The current state of the global economy is being reflected in the Canadian M&A marketplace. The credit crisis has tightened lending practices and reduced or eliminated the ability to complete the highly leveraged transactions that were driving valuations.
Reduced Deal Volume
The volume of North American M&A activity has decreased in the past 12 months. The reasons for this are varied, but the central issues are a reduction in available credit and concern by investors about whether markets have yet reached a bottom. In addition, lower levels of activity in Canada (more so than in the US) are also due to sellers’ valuation expectations not yet having aligned with the reality of the downturn in public markets.
Return of the Strategic Buyer
As part of their overall strategy to drive enhanced returns, most financial buyers have historically looked to highly leveraged transactions. With the current lack of liquidity in the credit markets (and significantly less friendly covenant and condition packages associated therewith), private equity firms and other financial buyers have been significantly less active in the M&A field. Strategic buyers with a focus on synergies or other business drivers for an acquisition have suddenly found themselves able to pay competitive prices for targets.
We believe this will continue for the foreseeable future. As a consequence of this change in the nature of the “buyers’ universe,” we believe sellers will find themselves with fewer prospective alternatives, which in turn will put pressure on sales processes. We are seeing buyers with much less appetite for participating in “auction processes,” more pressure to provide buyers with exclusivity, more restrictive “fiduciary out” terms, and potentially increased break fees for prospective buyers.
We expect that financial buyers backed by sovereign wealth funds will be the exception to the above and will remain active. Although these buyers have also been affected by current market conditions, they are not as dependent on third-party financing and may compete with strategic buyers for more significant transactions. Despite poor performance in several high-profile investments by sovereign wealth funds in the last year and reduced revenue in oil-producing regions, these entities still have a need to deploy significant amounts of capital. Historically low valuations for major publicly-traded companies may lead to significant activity in this sector. The recently announced acquisition of Nova Chemicals Corp. by IPIC could prove to be an example of a growing trend.
Greater Activity in Small and Mid-Range Transactions
The high cost of credit will likely mean a reduction in the number of larger transactions. We expect that strategic buyers will focus on small or mid-sized acquisitions that can be funded from operations without seeking significant financing. The generally reduced share prices of small companies and their inability to secure additional financing on favourable terms will likely create opportunities for well-funded strategic buyers. The acquisition of Certicom Corp. by Research In Motion is a recent example of this type of transaction.
We expect that significant transactions will continue, but at a slower pace. Larger transactions will more commonly take the form of share exchange transactions with strategic buyers that are in the nature of mergers of equals. Large infrastructure and industrial acquisitions by pension funds and financial investors backed by sovereign wealth funds will also continue.
Deal Closure Risk Significant
As the recent BCE transaction (among others) demonstrated, the current economic climate has significantly increased the risk of deal failure. There are two key elements to these risks:
(a) any financing required by the buyer (debt or equity) may be highly conditional; and
(b) during the interim period (the time between signing an acquisition agreement and closing) the target’s economic circumstances may change.
We are seeing a number of marketplace responses to these issues, which we expect to continue and expand:
- the use of “reverse break fees” (i.e., where the buyer pays the target liquidated damages for simply walking away from a deal) where a buyer’s financing or other closing conditions are highly conditional;
- a reconsideration of the risk allocation between buyer and seller that underpins some traditional M&A agreement provisions, including, in particular, “Material Adverse Change” provisions. Recent US court decisions have confirmed (absent specific wording to the contrary) a narrow construction of these provisions against their use by buyers. We look to see more specific requests by buyers for representations from sellers about current and future economic circumstances related to the target and potentially (and most controversially) the introduction of closing conditions resembling “financial market outs” traditionally found in public financing agreements.
Going Private Transactions
With current depressed market prices, escalating incremental costs of running public companies and a reduction in public financing opportunities, we expect that “going private” transactions by public entities and their controlling shareholders will become increasingly attractive in the coming months. This will be particularly true in the context of public income trusts. As January 1, 2011, approaches, income trusts are facing the prospect of having to undergo a significant expense associated with conversion to a corporate (or other) structure. A number of controlling shareholders of income trusts who took their businesses public (often at significantly higher prices than current prices) may look to the looming conversion event as a springboard for going private opportunities.
Refinancing of Existing Obligations
The need to refinance outstanding term debt as it matures may also prompt companies to consider sales, even with current low market valuations. The high level of M&A activity through 2007 was driven largely by financial buyers in highly leveraged transactions. These transactions have resulted in a large number of outstanding loans on favourable terms with five- to seven-year maturities. As the facilities from transactions completed early in the M&A cycle mature in the current credit environment, the sale of a portfolio company or a division may be one of the few options available.
We expect industries characterized by high levels of near-term debt maturities, such as the media and entertainment sector, to experience a high level of consolidation and restructuring.
Consolidation in the Oil and Gas Sector
Prior to October 31, 2006, small-cap oil and gas exploration and development companies were often established with the intention that the companies would have a limited life cycle, based on the premise that a start-up oil and gas company could grow to a certain size, either through drilling or merger or a combination of both, and sell out to a willing and able oil and gas trust that was anxious to maintain production levels.
The announcement on October 31, 2006, that energy trusts will become taxable as of 2011 brought an abrupt end to this cycle. Many oiland gas companies that were created prior to October 31, 2006, have refocused their plans and developed longer-term growth strategies.
The shift to longer-term strategies has been complicated by the recent market conditions.
The collapse of the financial markets and commodity prices in late 2008 has resulted in limited capital being raised by oil and gas companies. Those that choose to and are able to raise capital are financing at significant discounts to their net asset value (NAV). Larger oil and gas companies are financing at even lower discounts to NAV.
With the lower commodity and equity markets, junior oil and gas companies find themselves with increased need for capital to fund growth, with no ready source of investment or potential acquirors. Larger oil and gas companies are able to raise financing, but only with significant dilution.
To date, there has been limited merger and acquisition activity and limited consolidation in the junior and mid-cap oil and gas industry. Likely this is due to an unwillingness to accept current market values. We have seen this from the perspective of both significant investors and management.
Although global demand for commodities continues to be reduced by economic contraction, the finite supply of natural commodities remains a pressing issue. The lack of financing today will inevitably lead to lower supplies in the future. Those companies that are able to survive in the current markets may reap significant benefits as economic recovery begins to drive demand for commodities higher in the coming years.
As a result, there is considerable reluctance to sell at current market values, which is acting as a barrier to consolidation in the junior and mid-cap oil and gas sector. We believe that as the market adjusts to the annual reserve reports released this year, there will be heightened pressure for many issuers to consider mergers and acquisitions, including farm-ins and asset sales.