Canada: Private Equity

Canada has a sophisticated private equity market that, though much smaller in size, is similar to and closely integrated with that of the United States. The most active financial sponsors in Canada include conventional privately managed private equity funds, as well as private equity branches of banks, pension funds, and provincial and federal government-controlled entities.

According to figures published by both Refinitiv [1] and the Canadian Venture Capital and Private Equity Association (CVCA) [2], 2021 proved to be an exceptional year for transactions in Canada, while the first three quarters of 2022 have shown a normalization or even reduction in the market. Deals involving a financial sponsor have largely followed these general market trends.

• 2021: Based on Q4 2021 data, Canadian buyout and related investment reached C$39.7 billion in 658 deals during 2021, an increase of 130% in dollar terms compared to 2020 levels, and the strongest annual period for buyout and related investments on record. The number of deals completed in 2021 represented the best year on record since 2005. Deal volumes and dollars invested in the fourth quarter totaled only C$6.4 billion in 180 deals, which was down 66% in deal values, and 2% in deal volumes from the previous quarter, but Q3 was itself the second-best quarter on record for buyout investment in Canadian companies.
• 2022: The data for 2022 does not reveal the same upwards trend. As of Q3 2022, Canadian buyout and related investment totaled C$12.2 billion of deal values across 361 transactions announced or completed throughout the first three quarters of the year. This resulted in a year-over-year decrease in values of 65% and in volumes of 35% from the first three quarters of 2021. Furthermore, financial sponsor exits fell 67% in the third quarter versus last year. One major reason for the decline has been uncertainty in the leveraged financing markets, which has had the effect of limiting the size of deals that financial sponsors have been able to execute. That said, financial sponsor activity remains on pace to return somewhere close to pre-pandemic levels in 2019-2020. Specifically, it is worth noting that private equity investors continue to actively invest and largely invest in Canada’s SMEs (87% of investments with disclosed values were under CAD $25M so far in the first half of 2022).

Footnotes:

1. https://www.refinitiv.com/en/products/deals-intelligence/private-equity-venture-capital?gatedContent=%252Fcontent%252Fmarketing%252Fen_us%252Fproducts%252Fdeals-intelligence%252Fprivate-equity-venture-capital)
2. https://www.cvca.ca/research-insight/market-reports

• As a general rule, financial sponsors selling a company will be seeking a “clean break” at the time of closing in order to accelerate return on investment payable to their stakeholders. In particular:
  • The use of R&W Insurance with limited recourse available by the buyer beyond the scope of the policy is common practice, though we note that it is also becoming increasingly popular among trade sellers.
  • The structure of the purchase price is affected by this priority to receive consideration up front; mechanisms of deferred consideration, earn outs and rolled equity are less frequent where the seller is a financial sponsor.
• Financial sponsors tend to be more focused on pure asset value and potential for growth as opposed to operational synergies, though for a number of reasons, this is less true today than it was a decade ago. This impacts everything from valuation, to due diligence, to post-closing action items.

In Canada, the transfer of shares is effected through the execution of a share purchase agreement, as well as a share transfer form representing the purchased shares. Accompanying corporate documents include resolutions of the buyer and seller parties, a resolution of the company confirming the transfer, the issuance of a new share certificate (if certificated), and an update to the corporate ledgers. No transfer taxes are payable on a sale of shares in Canada.

Financial sponsors will rarely intervene directly in the purchase agreement with a special purpose vehicle (SPV) buyer. Instead, financial sponsors will either agree to (i) put the balance of purchase price in escrow; or (ii) provide equity and debt commitment letters. In the case of (ii), the equity commitment letter is typically addressed solely to the SPV, and provides a firm commitment to pay the subscription price equal to the portion of the purchase price the SPV owes to the seller, while the debt commitment letter confirms the debt to be assumed by the SPV to make up the balance of the purchase price.

Locked box pricing mechanisms are very uncommon in Canadian transactions. While some might argue that current market trends (particularly, a strong seller’s market and increased involvement of financial sponsors) might eventually lead to the increased use of locked box pricing mechanisms in North American transactions, no such trend is yet observable in the Canadian market.

• Financial sponsor buyers are not sympathetic to assuming risks related to business before it becomes the owner. They overwhelmingly tend to adopt the principle of “your watch/our watch” on all matters. However, the current climate has been a “seller’s market”, which has resulted in competitive processes and more tempered provisions in this regard. 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 terms of how these risks are allocated in practice:
• 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.
• Traditional negotiation of representations and warranties (scope and materiality/knowledge qualifications) and indemnification provisions (baskets and caps) to allocate risks of misrepresentations and breach of covenants.
• Escrows traditionally served as the classic deal protection and risk allocation mechanism. Today, we are seeing escrows increasingly supplemented or even replaced entirely by representations and warranties insurance (RWI). This is particularly true in deals backed by financial sponsors.

Financial sponsors in Canada have readily adopted the RWI product in their transactions, although its use is not universal and there is still much opportunity for growth in the Canadian market. 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.

While acquisitions by financial sponsors of public companies are not unusual, they are far less common than acquisitions of private companies. When they do occur, it is generally implemented through a plan of arrangement, merger or takeover bid that is subject to the securities laws applicable to the listed company. Acquisitions of public companies by financial sponsors 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. Given the current state of capital markets and the prevalence of dry powder, we expect to see financial sponsors increasingly looking to buy public company targets.

Investment Canada Act – Net Benefit to Canada
Pursuant to the Investment Canada Act (ICA), an acquisition of control by a non-Canadian of a Canadian business, and/or the establishment by a non-Canadian of a new Canadian business, is subject to either notification or 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. The review thresholds are indexed and are revised annually.

For 2022, the applicable thresholds are as follows: (1) C$1.141 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) C$1.711 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) C$454 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) C$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 prior to or within 30 days after closing.

Investment Canada Act – National Security

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.

The Competition Act sets forth both a “transaction-size” threshold and a “party-size” threshold for acquisitions in Canada. If both of these thresholds are exceeded, a transaction is considered “notifiable” and it triggers a pre-merger notification filing with the Competition Bureau. The “transaction-size” threshold is subject to annual adjustment. The 2022 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 C$93 million. The “party-size” threshold has remained 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 C$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, 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.

Co-invests are relatively common in Canada. We have seen an increase in minority investments in 2022, 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. We also increasingly see investors requiring restrictions on the structure of future co-investments. In addition, we have seen an increase in “continuation fund” transactions, where a financial sponsor divests one or more portfolio companies to funds managed by the same sponsor.

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 an employee that allows the employee to purchase stock of the company at a pre-determined, 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.

At the time stock options are exercised by an employee, a taxable benefit is generally 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 corporation (CCPC) at the time the options are granted (“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 and/or public corporations.

Under the current rules, an 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 legislative changes now 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) otherwise subject to, upon exercise, the 50% deduction allowed under the General Deduction Rule. Under such changes, 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 calendar year in which the option becomes exercisable (assuming rights to acquire the shares under such option become exercisable on a pro rata basis over a period starting on the grant and ending at the earliest of: (A) 60 months after the grant of the option, and (B) the expiry of the option). Employee stock options above the $200,000 annual vesting limit would not qualify for the 50% deduction under the General Deduction Rule. This annual vesting limit does not apply to employee stock options granted by: (i) CCPCs; and (ii) non-CCPCs that, on a consolidated group basis, reported $500M or less of revenue in their last consolidated statements.

Non-competes are frequently included in employment agreements of senior executives. If properly drafted as to scope, territory and duration, they can be enforceable, though Canadian courts are proving increasingly unwilling to enforce them. In fact, Ontario has just passed legislation that bans outright any non-competition clause in an employment agreement, except where the employee is (i) a vendor of the business, or (ii) serves as president or in another chief executive role. In jurisdictions where non-competes are enforceable, such as Québec, the maximum allowable duration of a management non-compete is typically 24 months, with 12-18 months being closer to the norm.

Financial sponsors will negotiate a variety of controls in the shareholders’ agreement. Such rights typically include: (i) nomination of a majority of the members of the board of directors; (ii) information rights (e.g. requiring the company to submit timely financial and other relevant metrics to the shareholder on a set schedule); and (iii) a detailed 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.

Management pooling vehicles are used in Canada, although their use is not universal. Such pooling vehicles are typically used to simplify voting and decision making 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, as well as drag-along provisions requiring them to sell their shares alongside the financial sponsor.

In Canada, we most commonly see conventional “cash flow based” credit facilities including term loans that are generally accompanied by revolving facilities to finance operating requirements and future permitted acquisitions. Over the past few years, delayed-draw term loans to finance anticipated capital expenditures and future permitted acquisitions have become increasingly common. Subordinated debt is also ubiquitous in the Canadian market. ABL structures are sometimes utilized where there is not sufficient cash flow to support cash flow-based structures.

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

There is no standard form of credit agreement in the Canadian market. Negotiation is generally limited to moderate, as the most active firms in the space are well aware of the current market position on the most terms.

The following have been the key areas of negotiation: (i) financial leverage covenants (opening leverage, in particular), (ii) EBITDA add-backs and, to a lesser extent, (iii) equity cure provisions (which are now broadly accepted, though they are focused on EBITDA support as opposed to being applied as debt reduction) and (iv) cash flow sweeps on smaller transactions.

Use of capital raised from private debt funds remains relatively uncommon on transactions where the lenders, sponsor and target are primarily domiciled in Canada. There has, however, been an increase in the utilization of alternative sources of credit capital on the largest transactions and those where a US domiciled sponsor is executing a Canadian acquisition.