seller will necessarily seek to limit liability as much as possible, thereby maximising returns for 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:

• the accuracy and completeness of financial statements;
• that there are no undisclosed liabilities;
• a list of material contracts;
• that there is insurance coverage in place;
• warranties provided to customers;
• material compliance with the applicable laws for a limited lookback period;
• pending and threatened litigation;
• relationships with material customers and suppliers;
• material compliance with employment and benefits laws;
• a list of required consents, notifications and regulatory approvals;
• a list of owned and leased real property;
• compliance with environmental laws and the availability of environmental reports;
• breaches of privacy, anti-spam, cyber-risk and anti-corruption policies and laws;
• IP ownership and infringement; and
• the status of IT and information systems.

Private equity sellers will conduct a thorough disclosure exercise with management and external counsel to ensure that 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. In the context of transactions involving representations and warranties insurance policies, a buyer will typically require comprehensive representations and warranties, as the overall liabilities of the sellers will be limited to a small fraction of the purchase price (sometimes with exceptions for fundamental and tax representations, fraud and special indemnities). As a result, representations and warranties are typically easier to negotiate between buyers and sellers where such policies are in place. Also, buyers will typically require a materiality scrape provision that will facilitate the determination of whether or not a breach has been made and the amount of damages incurred.

As mentioned above (in the absence of representation and warranty insurance), a private equity seller’s representations will be limited by pervasive qualifiers, in time (12–24 months), by capping the indemnification (as low as possible – commonly below 10% of the purchase price), and applying de minimis thresholds such as deductibles or tipping baskets.

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.

Representations and warranties insurance has become commonplace in Canadian transactions. 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.

When first introduced, indemnification provisions in purchase agreements with representations and warranties insurance policies provided a “first recourse” against the sellers (often for a value not exceeding 0.5% of the enterprise value after having applied a deductible – often in the same amount) before accessing the policy. As a result, sellers had some “skin in the game” before the policy would kick in. These limitations did not typically apply to fundamental or tax representations, or to fraud.

However, although many transactions still reflect this approach (with variations), the growing trend in larger private equity transactions is to have vendors benefiting from public company-style representations and warranties packages with zero recourse after closing, with buyers relying entirely on the representations and warranties insurance policy.

Most of the mid-market private M&A and the great majority of the large private M&A involving private equity investors will involve representations and warranties insurance.

With the widespread adoption of representations and warranties insurance, there has been a trend towards smaller or no indemnification escrows. However, purchase price adjustment escrows continue to be used. In competitive bids and in a sellers’ market, there is a growing trend of purchase price adjustment escrows being the sole recourse of the buyers against the sellers with respect to purchase price adjustments.

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, but 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. The public-to-privates by private equity firms that do occur are rarely done on a hostile basis; generally, the negotiations are friendly and the transaction is ultimately supported by the target board (and significant shareholders, where possible). As public markets continue to struggle in 2023, there may be more opportunistic acquisitions by private equity firms.

In a public-to-private deal, the target board (or a special committee of the board formed of uninterested members in the transaction) is a key actor in the negotiation process. The committee’s recommendation, and the board’s ultimate recommendation, to the company shareholders, together with fairness opinions (and formal valuations, where required) are essential to getting these deals across the finish line.

Holdings of more than 10% of the equity of a public company in Canada trigger the filing of an early warning report, which provides public disclosure of the shareholdings of the holder. Holders of more than 10% of the equity of a public company in Canada are considered “insiders”. An early warning report is comprised of the dissemination of a press release and the filing of an early warning report form on the issuer’s profile containing prescribed information on SEDAR (the System for Electronic Document Analysis and Retrieval at www.sedar.com – the website used by Canadian reporting issuers to file public securities documents with the Canadian Securities Administrators).

Crossing the 10% equity holding threshold of a public company also requires concurrent insider report filings on SEDI (the System for Electronic Disclosure by Insiders at www.sedi.ca – the browser-based service for the filing and viewing of insider trading reports and required by the Canadian provincial securities regulators). An insider report outlines the current holding of insiders of an issuer. Insider reports are typically required to be updated within five business days of any changes to the holdings of an insider (a director, officer or 10%+ equity holder of the issuer). 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.

Subject to limited exemptions, 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. However, the issuance of shares 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.

It should be noted that there has been a growing use of earn-out provisions in an effort to bridge valuation gaps between buyers and vendors. For public company take-private deals, these can take the form of contingent value rights (CVRs – securities that provide for shareholders’ right to get certain additional benefits/payments upon the occurrence of specific events, such as earning thresholds, etc, over a period of time).

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 are obtained (66.66%, as well as any “majority of minority” that may be required), 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), while 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 through statutory mechanical “squeeze-out” provisions.

Where fewer than 90% but more than 66.66% 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 nearly always a prerequisite in the case of private equity-backed privatisations) 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. Under Canadian securities laws, shares tendered to the bid can be used by the buyer to vote in favour of the second stage squeeze-out.

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.

Stock options have historically been used by private equity firms in Canada as an effective means of incentivising management teams. The tax benefit of stock options for members of management may be limited if the corporation issuing the options is not a CCPC.

Most private equity investors in Canada focus on strong management teams when 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. Sweet equity is not common for companies of the size and stage a Canadian private equity fund is typically targeting.

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, or the appointment of agents 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 almost universally found in stock option plans, but are 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). In such circumstances, management employees may 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, regardless 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 the 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.

With the growing number of US private equity funds investing in Canada, there is a growing trend of having a portion of the stock options granted to managers vesting only upon the private equity fund having received a multiple of its capital in the target (for example, 1x, 2x or 3x), provided that management is still employed by the target at the closing of a liquidity event.

Non-competition covenants are enforceable in Canada (except in Ontario as it relates to non-competition clauses found in employment contracts of non-managerial staff) if they are crafted appropriately and are reasonable in terms of duration, scope and territory. Non-solicitation covenants and non-disparagement undertakings are also customary. Non-competition covenants are common in business acquisitions but are unenforceable in the province of Ontario in the case of mere employees (ie, they are only enforceable for individuals in positions of president or chief level positions and for executives who are shareholders in relation to a sale of business).

In an employment agreement, the upper limit for a top executive in terms of a non-compete is typically up to two years. However, most enforceable covenants of late have been in the 12-month range. A private equity purchaser will often seek to obtain a seller non-compete from exiting management shareholders (in each case in their capacity as shareholders) for the following reasons:

• employment non-competes are no longer permitted in certain provinces; and
• in provinces where employment non-competes are still permitted, the scope of protection under a shareholder non-compete is generally for a longer period than non-competes tied to employment.

Since 23 June 2023, the Competition Act has included a criminal provision prohibiting unaffiliated employers from agreeing “to not solicit or hire each other’s employees”. As with the general cartel provisions, this new provision includes an ancillary restraints defence. According to recent guidance issued by the Bureau, this provision does not require that the unaffiliated employers be competitors or potential competitors, which is unlike the framework that applies to the general conspiracy provisions in the Competition Act. This guidance also makes it clear that the new provision applies only to agreements to not solicit or hire “each other’s” employees, with the result that “one-way” restraints (ie, restraints that only apply to one employer) are not subject to the new provision. However, when there are separate agreements between two or more unaffiliated employers that result in reciprocating promises to not poach each other’s employees, then the Bureau may take enforcement action.

Accordingly, non-solicit clauses or other employee-related provisions in transaction agreements should have regard to this new no-poaching prohibition. In particular, provisions that go beyond what may be typical in duration and scope should be considered closely to ensure they are reasonably necessary to achieve the objective of the broader transaction agreement.

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 veto rights, which 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, certain veto rights might be granted, but such rights are highly dependent on the circumstances.

Similarly, whether or not a management team (either collectively or certain executives) has board appointment rights depends 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. 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 investor to entertain the idea of giving this power to management.

Private equity funds typically seek maximum control over their investment, in terms of board oversight and veto rights. The board is customarily controlled (majority-composed) by the lead private equity investor. Veto rights requested can include a variety of items, including:

• consents required as to any proposed corporate restructurings, acquisitions or divestures;
• the incurrence of additional debt;
• the issuance of additional equity;
• budget approvals;
• changes to key management; and
• a change to the head office location.

Information rights are also regularly provided 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.

Courts in Canada will generally not pierce the corporate veil, except in very unusual circumstances, such as the company being used to shield against illegal or fraudulent acts.

Sales to foreign (mostly US) private equity firms have dominated recent exits in Canada. Private equity exits through M&A and secondary buyouts have been the most prevalent. 

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. There have been no IPO exits of private equity-backed portfolio companies in 2022 and 2023 to date. 

Recapitalisations and continuation vehicles are options on the table in the current climate as private equity sellers’ traditional exit strategies are seeing lower valuations and challenging public market opportunities.

Private equity funds will typically include sophisticated drag mechanisms in their shareholder agreements to ensure that they can force an exit on the shareholders of a portfolio company.

In practice, these provisions rarely have to be enforced as private equity funds will rely instead on the co-operation and willingness of minority investors to participate in the sale. There is no typical drag threshold in Canadian jurisdictions, other than in the public company context (of 90% + tendering to a bid under a statutory squeeze-out or more than 66.66% but less than 90% tendering to a bid for a second stage squeeze-out). In the private company context, this is a contractually negotiated threshold.

Tag rights are sometimes granted to minority shareholders (including management), especially in the case of change of control transactions. There is no typical tag threshold in Canada.

However, institutional co-investors will be required to fully tag along with any sale of the private equity sponsors (subject to certain limited exceptions).

In addition to any escrows that may be required by the applicable stock exchange on which the target is to be listed (typically applicable to companies with less than CAD100 million market cap), the underwriters will typically request lock-ups from private equity shareholders who do not sell concurrently with the IPO for a period of 60 to 180 days following the offering. Arrangements are sometimes implemented to provide for board nomination rights and registration rights (secondary prospectus sales).