Canada: Private Equity (2nd edition)

1. What proportion of transactions have involved a financial sponsor as a buyer or seller in the jurisdiction over the last 24 months?

According to Refinitiv buyout-related deals in the first nine months of 2019 account for 23% of Canadian M&A activity. This is up from 16% a year ago. M&A transactions generally have declined by 11% compared to 2018 figures, which may account for the proportionate increase.

2. What are the main differences in M&A transaction terms between acquiring a business from a trade seller and financial sponsor backed company in your jurisdiction?

Financial sponsors selling a company are seeking a "clean break" at time of closing in order to accelerate return on investment payable to their stakeholders. The use of R&W Insurance with limited recourse available by the buyer beyond the scope of the policy is therefore common practice. The structure of the purchase price is also affected by this priority to receive consideration upfront; as such, mechanisms of deferred consideration, earn outs and rolled equity are less frequent where the seller is a financial sponsor.

3. On an acquisition of shares, what is the process for effecting the transfer of the shares and are transfer taxes payable?

Financial sponsors selling a company are seeking a "clean break" at time of closing in order to accelerate return on investment payable to their stakeholders. The use of R&W Insurance with limited recourse available by the buyer beyond the scope of the policy is therefore common practice. The structure of the purchase price is also affected by this priority to receive consideration upfront; as such, mechanisms of deferred consideration, earn outs and rolled equity are less frequent where the seller is a financial sponsor.

4. How do financial sponsors provide comfort to sellers where the purchasing entity is a special purpose vehicle?

Financial sponsors will rarely intervene directly in the purchase agreement with an SPV purchaser. Instead, financial sponsors will either agree to put the balance of purchase price in escrow or provide equity and debt commitment letters. The equity commitment letter is typically addressed solely to the SPV, and provides for a firm commitment to pay the subscription price equal to the portion of the purchase price the SPV owes to the seller. Concurrently, the debt commitment letter confirms the debt to be assumed by the SPV to make up the balance of the purchase price.

5. How prevalent is the use of locked box pricing mechanisms in your jurisdiction and in what circumstances are these ordinarily seen?

Locked box mechanisms are very uncommon in Canadian transactions.

6. What are the typical methods and constructs of how risk is allocated between a buyer and seller?

Financial sponsor buyers are not sympathetic to assuming risks related to business before it becomes owner. They adopt the principle of "your watch/our watch" for all matters. However, the current climate has been a "seller's market", which has resulted in competitive processes and more tempered provisions. In such circumstances, financial sponsor sellers have successfully forced a more seller-friendly purchase agreement, with limited recourses available to the buyer post-closing.

In two step transactions, the closing conditions to the purchase agreement will typically include (i) a bring down of representations and warranties with a materiality scrape; (ii) no material adverse effect. In addition, interim period covenants will cover ordinary course operation of the business.

7. How prevalent is the use of W&I insurance in your transactions?

Duff & Phelps estimate market penetration of representation and warranty insurance at approximately 17% of the addressable market, suggesting there is still room to grow. It should be noted that the addressable market is not exclusive to the financial sponsor context.

Financial sponsors have readily adopted the representations and warranties insurance product in their transactions, although use is not universal. The size of the deal and competitiveness of the process is still a key determinant in the use of the product. While there is a trend towards adoption of a full "clean break" with the advent of this product, in Canada, it is still common to see a combination of indemnification escrows as a first recourse prior to the policy, and specific indemnities for known (and uninsured) risks may still be requested.

8. How active have financial sponsors been in acquiring publicly listed companies and/or buying infrastructure assets?

Acquisitions by financial sponsors of public companies are not nearly as common as acquisitions of private companies. Where they do occur, the acquisitions of public companies are virtually all "friendly" acquisitions having been negotiated with the support of the target board and the securing of voting support agreements from key shareholders. Some recent notable pending privatizations by financial sponsors include the acquisition of WestJet by Onex, the acquisition of Canfor Corp. by Great Pacific Capital Corp., and the sale of Ridley Terminals Inc. (a Canadian crown corporation) to a company owned by Riverstone Holdings and AMCI Group.

Investments in infrastructure assets is common in Canada, with many specialty funds established or having a division focusing exclusively on this asset class.

9. Outside of anti-trust and heavily regulated sectors, are there any foreign investment controls or other governmental consents which are typically required to be made by financial sponsors?

Pursuant to the Investment Canada Act (ICA), an acquisition of control by a non-Canadian of a Canadian business, and the establishment by a non-Canadian of a new Canadian business, is subject to notification or to review and approval according to a "net benefit to Canada" test where a specified threshold is exceeded. Factors to be considered under this test (as enumerated on the government of Canada website) include: (1) the effect on the level of economic activity in Canada, on: employment, resource processing, the utilization of parts and services produced in Canada, and exports from Canada; (2) the degree and significance of participation by Canadians in the Canadian business or new Canadian business and in any industry or industries in Canada; (3) the effect of the investment on productivity, industrial efficiency, technological development, product innovation and product variety in Canada; (4) the effect of the investment on competition within any industry in Canada; (5) the compatibility of the investment with national industrial, economic and cultural policies; and (6) the contribution of the investment to Canada's ability to compete in world markets. These review thresholds are indexed and are revised annually.

For 2019, the applicable thresholds are as follows: (1) Cdn$1.045 billion in enterprise value for a direct acquisition of control of a Canadian (non-cultural) business by a WTO investor that is not a state-owned enterprise; (2) Cdn$1.568 billion in enterprise value for direct acquisition of control of a Canadian (non-cultural) business by a "trade agreement investor" (i.e., investor from countries with whom Canada has a trade agreement, such as the U.S. the E.U).; (3) Cdn$416 million in asset value for a direct acquisition of control of a Canadian (non-cultural) business by a state-owned enterprise from a WTO member country; and (4) Cdn$5 million in asset value for a direct acquisition of control of a Canadian cultural business.

If the applicable threshold for a net benefit to Canada review under the ICA is not met or exceeded, the acquisition of control of any Canadian business by a non-Canadian entity is subject to a relatively straightforward notification, which can be made either before or within 30 days after closing.

Separate and apart from the net benefit to Canada review process, the ICA also contains a mechanism to allow the Canadian government to review a foreign investment on national security grounds. There are no thresholds for such national security reviews; rather, they can be initiated at the discretion of the government.

10. How is the risk of merger clearance normally dealt with where a financial sponsor is the acquirer?

The Competition Act prescribes a "transaction-size" threshold and a "party-size" threshold for acquisitions in Canada. If both thresholds are exceeded, a transaction is considered "notifiable" and it triggers a pre-merger notification filing. The "transaction-size" threshold is subject to annual adjustment. The 2019 transaction-size threshold requires that the book value of assets in Canada of the target, (or in the case of an asset purchase, the book value of assets in Canada being acquired), or the gross revenues from sales in or from Canada generated by those assets exceeds Cdn$96 million. The "party-size" threshold remains unchanged from 2018, requiring that the parties to a transaction, together with their affiliates, have assets in Canada or annual gross revenues from sales in, from or into Canada, exceeding Cdn$400 million.

Transactions exceeding such thresholds cannot close until notice has been provided and the statutory waiting period has expired or has been terminated or waived. As such, it goes without saying that any required clearance under the Competition Act is a condition to closing. A "hell or high water" undertaking is sometimes accepted in where there is a regulatory condition; this provision is negotiated and ultimately depends on the nature and regulatory sensitivity of the deal.

11. Have you seen an increase in the number of minority investments undertaken by financial sponsors and are they typically structured as equity investments with certain minority protections or as debt-like investments with rights to participate in the equity upside?

Co-invests are relatively common in Canada. We have seen an increase in minority investments, especially where institutional investors have teamed up to pursue larger deals. We have also seen increased minority shareholder protections being negotiated. The structure of the minority investment varies depending on the deal and the role and interaction between the various sponsors. The most popular structure remains straight common equity, although we see other types such as convertible instruments or preferred shares.

12. How are management incentive schemes typically structured?

The most common management incentive regime used in Canada is the employee stock option plan. An employee stock option is generally a right granted by a company to its employees that allows the employees to purchase stock of the company at a predetermined fixed price. Typically, the stock option will vest (become exercisable) over a certain period of time (frequently 4-5 years) and will survive and be exercisable for a finite period of time before it expires. Stock options may also include a performance vesting criteria. The options, once vested, may be exercisable into voting or non-voting shares. Stock options present advantageous tax treatment to Canadian resident employees, as described below.

13. Are there any specific tax rules which commonly feature in the structuring of management's incentive schemes?

At the time stock options are exercised by an employee, a taxable benefit is added to the employee's income to the extent the fair market value ("FMV") of the underlying shares exceeds the exercise price specified in the option agreement. However, if the company is a Canadian-controlled private corporations ("CCPC") at the time the options are granted (the "CCPC Options"), the benefit is not subject to tax until the year of disposition of the shares. A CCPC is generally defined as a private Canadian corporation that is not controlled by non-residents or public corporations.

Under the current rules, the employee can claim a deduction equal to 50% of the amount of the taxable benefit provided that (i) common shares are issued upon the exercise of the options and (ii) at the time of the grant, the options are not in-the-money (i.e. the exercise price is not less than the FMV of the underlying shares at the time of grant) (the "General Deduction Rule"). For CCPC Options, the 50% deduction is also available if the employee has not disposed of the shares within two years after the date he acquired them.

Recent draft legislative proposals, if enacted as proposed, would impose a $200,000 annual vesting limit on employee stock option grants (based on the FMV of the underlying shares at the time the options are granted) that could be entitled to receive the 50% deduction allowed under the General Deduction Rule. Under the new regime, a vesting year in respect of an option agreement is determined by either: (i) the calendar year in which the employee is first able to exercise his or her option as specified in the option agreement; or (ii) if the option agreement does not specify a vesting time, the first calendar year in which the option can reasonably be expected to be exercised. Employee stock options above the $200,000 annual vesting limit would not qualify for the 50% deduction under the General Deduction Rule.

The new annual vesting limit would not apply to employee stock options granted by: (i) CCPCs; and (ii) non-CCPCs that meet certain prescribed conditions (yet to be released). The new draft legislative proposals will apply to employee stock options granted on or after January 1, 2020.

14. Are senior managers subject to non-competes and if so what is the general duration?

Non-competes are relatively frequent in employment agreements of senior executives and, if properly drafted as to scope, territory and duration, enforceable in Canada. The longest duration of management non-competes is typically 24 months.

15. How does a financial sponsor typically ensure it has control over material business decisions made by the portfolio company and what are the typical documents used to regulate the governance of the portfolio company?

Financial sponsors will negotiate a variety of controls in the shareholders agreement. Such rights typically include: (i) nomination of a majority of the members on the board of directors; (ii) information rights (requiring the company to submit timely financial and other relevant metrics to the shareholder on a set schedule); and (iii) a laundry list of "special approvals" or vetoes that must be presented to the financial sponsor, as shareholder, prior to implementation (notwithstanding any board approval). These approvals are largely negotiated on a case by case basis; examples include items such as approval of annual budget, incurring of additional debt, capex expenditures, changes to key management, settling material litigation. It is not uncommon for the board to also adopt a delegation of authority establishing the parameters for various levels of management, executive management and board level approvals.

16. Is it common to use management pooling vehicles where there are a large number of employee shareholders?

Management pooling vehicles used in Canada although there may not be seen as the rule. Such pooling vehicles are typically used to simplify decision making (voting) at the shareholder level in the investee corporation. When such structure is used, the shareholders agreement of the investee corporation will address the impact and issues at the pooling vehicle level (and prevail over any other agreement or undertaking that employee shareholders may have). Typically, management shareholders will be subject to all customary transfer restrictions, and drag along provisions in a shareholders agreement requiring them to sell their shares alongside the financial sponsor's position.

17. What are the most commonly used debt finance capital structures across small, medium and large capital financings?

In Canada, we most commonly see conventional term loans that are generally supported by revolving facilities to finance operating requirements and future permitted acquisitions. Subdebt is also ubiquitous in our market.

18. Is financial assistance legislation applicable to debt financing arrangements? If so, how is that normally dealt with?

Financial assistance legislation is rarely relevant in the Canadian market. It only factors in limited instances involving certain foreign guarantees.

19. For a typical financing, is there a standard form of credit agreement used which is then negotiated and typically how material is the level of negotiation?

There is no standard form of credit agreement in the Canadian market. Negotiation is generally moderate, as the most active firms are well aware of the current market position on the most contentious terms, and banks will use their forms and allow minimum deviations.

20. What have been the key areas of negotiation between borrowers and lenders in the last two years?

Financial leverage covenants, EBITDA add-backs and, to a lesser extent, equity cure provisions (which are now broadly accepted) are commonly negotiated.

21. Have you seen an increase or use of private equity credit funds as sources of debt capital?

Private equity credit funds remain relatively uncommon in Canada. However, in the past 2 years, there has been a notable increase in the creation of these alternative sources of credit capital.

Originally published by Legal 500 Practice Guide – Private Equity (2nd Edition) Canadian Chapter.

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