The Canadian private equity market has been steady over the past few years, seeing robust multiples and continued competition for transactions and strength in deal volume. Deal flow in Canada continues to be dominated by traditional sectors such as industrial and manufacturing, and technology. Financial institutions and the more specialized sector of payment processing has seen increased activity following global consolidation trends in the industry. Agro-food deals may be more uniquely Canadian, and there has been an uptick in this space from private equity players in 2019. This article covers private equity deal activity for 2018 and 2019 (up to the third quarter) and recent trends in the legal landscape for private equity deals.
2018 Deal Activity
In 2018, there were 324 Canadian private equity deals, representing a small contraction of 8.6% as compared to 2017. By deal value, C$52 billion in private equity activity was reported, which represents a decline of 6% as compared to 2017. While the numbers may indicate a contraction in the year-to-year comparison, it should be noted that 2017 Canadian private equity activity was at its highest rate in 10 years in terms of deal count and deal value. As such, the market remained relatively healthy in 2018 with the second-highest aggregate deal value in the past decade.
The strength of the Canadian private equity market is the mid-size transaction. By size, the largest proportion of Canadian private equity deals in 2018 were under C$100 million, with 250 deals accounting for approximately 77% of all deal volume for the year. Conversely, there were only nine transactions over C$500 million. Of these, five were in the C$500 million to C$1 billion range, one was in the C$1 billion to C$2.5 billion range, and three amounted to over C$2.5 billion.
Of the major sectors in Canadian private equity, the business-to-business sector again remained at the top in 2018 (37%) with the information technology sector following (21%) and the business-to-customer sector remaining in third (18%). Other ancillary sectors included energy (7%), healthcare (6%), financial services (6%), and materials and resources (5%).
A notable private equity deal in 2018 was GFL Environmental Inc.’s completed C$5.1 billion recapitalization by an investor consortium which included the Ontario Teachers’ Pension Plan, thus making it one of the largest environmental services companies in North America.
2019 Deal Activity
Mid-market deal size continues to be the engine of Canadian private equity activity with most of the announced deals in 2019 being under C$100 million. Thus far, as of the third quarter of 2019, 202 private equity deals representing C$6.83 billion in capital invested have occurred. The first quarter of the year started off stronger in terms of volume, garnering 81 deals with C$651 million in capital invested. The second quarter accounted for 58 deals and C$1.7 billion in investment, while the third quarter resulted in 63 deals with C$4.45 billion in capital invested. A significant transaction announced in 2019 is Onex Corp.’s C$5 billion buy-out of WestJet Airlines Ltd.
The breakdown by sector for 2019 is largely in line with prior years’ results as the business-to-business sector accounted for the highest proportion of 2019 deals, followed by the information technology and business-to-consumer sectors periodically outpacing each other to take the second spot in terms of number of deals by sector.
One notable trend in Canada in 2019 has been the creation of specialized, industry-specific funds, in addition to the continued maturation of more traditional private equity funds. Over the past year, structuring and fundraising efforts have been deployed for funds focused on sectors ranging from real estate, insurance, and financial institutions to agro-food, cleantech, cannabis, and life sciences. Private equity players are also exploring alternative funds focused on distress financing and credit and other flexible capital, as a complement to M&A activity.
It will be interesting to see how the development of these alternative vehicles impacts the transaction landscape — for example, in attracting a broader range of entrepreneurs to consider private equity partnerships or by creating increased competition from more private equity buyers. The heightened level of understanding and sophistication a specialized fund develops within a particular industry may also lead to more obvious front-runners in auction processes and large-scale consolidation activities in previously fragmented industries.
Private Equity Exits
The year 2018 saw the second-highest private equity–backed exit value ever with 84 exits totaling $35.2 billion. This illustrates a high level of activity for private equity sellers within the past five years. While exit count is lower compared to 2017, by 11 deals, exit value in 2018 was C$11.4 billion higher than its equivalent value in 2017. The defining transaction of the year was Berkshire Hathaway & OMERS Private Equity’s C$4.9 billion sale of Husky Injection Molding Systems Ltd. to Platinum Equity LLC, which ranked as Canada’s top exit in 2018.
Secondary buy-outs often represent a large proportion of private equity–backed exits, but 2018 represented a shift in this trend. Notably, sponsor-to-sponsor sales accounted for a majority of the year’s private equity–backed exit value.
Since the third quarter of 2019, there have been 49 exits worth C$6.95 billion. A notable transaction occurring in the near future is GFL Environmental Inc.’s initial public offering led by BC Partners and Ontario Teachers’ Pension Plan. The offering is expected to raise approximately C$1.9 billion and would represent Canada’s largest initial public offering in approximately five years, providing further credibility for the Canadian markets to deliver on large public offerings.
Private Equity Fundraising
Fundraising in 2018 resulted in the closing of only two capital raises worth C$1.2 billion. However, it should be noted that 2017 resulted in the highest level of fundraising in the last decade with seven raises totaling C$11.6 billion. Comparatively, 2019 fundraising up to the third quarter is showing signs of promise. Prominent raises in 2019 include Brookfield Properties’ global private real estate fund raise of C$15 billion and DW Healthcare Partners’ raise of C$610 million for its new Fund V.
Private Equity Deal Structures in Canada
The most common deal structures used for private equity transactions for public-take-privates are the plan of arrangements and take-over bids. In comparison, private company transactions are generally structured as share deals or asset deals depending on tax and liability considerations. There follows a brief discussion of these structures and certain current trends in these structures.
Plan of Arrangements
A plan of arrangement is the preferred transaction structure used to implement negotiated public merger and acquisition transactions in Canada. A plan of arrangement is a court-sanctioned process (similar to the UK scheme of arrangement) used when both parties to a transaction are “friendly” and willing to enter into an agreement subject to negotiations and requisite approvals.
A key consideration in a plan of arrangement is the fairness opinion received by the target company board of directors, which is customary in all public company transactions. As a result of recent litigation in the acquisition by Exxon Mobile of InterOil in 2016, where the court questioned the adequacy of financial disclosure in the fairness opinion received by InterOil, parties and their advisors should carefully consider the scope of financial disclosure and the independence of the financial advisors when relying on a fairness opinion as part of the approval process for a plan of arrangement and whether a second “fixed fee” fairness opinion is required if the financial advisor is receiving a success fee. We believe the market is moving in this direction.
Conversely, few private equity deals are conducted by way of take-over bid (whether friendly or hostile) in Canada. Regulatory hurdles, complex compliance requirements for non-Canadian bidders, as well as delays and costs associated with possible second-step (squeeze-out) transactions are major deterrents. A formal take-over bid is required under Canadian securities laws when an acquirer acquires 20% or more of the securities of a class of a target company.
Canadian hostile bids have declined over the past decade, probably as a result of the new take-over bid rules implemented in 2016. These rules now mandate a 105-day minimum deposit period whereby offers must stay open for this time in order to allow the target company to reflect, decide, and potentially solicit competing offers.
Trends in Deal Terms
Representation and Warranties (R&W) Insurance
In the last five years, there has been an uptick in the use of representation and warranty (R&W) insurance by private equity buyers and sellers. Canadian private equity deals continue to be cross-pollinated by American deal terms, both for buyers and sellers, with a view of creating a more competitive process. As such, the insurance coverage is broadening in relation to terms and coverage, increased capacity in the market, competitive pricing, and a marked improvement in the underwriting process. With the widespread adoption of representation and warranty insurance, there has been a trend towards smaller or absence of indemnification escrows.
Overall, indemnification deal terms are becoming more seller-friendly given the competitiveness among private equity buyers. Sellers in Canadian private equity transactions seek to limit liability through the use of materiality thresholds and knowledge qualifiers when providing representations and warranties, the application of baskets and deductibles (i.e., imposing minimum thresholds that must be obtained before out-of-pocket expenses are paid), shortened durations for representations, and warranties and reducing the cap on indemnification. In competitive auctions private equity buyers are offering very limited indemnity packages and, in some cases, a public style indemnity with no recourse to the seller after closing.
The duration of representations and warranties in a non-insured deal typically range from 12 to 24 months (with carve-outs for fraud or specific representations such as fundamental representations, which can last longer). Following US trends, fundamental representations are now restricted in time, although often longer than the general duration for other representations. As a result, sophisticated private equity purchasers have sought to expand the definition of fundamental representations beyond what was covered historically (share ownership and authority to sell) to include some creative core zones of risk, such as intellectual property.
Legal Consideration in Canada Private Equity Deals
In recent years, competition/antitrust enforcers around the world, including Canada, have taken a marked interest in private equity deals. This is part of a broader global trend towards tougher merger enforcement. Private equity firms that take ownership positions (controlling or minority) in portfolio companies that are competitors have been subject to heightened scrutiny. Just recently, Canada’s competition enforcer, the Competition Bureau, sought to unwind a completed merger involving the acquisition of Aucerna (a company offering valuation and reporting software to oil and gas producers) by Thoma Bravo, a private equity firm, in circumstances where Thoma Bravo already owned a competing business to Aucerna. The litigation was settled very recently by way of a registered consent agreement, after Thoma Bravo agreed to divest a major business within its control to a purchaser acceptable to the Competition Bureau.
Further, there is a greater focus in Canada on scrutinizing foreign investments in Canadian businesses on national security grounds, particularly investments involving foreign state-owned enterprises. A consequence of this focus is greater scrutiny of private equity investors that may have ties to or significant investment from state-owned enterprises.
Trends for Energy, Infrastructure, and Resource Projects
Two important and recent trends affecting Canadian energy and infrastructure investments and transactions are the increasing number of deals in sectors involving private equity and other financial buyers and major projects and transactions involving Canadian Indigenous groups. In some high-profile cases the two trends are evident in the same transaction.
Private equity interest and deal flow in Canada is increasing with private equity investment focusing on opportunities in the Canadian energy and infrastructure sectors. Given the status and importance in Canada of Indigenous rights and title affecting many of these sectors and projects, major transactions or projects in Canada increasingly consider or involve First Nations, or groups of First Nations, often as a minority interest in the business or transaction structure, with the intent of aligning business, reconciliation, and other interests. The two trends are combining to create unique opportunities and arrangements in Canada including transaction and business structures involving private equity/Indigenous co-ownership and business models. A notable transaction in 2019 involving private equity investment and First Nation participation is the recent acquisition by private equity firms of the Ridley Terminals in British Columbia with minority participation by two First Nation communities.
Proposed Changes to Stock Option Tax Treatment
Stock options have historically been used by private equity firms in Canada as an effective means of incentivizing management teams. In Canada, stock options are considered part of employment income, and taxed accordingly. Further, they are taxed at time of exercise, not grant. Given these attributes, stock option plans have been widely used within portfolio companies. Proposed amendments to the taxation regime for stock options should therefore be followed carefully.
In its 2019 Federal Budget, the Canadian government outlined its proposal to introduce a C$200,000 annual limit on employee stock option grants for employees of “large, long-established, mature firms.” The government explains that the current regime disproportionally benefits executives of large, mature companies who take advantage of the rules as a preferred form of compensation instead of achieving the policy objective of supporting younger and growing Canadian businesses. The new draft legislative proposals will apply to employee stock options granted on or after January 1, 2020.
Under the current stock option rules, a taxable benefit is added to the employee’s taxable income at the time of exercise, to the extent the fair market value of the underlying shares exceeds the exercise price specified in the option agreement. However, the employee is entitled to claim a deduction in the amount of 50% of the taxable benefit provided that at the time of the grant, the options are not “in-the-money” and, generally, common shares are issued upon the exercise of the options.
If enacted as proposed, the legislation would impose a C$200,000 annual vesting limit on employee stock option grants (based on the fair market value of the underlying shares at the time the options are granted) that could be entitled to receive the 50% deduction. This vesting limit would not apply to employee stock options granted to either Canadian-controlled private corporations (CCPCs) or non-CCPCs that meet certain prescribed conditions (yet to be released).
The federal government is currently seeking input on the characteristics of companies that should be considered “start-up, emerging, and scale-up companies” for purposes of the prescribed conditions as well as views on the administrative and compliance implications associated with putting such characteristics into legislation. Given an upcoming federal election and this ongoing consultation process, it is unclear if or how these provisions will ultimately be implemented.
CBCA Disclosure of Beneficial Ownership
As of June 13, 2019, companies governed by the federal statute in Canada, the Canada Business Corporations Act (CBCA), are required to maintain a detailed shareholder register that reflects all individual shareholders having significant direct or indirect control over the corporation. With the CBCA amendments, the new regime will now require private corporations to expand their central securities register to also include information about individuals who hold “significant control” over the corporation. The number of shares held by an individual is deemed “significant” if it (i) carries 25% or more of the voting rights attached to all the corporation’s outstanding shares, or (ii) is equal to 25% or more of all the corporation’s outstanding shares measured by fair market value. Practically speaking, private equity funds often hold controlling positions (in terms of percentage owned or, in fact, through shareholder arrangements) in their portfolio companies governed by the CBCA and should therefore be prepared to provide additional information about their own controlling interests.
Conclusions for the Remainder of 2019
Given the deal activity up to the third quarter of 2019, as well as general market trends and current events, we are optimistic for continued strength in 2019. Deal count and value have generally been trending upward over the past decade and do not appear to be plateauing. Furthermore, deal valuations remain high and debt capital is available at large multiples of EBITDA, which makes Canada an attractive market for investment. Much of this increased incremental growth can be attributed to Canada’s extremely regulated capital markets regime, competitive tax rates, and modern and innovative economy. Many young and innovative sectors are obtaining financing and our mature sectors continue to steadily produce strong players that result in Canada remaining an attractive market for investment.
This sentiment is illustrated when considering that inbound foreign investment remains at historically optimal levels and projections indicate that 2019 may even reach new records of such inbound foreign investment. 2018’s cross-border private equity activity was very active as C$39 billion of the total C$52 billion in deal value for 2018 involved foreign investors. Moreover, private equity activity in 2018 that included no domestic investors flourished to a new high of 180 transactions (of a total of 324 transactions in 2018) worth C$29.9 billion. In addition to the increase in cross-border activity, similar to the US environment, Canada is seeing an increase in direct family office participation in private equity transactions, as well as sovereign wealth funds and investors from China and the Middle East, which will add more competitiveness to the private equity landscape.
Bearing in mind the above, we look to the future with an air of caution given the current political landscape, global trade challenges, concerns about sustained economic growth, and current events that exist in Canada and across North America.
The authors would like to thank Andrew Gunpat and Laura Konkel for their assistance in preparing this article.