April 30, 2011

Canadian M&A: Eleven Trends for 2011

U.S. investors attracted by Canada's robust M&A market should take note of 11 trends and developments north of the border in 2011.

As the global financial storm subsides, Canada's economy is commanding unaccustomed attention and some new-found respect. A solid regulatory system and strong demand for Canadian resources and commodities have kept the United States' northern neighbor in the global business headlines. In the M&A sector, there is every indication that the rebound experienced in 2010 will continue in 2011, as market players continue to seek out new opportunities. Canada's current popularity as a destination for foreign investment may be due to the reassuring familiarity of its legal and business culture, but that does not mean that U.S.-Canada cross-border transactions can be approached in exactly the same way as domestic U.S. transactions. Heading into 2011, there are a number of significant Canadian developments to watch out for, including the 11 key trends identified below.

1. Foreign Investment Review Post-Potash

In 2010, the government of Canada's decision that BHP Billiton's proposed US$38.6 billion unsolicited bid for PotashCorp was not in Canada's national interest effectively ended the bid and made headline news in the U.S. and around the world. In spite of this publicity, the consensus among Canadian practitioners is that the Potash situation was an anomaly. To put the matter into perspective, only two acquisitions have been rejected by Canada's foreign investment review process in over 20 years. In addition, the Canadian government has now indicated that it intends to review the relevant legislation, known as the Investment Canada Act (ICA), to determine whether, among other things, the "net benefit" test requires clarification. Every indication is that Canada remains open for business and that it will be business as usual in 2011 for most foreign acquisitions of control of Canadian businesses.

Another important piece of the Canadian foreign investment review process is the applicable threshold for review and approval of foreign acquisitions of control of Canadian businesses. In keeping with the current government's pro-investment stance, there is reason for optimism that the threshold figure will increase significantly. In 2009, the government announced its intention to raise the threshold amount in bi-annual stages to C$1.0 billion in 2015 (based on the "enterprise value" of the business). However, as this change has yet to be implemented, the review and approval test remains at the C$299 million threshold, based on the traditional "book value of assets" test, subject to certain exceptions. It is likely that in the near term (particularly in light of the government's proposal to review the entire Investment Canada Act) the review threshold will be increased in the normal course, under the existing rules, by annual cost of living indexing to approximately C$310 million. Finally, the lower review thresholds of C$5 million that had applied to certain sensitive sectors have been repealed for financial services, transportation services, and uranium mining. Only cultural businesses continue to be subject to the C$5 million asset threshold for direct acquisitions of control (as well as to a special review by Heritage Canada, the department of the government of Canada with responsibility for cultural affairs).

2. Developments in Canadian Poison Pills

Canadian regulators have opened new room for debate in one area of Canadian securities law that had long been considered settled--the role of poison pills in defending against a hostile take-over bid. In contrast to Delaware practice, Canadian shareholder rights plans have traditionally been strictly limited to the single purpose of helping the board "buy time" to seek out improved or alternative offers. Once that purpose had been served, Canadian securities commissions would routinely "cease trade" poison pills, sending whatever offer was on the table to a shareholder vote. It was widely accepted that, under such conditions, a "just say no" defense was not available in Canada. This position was consistent with National Policy 62-202 of the Canadian Securities Regulators (an umbrella organization that co-ordinates policy among Canada's provincially-based securities regulators), which policy clearly states that the primary objective of take-over bid regulation is to protect the bona fide interests of the target's shareholders.

In two recent decisions, however, the Alberta Securities Commission (Pulse Data, 2007) and the Ontario Securities Commission (Neo Material, 2009) refused to cease trade shareholder rights plans, even where the target's board had not solicited other bids. In each decision, the commission in question was influenced by the fact that the poison pill had been strongly endorsed by the shareholders, while in Neo Material the OSC also acknowledged that tough economic times and the possibility of coercive bids might justify keeping the pill in place and, in addition, placed considerable reliance on Supreme Court of Canada jurisprudence stating that the board of directors' duty is to the corporation as such, rather than specifically to its shareholders.

The trend that seemed to be developing in Neo Material and Pulse Data was revisited by the OSC in its 2010 Baffinland Iron Mines Corporation decision. In Baffinland, the OSC issued an order cease-trading the shareholder rights plan on the basis that the rights plan had provided sufficient time for the Baffinland board to obtain a competing offer from ArcelorMittal SA and that the plan had accomplished the objective of stimulating an auction by obtaining a competing offer. The Baffinland board later approved a new rights plan and the transaction is ongoing. As a consequence of Baffinland and certain other developments, it is widely believed that the Neo Material and Pulse Data rulings will have considerably less long-term effect on the traditional Canadian position on poison pills than appeared likely at the time those rulings were made.

3. Continuing Demand for Canadian Commodities

Continuing demand by foreign investors for Canadian natural resources is almost a certainty in 2011. The most prominent recent example was BHP Billiton's abortive bid for PotashCorp, but many other multi-billion dollar transactions have proceeded more quietly. A key development in this sector is the emergence of more creative and strategic-based structuring for effecting transactions, not just conventional going-private transactions and takeovers. Alternative transaction structures in the mining sector include acquirors taking toe-hold positions in a target, coupled with a joint venture arrangement to provide for offtake, supply, or other strategic agreements (an "offtake" being an agreement with respect to the purchase of a portion of the production of a mine going forward, based on a predetermined pricing structure). Another well publicized creative structure occurred in the acquisition of a 51 percent stake in Uranium One (a company listed on the Toronto-based TSX) by Russia's ARMZ, which included an asset "vend-in" by ARMZ involving that company's stake in two Kazakh uranium mines.

4. Bridging the Gaps in Financing and Valuation

Notwithstanding increasing confidence in the Canadian economy, acquisition financing is still not always easy to arrange, and residual economic uncertainty continues to produce many real or perceived value differences between buyers and sellers. The continued use of various techniques for bridging gaps in financing and valuations is therefore likely, at least in the short term. These include earnouts, seller financing (typically secured and subordinated), seller rollover equity, and the seller receiving buyer stock (often accompanied by mutual "puts" and "calls," to ensure an ultimate takeout). Other more creative techniques that have recently been used in the Canadian marketplace include:

  • Structured equity, whereby the seller receives equity which provides a back-end payment tied to a hurdle rate of return--if the buyer meets the target over a period of time (usually three to five years), the seller participates in any upside.
  • "Loan to own" strategies or creeping takeovers in distressed situations, where a potential buyer makes a secured loan to a troubled target (possibly accompanied by warrants) so that, in the event of default, the secured lender is in a very strong position in any insolvency proceeding to "foreclose" on the target and own all or a significant portion of the equity.
  • Contingent value rights (CVRs), a form of transferable, earn-out security sometimes used as partial acquisition currency in the purchase of a public company. For example, CVRs have been used to guarantee the value of buyer's stock for a period after closing.
  • Standby equity distribution agreements (SEDAs) have recently provided increased flexibility to issuers in raising financing in Canada. SEDAs provide that one or more investors contractually agree to purchase, upon demand of the issuer, unissued shares of (smaller) publicly-traded companies in one or more tranches at a small discount from market (usually 5 percent or less) over a period of time (usually two years, with a right to renew for one or two additional years).

5. Hedge Funds, Pension Funds, and Other Pools of Capital

As always, the adage "follow the money" applies. Hedge funds, pension funds and other pools of capital have increasingly been taking active positions in public companies or participating in Companies' Creditors Arrangement Act-based transactions (or other distressed transactions). Sovereign Wealth Funds (SWFs), state-owned enterprises (SOEs), and hedge funds have also been active in the natural resource and oil and gas industries, both in Canada and abroad. In addition to Canadian pension funds, another emerging source of investment is coming from certain U.S. state pension funds that are creating new independent firms--such as the South Carolina Retirement System Investment Commission--to oversee their funds' private equity holdings. These are similar to the direct investment funds created by two of Canada's biggest pension plans, the Ontario Teachers' Pension Plan and the Canada Pension Plan Investment Board. In 2011, the Canadian M&A market is very likely to see increasing volumes of direct investment by large pools of capital that have not traditionally participated in such transactions. The indications are that this market is prepared to go where the cash is--whether it is with private equity firms, hedge fund investors, pension fund investment vehicles or elsewhere.

6. Growth of a Domestic High-Yield Debt Market

As credit markets begin to open up and liquidity pipelines begin to flow more freely, greater transactional leverage in Canadian M&A will almost certainly result. A key example is the emergence of a high-yield debt market in Canada. Beginning in 2009, such a market began to develop to raise the funds for potential acquisitions and other purposes. In 2010, as investors hungered for higher yields, Canadian companies continued to issue Canadian dollar-denominated, non-investment grade debt. Income trusts, which have been the principal Canadian issuers of high-yield debt, will likely retain their taste for this form of financing as they restructure as corporations (in response to a change in Canadian federal tax policy), providing new impetus to the high-yield market in the corporate sector. Certain recent Canadian transactions, such as the acquisition by RTL-Robinson Enterprises Ltd. of Westcan Bulk Transport Ltd., have already successfully used a high-yield debt issue as a financing mechanism. Over the coming year, as the domestic high-yield market continues to develop, high-yield debt should increasingly factor into M&A transactions, especially if, as expected, interest rates remain at near-historic lows.

7. Going with the (Cash) Flow in Valuations

In order to obtain more deal certainty on value, a number of Canadian institutional investors have begun to favor a multiple of "free cash flow" in valuing target companies in certain industries. Previously, potential acquirors had typically relied on any of several measures of the target's earnings multiple--derived from net income, "EBIT" (earnings before interest and taxes) or "EBITDA" (earnings before interest, taxes, depreciation and amortization), as the case may be.

The progression from net income to EBIT and EBITDA can be seen as an attempt to climb higher up the income statement to get a number closer to cash flow. The Canadian market is now seeing the free cash flow (FCF) method used with increasing frequency as an alternative way to achieve a valuation that reflects cash flow. FCF is generally defined as follows:

FCF = [Net Income] + [Depreciation and Amortization] - [Changes in Working Capital] -
[Capital Expenditures]

As this suggests, there are two fundamental differences between FCF and an alternative such as net income when it comes to valuation. First, the net income approach uses depreciation, while FCF measures the last fiscal period's net capital purchases, such that capital spending is in current dollars (although a disadvantage is that capital investment is discretionary and can be sporadic). A second difference is that FCF deducts increases in net working capital, while the net income method does not.

FCF is basically the cash flow available for distribution to all holders of security, including equity holders, debt holders, preferred stockholders, and convertible equity holders. It represents the cash that an entity is able to generate after expending the funds required to maintain and expand its asset base, thereby allowing the company to pursue opportunities that enhance shareholder value. Some investors, concerned that income can be clouded by accounting practices, believe that cash flow is much harder to obscure and that FCF gives them a much clearer view of the ability to generate cash (and thus profits).

8. Income Tax Developments

As the economy continues to improve and cross-border M&A activity increases, a number of recent amendments to the Canadian Income Tax Act and some long-standing deal structures and techniques will have an even greater impact:

  • The repeal of withholding tax on most cross-border interest payments should continue to facilitate accessing the most favorable sources of acquisition debt financing outside of Canada.
  • The repeal of Canada's compliance and withholding regime on cross-border equity dispositions (except where the equity effectively constitutes a real property interest) will facilitate sales by foreign investors holding shares of Canadian companies and will encourage new foreign investors contemplating an exit strategy devoid of most administrative hurdles.
  • As purchase prices increase, the use of "exchangeable shares" may become more prevalent, in order to provide a rollover for capital gains purposes for Canadian shareholders of a Canadian target where the consideration includes, in whole or in part, stock of a foreign acquiror.
  • Recent administrative rulings appear to have softened the harsh impact on Unlimited Liability Companies (ULCs) of the anti-hybrid rules contained in the Fifth Protocol to the Canada-U.S. Tax Convention, which had negatively impacted the payment of dividends and return of capital, among other things, to the U.S. ULCs have been used as "check-the-box" tax flow-through vehicles for U.S. tax purposes in many cross-border structures.

9. Bilateral Investment Treaties and M&A Transaction Structures

As global leaders in mining, resource and energy finance, Canada and its investors are increasingly recognizing the importance of bilateral investment treaties (BITs). BITs permit investors to seek monetary damages from foreign governments that violate their treaty obligations, as do the investment chapters of many free trade agreements, including Chapter 11 of NAFTA. The private, investor-state dispute mechanism typically allows foreign investors to bring claims for damages before independent arbitral tribunals in the event that foreign governments take harmful actions that violate BIT obligations, including those that prohibit discriminatory or unfair treatment or expropriation without adequate compensation.

In structuring investments and M&A transactions, Canadian counsel have traditionally been highly conscious of the implications of tax treaties and possible claims by indigenous peoples, but it is becoming equally important that investment into less stable countries is structured through a country that has a BIT with the host country (in conjunction with a favorable bilateral tax treaty). In light of this, it is likely that the Canadian government will continue to work toward the implementation of BITs in order to preserve Canada's leadership role in global mining, resource, and energy finance.

In August 2010, the Canadian government announced a C$130 million settlement of a Chapter 11 NAFTA claim by AbitibiBowater Inc. arising out of the expropriation by the government of Newfoundland and Labrador of certain water and timber leases held by Abitibi in that province. This is a reminder of the importance of bilateral investment treaties not only in Canada, but in making investments in other countries around the world.

10. Infrastructure

Infrastructure was one of the most robust trends in 2010, as pension funds and large private equity groups acquired infrastructure-focused companies and infrastructure assets. Examples include CPP Investment Board's October 2010 investment of C$894 million for a 10 percent stake in Ontario's Highway 407 Express Toll Route (407 ETR), soon to be supplemented with the additional 30 percent of 407 ETR that CPPIB will acquire as a result of its purchase of Intoll, an Australian company, for approximately C$3.6 billion. In 2011, there will be continued growth in acquisition and joint venture activity relating to transportation and energy infrastructure projects, including co-generation, nuclear, and hydro. Infrastructure-related M&A activity will remain a major theme in 2011, as stimulus spending continues and governments increasingly look to public-private partnerships (PPP) to bridge the gap between scarce public funds and public infrastructure needs--an important example being the recently concluded deal between Infrastructure Ontario and Windsor Essex Mobility Group to develop and maintain the C$1.6 billion Windsor-Essex Parkway. This was the first civil infrastructure PPP in Ontario and also the largest PPP in value in the province to date.

11. Similarities and Differences of Canadian and U.S. Deal Terms

We expect to see a continuation in 2011 of themes that have emerged over the past two years, namely a return to basics with cautious buyers; the return of more controlled auctions and the re-emergence of more strategic buyers (as distinct from financial buyers); the return of traditional bank financing (highly negotiated positive and negative covenants--no "covenant-lite" loans). In these respects, Canada and the United States are quite similar. However, while U.S. trends and practices in negotiated M&A transactions continue to be influential in Canada, counsel south of the border should nevertheless be aware of a number of marked differences. The recent ABA 2010 Canadian Private Target Mergers & Acquisitions Deal Points Study highlights some of the similarities and differences (compared with corresponding figures in the ABA 2009 U.S. Private Target Study):

  • Canadian transactions involve far fewer earnouts than U.S. transactions (29% in U.S.; 3% in Canada).
  • The concept of a Material Adverse Effect (MAE), as a defined qualifier of representations and warranties and/or conditions of closing, was defined in fewer purchase agreements in Canada than the U.S. (92% in U.S.; 73% in Canada).
  • The general survival period for representations and warranties was longer in Canada than in the U.S. (75% of Canadian deals specify 24 months or less, as compared to 88% in the U.S.).
  • "Baskets" (threshold or deductible for claims) as a percentage of transaction value totaled 69% for Canadian transactions for a basket of 1% of total value or less (U.S., 89%).
  • More interestingly, the cap on indemnity claims was the "purchase price" in 45% of the Canadian transactions (U.S., 5%) with only 17% of the Canadian transactions having a cap of 15% or less of purchase price (U.S., 64%).
  • Only 26% of Canadian transactions had an escrow or holdback component (U.S. figure not given; previous studies suggest that the figure in the U.S. is more than double that in Canada).
  • Finally, provisions relating to sandbagging are less common in Canada than they are in the U.S. (31% vs. 47%), and even when found in Canadian agreements are far more likely--by 21% to 10%--to be anti-sandbagging than pro-sandbagging (the reverse being the case in the U.S., where anti-sandbagging provisions were present 8% of the time vs. 39% of the time for pro-sandbagging provisions). Pro-sandbagging provisions are express statements that the buyer can seek indemnification for breach of warranties, notwithstanding knowledge of breach. Anti-sandbagging clauses can be dangerous for a buyer because, if not properly qualified, they invite the "you knew" defense for almost every claim.


These developments suggest that Canadian M&A is becoming increasingly globalized and increasingly creative. In an expanding economic climate with strong demand for energy and resources, there is every reason to believe that 2011 will see many more U.S.-Canadian transactions. For U.S. companies interested in international expansion, Canada is a familiar, accessible and stable market. For U.S. counsel advising such companies, the key is to understand that, in spite of the numerous similarities, there are certain distinctive aspects of Canada's legal landscape that must always be carefully considered when approaching a possible U.S.-Canadian transaction.