In 2009, Canadian M&A will continue to be affected by tight credit markets, lower valuations based on lower multiples (driven in part by lower earnings and difficulties in leveraging acquisitions), and a Canadian dollar that is likely to remain significantly below par (in the 75-85¢ U.S. range). Also affecting the Canadian market will be political and regulatory developments – not only domestically but in the U.S., Europe and Asia. While blockbuster deals are likely to be few and far between, opportunities will inevitably present themselves, especially to cash-rich acquirors. When all is said and done, the theme heading into 2009 is:
"Cash is king – it’s a buyer’s market once again."
Summarized below are ten developments that are likely to drive Canada’s M&A market in 2009.
1 Taxes Always Matter – Positive Cross-Border Taxation Developments
Recent amendments to the Income Tax Act (Canada) and the ratification by both the U.S. and Canada of the 5th Protocol to the Canada-U.S. Income Tax Convention (the “Treaty”) will provide, in most cases, substantial benefits for cross-border acquisitions. In particular:
Elimination of withholding tax on interest payments
The complete elimination of Canadian withholding tax on interest paid to arm’s length non-residents, regardless of their country of residence, will greatly facilitate direct, cross-border acquisition financing by foreign lenders. In addition, withholding tax on interest payments made to a related U.S. resident will be reduced from its current 10% to 4% in 2009 and will be eliminated completely for subsequent years. Leveraged cross-border acquisitions (particularly from the U.S.) will become much more tax-efficient.
Generally, the 5th Protocol will extend Treaty benefits, such as reduced withholding tax rates and the exemption for capital gains in certain circumstances, to U.S. limited liability companies.
Other Hybrid Entities
However, the 5th Protocol will deny Treaty benefits for certain other “hybrid” structures. One rule will deny Treaty benefits for structures, such as “synthetic NROs”, where a resident of either the U.S. or Canada derives or receives income, profits or gains through a hybrid entity that is treated as a separate entity in that resident’s country, but is fiscally transparent under the laws of the source country. The insertion of another entity into the structure that is resident in a jurisdiction with which Canada has entered into a tax treaty may assist in avoiding or ameliorating such adverse effects.
More importantly, the use of Canadian unlimited liability companies (ULCs) in acquisition structures may be ending on January 1, 2011 based on another rule under the Protocol. That rule will deny Treaty benefits in circumstances where a payment is made to a resident of one country by a hybrid entity that is fiscally transparent under the laws of the resident’s country, but is treated as a separate entity in the source country. A ULC (which currently can be incorporated under three provincial jurisdictions) is treated as a Canadian corporation for Canadian tax purposes, but may be considered a Canadian branch for U.S. tax purposes (i.e., tax flow-through vehicle). Thus the full withholding rate of 25% will apply on payments by a ULC to the U.S. parent on interest, royalties and dividends on and after January 1, 2010. It may be possible to avoid the adverse results of this rule by inserting an entity resident in another treaty jurisdiction (including Luxembourg and Barbados entities) above the ULC.
Preservation of Losses on Change of Control
In the current economic climate, buyers will become much more focused on their ability to continue to use accumulated (operating) tax loss carry-forwards upon the acquisition of control of a Canadian target. Among other restrictions, such tax losses can only be offset against the income from the same or a similar business carried on following the acquisition.
2 Open for Business (Again) – Encouraging Foreign Investment
The Federal Government’s November 2008 Speech from the Throne made reducing roadblocks to foreign investment a top priority. Among the proposed initiatives:
- Harmonizing the merger review provisions in Canada’s Competition Act with those in the U.S. Hart-Scott-Rodino Act: an initial review period of 30 days with the Commissioner of Competition having the discretion to initiate an intermediate second-stage review period ending 30 days after the merging parties comply with a second request for documents.
- Making significant changes to the Investment Canada Act:
- Increasing the minimum threshold for Ministerial review and approval of foreign acquisitions of control of Canadian businesses (to C$1 billion based on the as-yet-undefined “enterprise value” of the business, from the current C$295 million test (for 2008) based on book value of assets);
- Shifting the onus to the Minister to find that the proposed investment would be “contrary to Canada’s national interest” (currently, the purchaser must satisfy the Minister that the acquisition will be of “net benefit” to Canada);
- Eliminating the lower review thresholds for the “sensitive” sectors of financial services, transportation services and uranium mining (currently, virtually all such businesses will exceed the C$5 million asset threshold for direct acquisitions), leaving only “cultural businesses” subject to these low thresholds and special review by Heritage Canada; and
- Eliminating the requirement to notify the government of non-reviewable foreign acquisitions of Canadian businesses.
3 Lean and Mean – Industry Consolidation and Rationalization
Canada may not face the same cathartic changes that many industrialized countries are facing with respect to competitiveness, but the country will nevertheless continue to experience significant consolidation and rationalization:
- There will be continued consolidation in most sectors, including the natural resources (pulp & paper, mining, oil & gas), manufacturing (fabrication, auto parts, plastics and many others) and service sectors (insurance, financial services – but probably not the banks, at least not at this point).
- More companies will focus on the businesses they know best, divesting unprofitable or non-strategic businesses to concentrate on core competencies (and to raise cash at a time of tight credit).
- We will see more “industry rollups”, particularly by private equity funds, to prepare a critical mass for subsequent liquidity events.
- As a result of tight credit and cash constraints, we foresee more stock-for-stock deals.
- In addition, for the same reason, we foresee more “earn-outs” in acquisitions of private companies and operating divisions of public companies.
4 Mid-Market M&A – Just Keeps on Ticking
Good times or bad, there is always a consistent flow of mid-market Canadian M&A transactions. This won’t change in 2009, when a number of trends will move the market:
- Strategic buyers looking to acquire well-run and profitable Canadian companies (there are lots of them, at bargain prices).
- Baby boomers continuing to sell all or part of the equity in their companies.
- Public companies unloading non-core and unprofitable business lines.
- Private equity groups enhancing scale by adding to existing portfolio companies.
5 The Dealmaking Process – More Clarity, Greater Certainty
In the M&A world, the last year has been characterized by buyer’s remorse as values dropped precipitously and credit became very difficult to obtain on normal terms and conditions and in some circumstances vanished altogether. Buyers looked to “material adverse change” (MAC) conditions of closing, reverse break fees, litigation and other means of extricating themselves from what turned out to be bad deals. In Canada, we anticipate more certainty in M&A deals as courts and regulators continue to clarify the obligations of parties and as parties themselves take an increasingly cautious approach at all stages of the dealmaking process:
- Recent court decisions have given comfort to board members that their fundamental duties will generally be interpreted by the courts with due deference to the good faith exercise of “business judgment” and generally accepted commercial practices. In Re AiT Advanced Information Technologies Corp., for instance, an Ontario Securities Commission panel affirmed the widely accepted view that merger discussions generally need not be reported under Securities Act “material change” provisions until the board believes that the parties are committed to the transaction and that there is a “substantial likelihood” of success. In so holding, the OSC panel rejected the position of the OSC’s investigative branch that the report should have been filed when the non-binding letter of intent was signed – a position that many had regarded as commercially unrealistic.
- A second example was Deer Creek Energy Ltd. v. Paulson & Co., in which the Alberta Court of Queen’s Bench also took a “common sense” approach in rejecting arguments by a small group of dissenting shareholders that the company’s shares had been undervalued by the board, noting that the going-private transaction in question had been vigorously negotiated and had resulted in an offer at a substantial premium to the market price which had been accepted by the vast majority of long-term shareholders. The dissenters’ argument that their decision to invest had been based on much higher potential values touted at presentations made by the early-stage energy company’s management was rejected as “unrealistic and self-serving” by the court.
- The 2008 Delaware Court of Chancery ruling in Huntsman v. Hexion, in which Vice Chancellor Lamb refused to allow the acquiror to invoke a MAC condition of closing on the basis of the target’s poor post-credit crunch performance, will likely lead acquirors in the current buyer’s market to push for MACs with fewer carve-outs and clearer quantitative criteria than we have seen in recent years (including express limitations on the scope of “materiality” by a dollar amount or otherwise) in an effort to enhance their ability to “walk” in a wider range of circumstances.
- Finding ourselves in a buyer’s market once again, we may see acquirors pressing for “reverse break fee” provisions that amount, for all intents and purposes, to liquidated damages as the exclusive remedy (rather than just a down payment for actual damages).
- While sellers will continue to use the controlled-auction process to permit greater control of the process and more systematic approach to potential buyers, they can generally expect fewer buyers to show up, tighter timelines and condensed stages.
- Potential acquirors of public companies will be less likely to be foiled by shareholder rights plans (poison pills) with triggering thresholds under 20%. Under a 2008 TSX guidance, any such poison pill must be justified to the TSX and will be subject to special scrutiny if it has been adopted as a defensive measure against an anticipated or imminent acquisition, which must also be disclosed.
6 The Killer “D’s” – Debt Restructuring, Distressed M&A, Deals Gone Bad
As the economy continues to struggle through 2009, businesses in tight financial straits or a liquidity crisis will continue to look to formal and informal restructuring processes and, in some cases, seek out stronger partners for potential take-overs. In particular, the following trends seem certain to continue through the coming year:
- Banks and other financial institutions will continue to seek more and tighter security, tougher covenants (no more “covenant-lite” loans) and more equity from existing shareholders. Refinancings requiring additional equity injections have already increased.
- Although in recent years increased recourse to the Companies’ Creditors Arrangement Act (CCAA) – the Canadian equivalent of Chapter 11 of the U.S. Bankruptcy Code – has improved the survival rate of insolvent companies, one or more dispositions have become a routine and expected part of the process.
- We also anticipate increasing cross-border insolvencies (with resultant dispositions) since many U.S. and foreign companies have Canadian subsidiaries, in many cases which are still profitable. Increasing recognition by Canadian courts of the reciprocal enforcement principles underlying the UNCITRAL Model Law – which may be formalized in a proposed federal statute – may streamline cross-border insolvency proceedings, reducing the frequency of duplicative Chapter 11 and CCAA processes. This trend may provide more certainty in cross-border sales in a debtor-protection or bankruptcy scenario.
- In tough economic times, where deals fail to close (or close without producing the payoff investors hoped for), directors and officers can expect to find their actions closely scrutinized by disappointed and litigious shareholders. Recent Delaware rulings, notably Ryan v. Lyondell, suggest that the courts are willing to give angry shareholders their day in court with respect to a good deal that arguably wasn’t shopped around sufficiently. On the other hand, as Delaware’s Wayne County Employees’ Retirement System v. Corti ruling revealed, in a weak M&A market courts may be less sympathetic than usual to disgruntled shareholders seeking injunctive relief that in the court’s view could potentially scuttle the only viable deal available to a company.
7 Funding – Creative Dealmakers Will Find a Way
While tighter credit markets will continue to squeeze supplies of leverage for acquisition financing, dealmakers will respond creatively. Among the developing trends for 2009 are:
- An increasing use of preferred shares (including convertible preferred shares) as part of the increased equity – in many cases in financial hardship scenarios.
- Investors providing both debt and equity – ideally with a fully-secured debt position.
- In light of the fact that withholding taxes no longer apply to interest payments made by Canadian borrowers to arm’s length foreign lenders, we anticipate increasing use of acquisition financing directly from foreign lenders – which has no (or few) regulatory impediments.
- Increased numbers of investments in the form of private investments in public equity (PIPES), similar to the U.S. experience. Recent harmonization of securities laws relating to such private placements should facilitate these transactions.
8 Private Equity Investors – Getting Their House in Order
The acknowledged “Kings of M&A” over the past several years have had to reassess and develop new strategies in light of tighter or non-existent credit and general economic turmoil. We see the following for PE investors in 2009:
- Divestiture of unprofitable businesses.
- Industry roll-ups and consolidation to create critical mass – once again with a divestiture or other liquidity strategy as the end-game.
- Re-capitalization with increasing investments in equity (including preferred shares) or possibly subordinated, convertible, secured debt.
9 Going Private – An Increasingly Attractive Option
The trend among Canadian companies toward adopting longer-term, more stable growth strategies and revised compensation arrangements, together with the desire to avoid regulatory scrutiny and compliance costs, will result in more public companies going private in 2009. The fact that many Canadian public companies have one controlling shareholder (often a foreign company) combined with lower market prices will facilitate this trend. With the increase in PIPES, going private transactions in 2009 will also occur in two steps with less liquidity in the marketplace.
Harmonized rules for going-private transactions (including rules dealing with majority-of-minority approvals and valuations) give further impetus to this trend.
10 Acronyms are Back – BRICs, SPACs and SWFs
We anticipate continued modest participation by relatively new entrants to the M&A marketplace. In particular, we expect to see:
- Continued strategic acquisitions by investors from rapidly industrializing economies, notably the BRIC countries (Brazil, Russia, India and China).
- The formation of an increasing number of special purpose acquisition companies (SPACs), based on the U.S. model, prompted by low valuations of Canadian targets and amendments to TSX rules designed to encourage SPAC listings. These will be particularly attractive for purposes of industry consolidation, such as widely-disparate auto parts manufacturers, suppliers, fabricators and tool-and-die companies.
- Although sovereign wealth funds (SWFs) have in many cases reined in their foreign investment strategies in favour of more domestic agendas, Canada will continue to attract their interest as a safe place of investment. Accordingly, we expect to see more activity from SWFs in 2009.