MODERATE LBO VOLUME EXPECTED
With many sponsors and lenders remaining cautious amidst a tepid recovery in the U.S. and continuing economic uncertainty in Europe, we expect moderate leveraged buyout (LBO) volume in Canada this year. Nevertheless, coming off an uptick in Canadian LBO activity in 2011 in terms of both number of deals and dollar value compared with the prior year, some general partners (GPs) will take advantage of existing committed capital, the stability of Canadian banks and continued availability of financing for solid portfolio company acquisitions. We expect sponsors to look for attractive targets in the middle market, which remains the core of LBO deal activity in Canada, having accounted for a reported 82 per cent of all buyouts in 2011.
LBO DEAL TERMS
Although increasingly common in the U.S., go-shop provisions, which permit a target company to continue to seek a better offer even after a transaction agreement is signed, have not found significant favour in Canada. Our 2010/2011 Canadian Public M&A Deal Study identified only one transaction with a go-shop provision out of 50 surveyed transactions. The reluctance to utilize go-shops in Canada can be traced to several reasons, including fewer public to private LBOs than the U.S., general skepticism about their actual effectiveness in maximizing shareholder value and the lack of a “Revlon” duty in Canada that would otherwise place greater pressure on boards to carry out some kind of pre-closing market check.
Separately, at least two different reverse break fee constructs have found some use in Canada, a “pure option” reverse break fee that allows a buyer to walk away from a transaction upon paying a negotiated fee to the target company (with no availability of specific performance to the target company) and a reverse break fee for financing failure (with corresponding availability of specific performance where the lenders are ready, willing and able to lend). Lenders and buyers continue to successfully resist any ability on the part of target companies to enforce lending arrangements.
ACTIVE DIRECT AND CO-INVESTMENT STRATEGIES BY CANADIAN PENSION PLANS
Canada’s public pension plans will continue to employ active private equity investment strategies this year, both in Canada and abroad. According to published reports, pension plan investors were again involved in some of the largest Canadian private equity deals last year, representing over 85 per cent of all Canadian LBO dollar volume. In addition to direct investments, we expect co-investment deal volume to remain strong, providing both attractive deal opportunities for pension plans and needed capital to GPs for larger transactions.
NEW GENERATION OF INCOME TRUSTS MAY OFFER EXIT OPPORTUNITIES
The Canadian federal government’s prior tax policy shift that effectively shut down Canadian business income trusts by taxing trust earnings similarly to corporations did not impact trusts that derive their income from non-Canadian businesses. This has provided potential exit opportunities for sponsors to take their foreign businesses public as one of a new generation of cross-border income trusts in Canada, particularly for companies with stable cash flows. Although the first such “second generation” trusts have been energy-focused, there is generally no restriction on the types of businesses that may use this model, provided they are not Canadian.
DISTRESSED INVESTMENT OPPORTUNITIES
We expect to see distressed investments—both acquisitions and debt investments with a view to control—to be a continued area of focus in 2012, with GPs seeking opportunistic investments in underperforming and mismanaged companies. “Stalking horse” bid processes are expected to continue to gain favour as the preferred method to maximize value in insolvency asset sales.
CONTINUED DRIVE FOR VALUE AND GROWTH IN PORTFOLIO COMPANIES
Difficult conditions for exit transactions, including the relatively limited initial public offering market and reduced secondary deal market liquidity, have meant that the ability of GPs to generate value increasingly depends on the development and growth of portfolio company businesses. We expect continued focus and attention to driving value in 2012, including cost savings and retention of cash, bolstering internal operational capabilities and pursuing strategic follow-on acquisitions in anticipation of portfolio company sales.
IMPORTANCE OF FOREIGN INVESTMENT REVIEW
The Canadian federal government agency responsible for most inbound foreign investment—the Investment Review Division of Industry Canada (IRD)—continues to be at the forefront of public policy debate, with reviews of several high-profile deals garnering significant media attention. In light of IRD’s increased scrutiny of transactions, success will be increasingly dependent on developing effective government, media and key stakeholder relations strategies, in addition to legal strategies, early in the deal process.
CONTINUED CHALLENGES IN FUNDRAISING
Despite reports indicating a 10 per cent increase in Canadian fundraising in 2011 over 2010, we expect continued challenges for fundraising in 2012. Sponsors with proven track records may fair relatively better than their lower-performing counterparts as LPs pursue increasingly disciplined private equity investment strategies. LPs are expected to continue the push for favourable key deal terms, such as reduced management fees, while GPs continue to negotiate investment period extensions in order to put their committed capital to work and take advantage of deal opportunities in the coming year.
SOVEREIGN WEALTH INVESTMENTS EXPECTED TO CONTINUE
Sovereign wealth funds have increasingly looked to Canada for strategic and opportunistic investments, often structured as joint ventures to minimize foreign investment scrutiny, and we expect this activity to continue in 2012. Demand for commodities has continued to be strong and certain sovereign wealth funds have recently acquired a significant number of Canadian assets and minority interests, including in Canada’s oil and gas, mining and agricultural sectors.