It would be an understatement to suggest that 2008 and 2009 to date has been a difficult period for private equity. Canadian private equity did not escape the trend and saw significant drops in fund formation and investment activity.
On the funds side, the global credit-market crisis has slowed the pace of capital commitments in new funds and caused institutional investors to re-balance their portfolios to accommodate dramatically lower public-market valuations. This (along with other trends) has contributed to a dramatic drop in fundraising by Canadian private equity funds.
Canadian funds remain materially smaller than their European counterparts. However, Canada remains a marketplace that attracts significant foreign private capital; it is notable that 46% of the top 50 active global private equity investors have disclosed some activity in Canada (source: Thomson Reuters).
A relatively unique characteristic of the Canadian private equity marketplace is the widespread participation of Canadian pension plans, both in terms of investment dollars and strategic deal direction. Active pension plans include Canada Pension Plan Investment Board, Ontario Teachers’ Pension Plan, Caisse de dépôt et placement du Québec and OMERS Capital Partners. Private equity investments by such plans cover a wide spectrum, including limited partner investments in private equity funds, co-investments with private equity funds, and direct and co-sponsored buyouts. It remains to be seen whether the effects of the ongoing credit crisis will impact on the commitment of these funds to private equity investing over the long term.
FUNDS
Structuring and offering considerations
At first glance, Canadian private equity funds are very similar in form and governance to private equity funds in the US and Europe (particularly those formed under English law or in the Channel Islands). Private equity funds are typically limited partnerships, managed by an affiliate of the fund sponsor, which is entitled to a management fee (usually 1-2.5% calculated on committed capital during the investment period and invested capital thereafter) and a carried interest of 20% payable out of the net income of the fund after limited partners have received a return of their contributed capital plus a preferred return (usually 8%).
In Canada, as in Europe, the distribution waterfall used for determining the timing of the payment of the carried interest to the general partner is usually calculated on a ‘whole fund’ or aggregate basis, as opposed to a ‘deal-by-deal’ basis. One notable difference is that in Canada, portfolio company fees are more often offset 100% against management fees, as opposed to a 50:50 or 80:20 split, or some more elaborate sharing mechanism, as is often seen in US and European funds. As in Europe, ‘LP (limited partner) givebacks’ to fund indemnity claims are uncommon, even though they are commonly seen in US funds.
Investments are most commonly offered by private placement exempt from the prospectus requirements of provincial securities legislation. Marketing is typically limited to accredited investors; institutional investors and private investors with significant assets or income. Private equity funds offered by way of private placement are often marketed through an offering memorandum that must provide investors with a right of rescission or damages against the fund for misrepresentation. Since limits on holdings of foreign property were lifted, we have seen a measurable increase in non-resident funds marketing to Canadian institutional investors.
Although the general partner of a fund may not need to register as a dealer or advisor under securities legislation, depending on the facts, the manager retained by the general partner or the fund (including a fund established outside Canada soliciting Canadian investors) may be required to register in those capacities.
Registration reforms are pending in Canada with eventual implementation pushed back to late 2009. It is anticipated that these registration reforms will, on the one hand, require investment fund managers in Canada to register under a newly created category, while on the other hand exempting foreign dealers and advisors from being required to register in Canada if their services involve foreign securities or advising or managing funds established outside of Canada.
Fund trends in the current market environment
We have observed the following trends and expect these trends to continue through 2009.
- Fundraising: many fund sponsors, particularly new entrants, experienced difficulty reaching their target commitments in 2008. We have seen several general partners with first closings in 2008 seek extensions, from their limited partners, of the outside date for subscriptions, or the ‘final closing date’ set out in fund limited partnership agreements.
- Capital call relief: while the amount of outstanding commitments or ‘dry powder’ that many funds have on tap provides solace to many, some funds and limited partners are concerned over the ability of limited partners to meet their capital call obligations. Defaults, with their onerous consequences, are not in the interest of either the fund or the limited partners concerned. As a result, several creative solutions have emerged, such as the establishment of ‘fund within a fund’ or feeder partnership structures within which limited partners seeking relief from their commitments can continue to hold interests in existing portfolio company investments, while other limited partners can maintain or increase their commitments and benefit from portfolio company investments made at lower multiples in the new ‘buyer’s market’.
- Secondary sales: we have also seen an increase in secondary market activity as limited partners concerned over their ability to meet capital calls, or seeking to reduce their absolute dollar allocation to private equity in light of declining public markets, sell their limited partnership interests.
INVESTMENT TRANSACTIONS
Equity investments
Private equity investments in Canadian private companies are most commonly made through convertible preferred stock, or subordinated debt convertible into common stock, or accompanied by warrants to acquire common stock. Convertible preferred stock offers numerous advantages, including priority on liquidation or sale, preferred return, preferential voting or consent rights on material matters, and convertibility that facilitates liquidation transactions. Subordinated debt convertible into common stock or accompanied by warrants also offers these advantages, with the additional benefit of security on the assets of the investee corporations.
Buyouts
For a variety of reasons, including the high costs of complying with corporate governance rules and (sometimes) limited liquidity of Canadian public markets, public-to-private transactions have become more common in Canada. Buyouts are typically completed through either a one-step amalgamation or a plan of arrangement transaction, where the target is merged with a wholly owned subsidiary of the buyer, or a two-step process involving a takeover bid, followed by an amalgamation or another squeeze-out transaction. Under Canadian corporate law, amalgamations, arrangements and other forms of going-private transactions typically require shareholder approval of 66 2/3% of the votes cast at a shareholder meeting.
‘Go-shop’ provisions, which permit a target that has signed a support agreement with an acquirer to shop the company for a limited period, and which have gained some acceptance in US leveraged buyouts (LBOs), remain relatively uncommon in Canada.
Canadian corporate laws provide safeguards for minority shareholders in a buyout, including the right for shareholders to dissent from fundamental corporate changes (such as an amalgamation) and to have their shares purchased at ‘fair value’ as determined by a court. In addition to corporate legislation, Ontario and Québec securities laws operate to ensure fair dealing for minority shareholders in going-private and insider transactions. If applicable, the most important requirements imposed by these laws are to:
- prepare and disclose a valuation of the target securities;
- obtain ‘majority of the minority’ approval of each class of equity shareholder; and
- provide certain prescribed disclosure to shareholders.
Generally, these requirements will apply if the proposed acquirer is related to the target when the transaction begins or if management participates in the transaction. The management incentive packages typically seen in leveraged buyouts will invariably trigger at least the majority of the minority requirements in Canadian LBOs.
Income trust acquisitions are not governed by Canadian corporate laws and are typically structured either as takeover bids or the sale of all assets underlying the trust. Income trusts are created by contract and, as a result, each structure is unique and must be examined closely when structuring an acquisition of control transaction. Income trust declarations of trust typically require approval of 66 2/3 % of the votes cast at a unitholders meeting to approve the sale of all or substantially all of the trust’s assets. Canadian securities laws do apply to the acquisition of an income trust. Consequently, the requirements described above that ensure fair dealing for minority security holders must be carefully considered.
Investing trends in the current market environment
We have observed the following trends and expect these trends to continue through 2009:
- Focus on deal terms: 2008 saw a significantly increased emphasis on contractual terms in acquisition agreements, including the structure and implications of ‘material adverse effect’ clauses (now heavily negotiated with a laundry list of carve-outs having their own exceptions for disproportionate effects), break fees and reverse break fees, as well as the availability of specific performance as a remedy. 2008 also saw an end to a strict linkage between break fees and reverse break fees as boards sought to penalise sponsors that might otherwise treat the reverse break fee as a pure option on their business.
- Lower leverage: 2008 deals saw greatly reduced leverage levels and structuring designed to ensure that existing credit facilities and debt arrangements could remain in place if at all possible following a change of control.
- Nervous boards of directors: recent transaction experience has made boards of directors nervous about the degree of commitment of financial sponsors. Boards are increasingly placing deal certainty (including time and risk to close) ahead of maximum price in prioritising the deal process, which can make it challenging for financial investors to compete with strategic investors, absent anti-trust or other regulatory issues for the strategic investors.
CURRENT REGULATORY ENVIRONMENT
The most relevant regulatory approvals from the perspective of an acquirer are those required under the Investment Canada Act (the ICA) (for acquisitions by non-Canadians) and the Competition Act. In addition, companies operating in certain industry sectors, such as the forestry, telecommunications, broadcasting and radio, uranium, financial services and transportation industries, as well as cultural businesses, may be subject to a vast array of other complex regulatory regimes and/or limitations on foreign ownership.
Under the ICA, the acquisition of control (or presumed control) of a Canadian business by a non-Canadian is either:
- eviewable, in which case it is subject to an application, review and approval process; or
- notifiable, in which case it is subject to a straightforward reporting requirement without a corresponding review and approval process.
Whether an investment is subject to review or notification will depend on, among other things, whether the Canadian business is being acquired directly or indirectly (through the acquisition of a foreign corporation) and whether applicable monetary thresholds are exceeded. Special rules also apply where the Canadian business is a ‘cultural business’, as defined in the ICA.
With a few limited exceptions, a reviewable transaction may not be completed unless the responsible Minister is satisfied that the transaction is ‘likely to be of net benefit to Canada’. It is common practice for the Minister to require a non-Canadian investor to provide binding undertakings relating to the operations of the Canadian business, typically for a period of three to five years, as a condition of approving the proposed transaction.
The Department of Industry has recently adopted guidelines that apply to the review of investments by state-owned enterprises (SOEs) (including sovereign wealth funds) under the ICA. The adoption of these guidelines indicates that the Minister will pay close attention to acquisitions of Canadian businesses by SOEs.
In addition, as a result of recent amendments to the ICA, the Minister has new powers under the ICA to require a review of certain transactions on the grounds of whether they could be injurious to national security. These provisions can apply to any acquisition of control of a Canadian business (whether or not the investment is subject to review), the establishment of a new Canadian business or the acquisition of a non-controlling interest in a Canadian business. The amendments provide for the Cabinet’s right to prohibit a transaction or require a divestment where a transaction has been completed on the grounds that the transaction may be injurious to national security or, where appropriate, accept undertakings to address concerns. In 2008 the Minister of Industry rejected the planned C$1.325bn sale of MacDonald, Dettwiler and Associates Ltd’s (MDA) Information Systems and Geospatial Service Operations division to US-based Alliant Techsystems Inc. Media reports indicated that national security concerns relating to Arctic sovereignty and the feared loss of control over the Radarsat-2 satellite operated by MDA may have influenced the Minister’s decision. It remains to be seen whether the MDA decision is a one-time change predicated on relatively unusual facts or reflects a change in the government’s approach to foreign investment in Canada, which it will be in a position to take more clearly under the amended ICA.
The merger rules established under the Competition Act also must be considered when acquiring a Canadian business. These rules apply in two principal ways. First, mergers that exceed certain prescribed thresholds are subject to mandatory notification to the Competition Bureau (the Bureau). In such circumstances, a notification must be submitted by the parties and the applicable statutory waiting period(s) must expire before a notifiable transaction can be completed. Secondly, all transactions that qualify under the Competition Act as a ‘merger’ are subject to the substantive provisions of the Competition Act. Under these provisions, the Commissioner of Competition (the Commissioner) can challenge a merger before the Competition Tribunal (the Tribunal) at any time before or within one year following completion of the merger where the merger is likely to substantially prevent or lessen competition in Canada. The Tribunal has wide remedial powers, including the right to order either divestments or a dissolution of the merger. As a result, while the merging parties are legally entitled to complete their merger once the applicable waiting period(s) have expired, in some cases the parties may elect not to close until the Commissioner completes their assessment. Unique to Canada, the Competition Act provides a full efficiencies defence whereby the Tribunal is precluded from making an order, where the merger is likely to result in merger-specific efficiency gains that will be greater than, and will offset, the resulting anti-competitive effects of the merger, even if a merger is likely to substantially harm competition. In some cases, the acquiring party may decide to negotiate a remedy with the Commissioner that addresses the Commissioner’s concerns in return for the Commissioner’s commitment not to challenge the merger.
PRIVATE EQUITY EXITS
The most common form of exit from Canadian portfolio investments remains a trade sale. While value may be less than could be received on an initial public offering (IPO), the generally shorter timeframe, limited securities regulatory compliance requirements and greater deal certainty frequently favour a trade sale.
IPOs through Canadian income trusts have been an extremely successful exit strategy for private equity investors. Unfortunately, the Income Tax Act (Canada) has been amended, effective from 2011, to substantially eliminate the tax advantages that income trusts previously held over the traditional corporate structure, effectively terminating the income trust exit strategy in Canada. It remains to be seen whether the traditional common share equity capital markets will provide a similarly viable exit in Canada in the future.
CONCLUSION
Given current market conditions, the challenges experienced by Canadian and international private equity in 2008 are likely to continue through 2009. In both the formation of new funds and the deployment (or redeployment) of existing capital, we expect the market uncertainty and related investment caution to result in a renewed focus on fees and deal terms, and a constant tension between the flexibility desired by investors and buyers and the certainty desired by vendors.
Nevertheless, Canada remains an attractive marketplace for both domestic and foreign private capital, and as global private equity and debt markets recover there is no question that Canada will continue to be an important source of both private equity capital and investment opportunities.
By Michael Gans, partner, Jason Gudofsky, partner, and Kim Harle, partner, Blake, Cassels & Graydon LLP.
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