Global M&A update: current market factors

Despite a number of challenging economic headwinds, the market’s desire for mergers and acquisitions remains strong, and analysts expect mergers and acquisitions to remain one of the major drivers of corporate growth. Ernst &Young (EY) recently published a report entitled  “Global Capital Confidence Barometer, Buying and bonding: Alliances join M&A as engines of growth” which describes why the appetite for M&A remains strong despite economic stagnation and slow growth rates.

The report identifies a number of market factors which are keeping demand for M&A high, including:

  1. The closing of the valuation gap: The valuation gap (the difference in asset evaluation between purchasers and sellers) is starting to close. In 2015, volatility in prices, particularly among commodities, meant that there was a significant gap between what buyers and sellers thought was a fair price in valuations. In 2016, commodity prices have stabilized, leading a majority of executives to view the valuation gap to be less than 10%. Accordingly, negotiations on price are expected to be less difficult.
  2. An increase in distressed asset sales: Although commodity prices have rebounded from recent lows, the prolonged downturn in that sector has meant that an increasing number of companies have had to sell assets to maintain liquidity.
  3. A shift in private equity firms’ focus: Private equity firms may be finished the net selling of their portfolio investments, a process which has taken several years. Activity on the buy-side of the market may once again be their main focus, which EY predicts would bring between $465 billion and 1.3 trillion dollars to bear on possible mergers or acquisitions.
  4. The rebalancing of the Chinese economy: While the report concludes that the Chinese economy is unlikely to be an engine for global growth, it is in the midst of re-orienting towards consumers. As a result, the number of Chinese outbound acquisitions has surged, as Chinese businesses are looking to acquire western corporations with strong intellectual-property portfolios.

The report ultimately concludes that M&A will remain one of the most potent tools for corporate growth in today’s economy. In an era of sluggish growth, management teams will increasingly need to think about how to grow earnings and gain market advantage. M&A offers one area of diversification for growth, and successful deals can create corporate tailwinds even in the face of torpid market growth.

The author would like to thank Scott Pollock, articling student, for his assistance in preparing this legal update.

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Spotlight on Ukraine: a promising future for M&A activity

In March 2014, this blog featured an article discussing the effect of the recent crisis in Ukraine on M&A activity. The crisis began in November 2013 when Ukrainians protested en masse after then-president Viktor Yanukovych failed to sign an association agreement with the European Union. Yanukovyvh was ousted in February 2014. During that time and following, violent protest, armed conflict between separatist forces and the Ukrainian government, and the annexation of Crimea by Russia, played a substantial role in the contraction of Ukraine’s economy by 8% in the year 2014. Since this time, Ukraine has undertaken a number of steps that may signal an improvement in the economy. For example, on January 1, 2016, Ukraine officially joined the Deep and Comprehensive Free Trade Area to reduce trade barriers with the EU markets and enhance regulatory standards.

Since Ukraine’s economy is highly dependent on two highly polarized parties – the EU and Russia – any improvements to relations with one trading partner incites tension within the other. A recent report by MergerMarket Group, Open for Business: M&A in Ukraine, highlights the contraction of Ukraine’s M&A activity in recent years. According to the report, M&A deal volume in 2015 decreased to only 26 deals worth a total of USD $150 million. In contrast, there were 34 deals worth a total of USD $831 million in 2014.

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On the flipside, the report notes the upward potential for M&A activity in several key industries, including financial services, energy, mining, utilities and telecommunications. One key finding is that although there are only four reported deals in Q1 of 2016, the total value of those deals already surpasses the total value of all deals conducted in 2015.

Although the financial services sector is likely the most viable target for future M&A activity, the improvement of Ukraine’s economy will depend on enhanced privatization of state-owned enterprises. Ukraine’s State Property Fund, its privatisation authority, is planning to sell approximately 88 state enterprises in 2016. The sale of these large assets, encouraged by planned tax reforms, efforts to counter corruption and greater protection for minority shareholders, could help lift Ukraine out of its crisis.

The author would like to thank William Goldbloom, articling student, for his assistance in preparing this legal update.

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Inversion control: U.S. Treasury announces new rules affecting cross-border transactions

In September 2014 we reported on the practice of “tax inversions”, cross-border transactions in which the resulting entity may be headquartered in another country for tax purposes. A number of recent transactions between the U.S. and Canada have been seen as inversions by some. On April 4, the U.S. Department of the Treasury and the Internal Revenue Service announced new temporary and proposed regulations that may significantly impact cross-border transactions involving U.S. companies.

As a result of previous action by the Treasury, companies in a cross-border deal can avoid triggering the tax code’s inversion rules when the U.S. company’s value is less than 80% of the combined group value. In calculating the foreign parent’s value, the new temporary regulations will disregard stock of the foreign parent attributable to prior acquisitions of U.S. companies within three years. This means that if the foreign parent has recently engaged in other cross-border transactions, the new rules may classify the transaction as an inversion even if the ownership thresholds are met.

The Treasury also announced proposed regulations to address the issue of earnings stripping, a practice where companies move earnings to a jurisdiction with lower corporate tax rates. The measures taken largely involve reclassifying instruments that would normally be considered debt. Proposed regulations include:

  • Limitations on transfers of related-party debt to a low-tax foreign affiliate by treating the transferred instrument as stock;
  • Measures to address dividend distributions of debt in which a U.S. subsidiary borrows cash and pays a cash dividend distribution to the foreign parent;
  • Treating as stock instruments that might otherwise be considered debt if they are issued in connection with transactions between related corporations that are economically similar to dividend distributions; and
  • Rules allowing the IRS to divide a purported debt instrument into part debt and part stock.

The Treasury and the White House also released the The President’s Framework for Business Tax Reform. A key element of this new framework involves strengthening the international tax system to discourage profit shifting. It is clear that the current U.S. administration intends to introduce further and more permanent rules which will affect cross-border M&A deals. Companies considering deals involving U.S. entities will have to consider how to structure their transactions in light of these new considerations.

The author would like to thank Jacqueline Byers, articling student, for her assistance in preparing this legal update.

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Getting the best (asset) deal: tax efficient purchase price allocations

The number one consideration for anyone buying or selling a business is price. But getting the best price is not just about the total cash value. How the purchase price is allocated across the various assets included in the deal has significant implications for the future tax liabilities of both purchasers and sellers. This article discusses some of the major considerations for purchasers and sellers in deciding how to allocate the purchase price in asset purchase agreements, and recent proposed changes to the tax treatment of goodwill which may alter the current allocation preferences of the purchaser and seller.

Inventory

A purchaser will generally prefer to allocate as much of the purchase price as possible to inventory. Amounts allocated to inventory are treated as the purchaser’s cost of inventory and is deducted from the revenue received when the inventory is sold.

A seller’s ideal allocation will have a minimal amount of the purchase price allocated to inventory. An amount allocated towards the seller’s inventory will be fully included in the seller’s income as a sale of inventory.

Depreciable capital property

Under the Income Tax Act (Canada) (the ITA), the holder of depreciable capital property is entitled to deduct a portion of the total cost of each class of depreciable property held from its income each year, generally on a declining-balance basis. The rate of such deduction varies depending on the class of property.

Purchasers generally want to allocate as much of the price as possible to depreciable capital property. Purchasers will particularly want to shift the allocation towards the classes with the highest depreciation rates to maximize their ability to take advantage of that deduction.

Sellers will prefer a smaller allocation towards depreciable capital property, as amounts allocated to depreciable capital assets could result in a “recapture” under the Income Tax Act (Canada) (the ITA) if the amount allocated to the depreciable capital assets exceeds the assets’ undepreciated capital cost (UCC). Where this is the case, the recapture will be fully included in the seller’s income. Conversely, where the amount allocated towards the depreciable capital assets is less than the UCC, the seller will be able to deduct this “terminal loss” from their income for the year.

Eligible capital property, including goodwill

Historically, 75% of the amount paid for “eligible capital property”, such as goodwill, was deductible on a declining balance basis at a rate of 7%. However, amendments to the ITA proposed in the 2016 federal budget (Budget 2016) will, effective January 1, 2017, eliminate the old eligible capital property regime and include eligible capital property in a new class of depreciable capital property. The new class will have a depreciation rate of 5%.

Under the new rules, purchasers will likely prefer to allocate amounts to this new class of depreciable capital property to the extent that it has a higher depreciation rate than other classes of depreciable capital property.

Prior to the new rules, sale of goodwill generally results in an income inclusion equal to 50% of the amount by which the proceeds allocated to goodwill exceeds the seller’s cumulative eligible capital account. In certain cases, an election can be made to treat the income inclusion as a capital gain. With proposed changes in Budget 2016, goodwill and other eligible capital property will be treated as depreciable capital property; there is less benefit for a seller to allocate purchase price to goodwill as opposed to other depreciable capital property.

Non-depreciable capital property

Purchasers generally prefer to minimize allocations towards non-depreciable capital property such as land or partnership interests. While amounts allocated towards non-depreciable capital property do increase the purchaser’s tax cost in the asset, there are no ongoing deductions available to reduce the income of the purchaser. Moreover, the transfer of some non-depreciable capital property, such as land, are subject to additional taxes (i.e., the land transfer tax).

Sellers will generally prefer to allocate the purchase price to non-depreciable capital property as only 50% of the realized gain is included in income. This is in contrast to inventory and depreciable capital property (including, under the new rules, goodwill) where any gains (or, in the case of depreciable capital property, proceeds in excess of UCC) will be fully included in income.

Deemed allocation

While purchasers and sellers have their own preferences as to how purchase price is to be allocated, both parties must ensure that any allocation is reasonable and based on the actual value of the assets included in the deal. Section 68 of the ITA gives the Canada Revenue Agency (the CRA) the authority to impose its own allocation of the purchase price (with any resulting tax consequences) such that the consideration paid for each asset is “reasonable”. Generally, though, where there is genuine bargaining regarding purchase price allocation between the seller and the purchaser the CRA will accept the parties’ allocation. Accordingly, purchasers and sellers must keep in mind when negotiating the purchase price allocation that any allocation must be a reasonable reflection of the actual value of the asset in order to ensure the desired tax treatment.

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What can companies learn from PE sharks?

Divestment is one strategy that a corporation can use to unlock funds for future growth and create long‑term shareholder value. According to a recent E&Y study, a successful divestment must meet three criteria: (i) it must create a positive impact on the valuation multiple of the remaining company; (ii) it must generate a sale price above expectations; and (iii) it must close ahead of its timing expectations. Only 19% of the companies surveyed for the study met all three criteria. Considering that divestiture activities are likely to increase in 2016 (a more detailed discussion on 2016 divestiture outlook can be found here), it is critical for companies to analyze how they can maximize value through their next divestiture transaction.

The study looks to private equity firms, which have mastered the art of divesting. Some key lessons include:

  • Be an active seller. Of the private equity respondents who have carried out high-performing deals in the past, 51% of them stated that the strategic trigger for the deal was shareholder activism. In comparison, only 31% of the respondents claimed the high-performing deals were triggered by an opportunistic buyer approaching the seller. Activist-fueled transactions bring higher value because they force management to review corporate assets and re-focus management attention on core strategy. Investors generally react positively to shareholder activism, especially if the activist has a reputation for unlocking value for shareholders. On the other hand, when an opportunistic buyer knocks on management’s door to buy assets, the market perceives the transaction less positively because investors believe management undervalued the business and failed to generate maximum value with core assets. Companies need to act like activists to generate value, and they can achieve this by making bold divestment decisions in line with their announced strategy.
  • Conduct frequent portfolio reviews. The study found a direct correlation between frequent portfolio reviews and divestment success. 48% of the respondents who have carried out high‑performing divestment transactions review their portfolio on a quarterly basis. The report proposes that companies should take the approach popular with private equity firms and conduct in-depth portfolio reviews once or twice a year; carry out quarterly benchmark reviews against competitors and internal business plans; and have real-time access to performance data in order to make better decisions faster.
  • Always be prepared for execution. Companies should continue to create pre-sale value in a business targeted for investment as these companies are 75% more likely to receive a higher‑than‑expected sale price and 59% more likely to have a higher‑than‑expected valuation multiple post‑divestment. In addition, companies should be prepared to explain to a potential buyer how the divesting business can operate independently. For example, a selling company should prepare financial statements for the divesting business in order to create a compelling vision for the buyer as to how the divesting business can fit in its organization. Lastly, to generate more value, the study recommends that companies who are going through the bidding process should strive to demonstrate how the divesting business can create synergy for each bidder.

Companies that have divested strategically and followed the example of private equity firms are much more likely to carry out a successful divestment transaction. The report anticipates divestment activities will pick up among life science, financial services, consumer products and technology companies in the coming year, which will bring opportunities for both divesting companies and potential buyers to maximize value in well-considered transactions.

The author would like to thank Lucy Liu, articling student, for her assistance in preparing this legal update.

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M&A in the food industry

As the market changes, so must the food industry, and this has become evident in the M&A trends of the food and beverage sector. A PWC report entitled “An Appetite for M&A” outlines the challenges facing the food industry and how they impact M&A activity.

Five challenges are identified as forcing change in the food industry:

  1. Low growth in mature markets. The food industry has not recovered from the recession, which encouraged consumers to seek lower-priced goods, and forced manufacturers and retailers to maintain or lower prices.
  2. Pressure on margins. Despite the pressure to keep prices low, from 2009-2013 input costs have gone up 15-17% for consumer packaged goods companies. Output price has not kept pace, increasing only 4-5% over the same time period.
  3. Changing consumer preferences. Consumers have been diversifying in what products they want. Some demand high quality foods, and are willing to pay a premium, while others are seeking low-cost, high-value products.
  4. Changing retail landscapeSupermarkets are competing for food sales with growing competition from online sellers, dollar stores, convenience stores, and other non-traditional food retailers.
  5. Intensifying competition from smaller playersNo longer are economies of scale particularly important for food companies, and smaller brands are increasingly competing effectively.

In an attempt to combat these challenges, M&A activity has grown in the food and beverages sector. But what makes for a successful deal?  The report analyzed a number of deals and determined that companies succeed at mergers and acquisitions when they focus on their “capabilities”: things they are particularly good at compared to their competitors. Deals were more successful if the acquiring company either acquired new capabilities, or could use its existing capabilities to improve the target company. Deals were not effective when they required developing capabilities that neither the buyer nor the seller had going into the deal.

The takeaway from this report is that as the food industry faces new difficulties, effective acquisitions become all the more critical. Taking stock of one’s strategic advantages and capabilities can provide a valuable tool for assessing the potential value of a deal. Enter into deals that play to your strengths, not ones that rely on developing new capabilities. Making the most advantageous deal is one way to stay ahead of the increasing industry pressures and remain competitive in the changing food and beverages landscape.

The author would like to thank Kira Misiewicz, articling student, for her assistance in preparing this legal update.

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Regulators get serious about cyber-security

In a previous post, we discussed how to manage cyber security risks during the negotiation and due diligence stages of an M&A transaction. In this post, we discuss the ways regulatory bodies have begun managing these risks and the significance of these efforts to M&A participants engaging in substantial data asset transfers.

On February 18, 2016, the Investment Industry Regulatory Organization of Canada (IIROC) released its Compliance Priorities Report. Following this, in March 2016, the Ontario Securities Commission (OSC) released its Draft Statement of Priorities for 2016/2017. These reports, which constitute summaries of issues and action plans identified by the regulators, share a common focus on the systemic risks posed by insufficient cyber-security and recognize that our growing dependence on digital connectivity enhances exposure to cyber-attacks.

Cyber-security weakness at any level can jeopardize a company’s position during the M&A process.  Information loss during or after transactions and data transfers can have dire effects on stakeholder interests. If legal responsibilities and data security problems are left unaddressed, issues such as damaged reputations or the forfeiture of customers and future sales can result is serious losses.

The OSC and IIROC are positioning themselves to take a central role in enhance cyber-security resilience by undertaking oversight initiatives to promote proper due diligence in relation to internal breaches and intrusions from external parties. The agencies hope to achieve this by:

  • improving collaboration and communication between parties;
  • assessing cybersecurity resilience through targeted reviews;
  • providing guidance on cybersecurity preparedness; and
  • publishing notices of participant and infrastructure oversight.

What then can participants in the M&A market expect? When dealing with public companies, participants should bring higher expectations, in terms of cyber-security, to the table. The standards that will guide these expectations are yet to be announced by regulators. However, even after regulations are put in place, acquirers should review all the work their targets have done to satisfy cyber-security requirements.

While regulators focus on establishing stable standards to enhancing cyber-security resilience amongst market participants generally, parties to M&A transactions can be diligent in safeguarding their own interests by:

  • identifying digital assets to be transferred;
  • backing up any data prior to transfer;
  • transferring legal ownership of data quickly; and
  • planning for continuity in the event of data loss.

These steps should be taken as early as possible in the M&A process. As secure data transfers have become particularly important, early communication of duties and responsibilities is the safest way to combat the threats posed by cyber-attacks.

The author would like to thank James Parker, articling student, for his assistance in preparing this legal update.

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Confronting the mid-market M&A valuation gap

Firmex and Mergermarket recently published a report entitled Mid-Market M&A: The Valuation Gap (the Report), which explores valuation challenges that buyers and sellers are facing in mid-market M&A.

According to Mergermarket data, the number and value of American and Canadian mid-market M&A deals (US$10m to $250m in value) slipped year-on-year, with the slump continuing into the beginning of 2016. The valuation gap between buyers and sellers may help to explain why mid-market M&A momentum has stalled, despite high buyside interest.

Some experts contend that the valuation gap is in part due to the prevailing expectations of sellers, which are driven by the widespread publicity received by lucrative M&A deals and attractive valuation multiples for businesses across a broad range of industries. The availability of credit and heightened competition for high quality mid-market businesses has raised valuations for select companies which, in turn, are widely reported in the press. On the other hand, average and less attractive deals receive little press. As groups such as baby-boomers look to sell their businesses, reports of attractive valuation multiples may be an important motivating factor. However, their valuation expectations may not be realistic or applicable to their specific business or circumstances, which may pose difficulties as they negotiate with potential buyers.

The valuation gap is also an issue in highly speculative industries, such as the technology and life sciences industries. While the potential for upside in these sectors is alluring, the inherent risk and speculative nature of these businesses make them difficult to value and often invite closer scrutiny from buyers.

In light of the above, how can buyers and sellers confront the valuation gap and complete a successful M&A transaction? One useful tool is to use an earn-out to tie a portion of the business price to the post-closing performance of the business. Helpful tips for negotiating earn-out provisions have been addressed in a previous post on this blog. Other techniques may also include increasing the proportion of management equity rollover, on the theory that the interests of management and the buyer will be better aligned, and spreading out buyer-side risk by bringing on co-investors.

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Shareholder representatives in M&A

The post-closing process can be complex and time consuming. Hiring a professional independent shareholder representative to manage post-closing matters, such as purchase price adjustments, indemnification claims, earn-outs and escrow management, may be beneficial for target shareholders and management. In recent years, shareholder representatives have been commonly used in the U.S., and they are becoming increasingly common in Canada.

There are many benefits to hiring a shareholder representative to deal with post-closing matters:

  • Avoid conflicts of interest. When the purchaser decides to continue to employ target executives and management post-transaction, there is an inherent conflict of interest for the target executives and management to represent the interest of target shareholders. For example, if a potential claim arises with regard to a breach of representation or warranty by the purchaser post-closing, the target executives may not feel comfortable bringing a claim against the purchaser, who is now their new employer.
  • Expertise. Many post-closing matters are highly complex, and the existing target executives and management may not have the skill and knowledge to carry them out. For instance, according to a survey done by SRS Acquiom, 73% of private M&A transactions have a purchase price adjustment mechanism in place. Purchase price adjustments are often difficult to calculate without proficiency in tax and accounting, and having experts in the field to manage the adjustment process will ensure price adjustments are computed in an accurate and timely manner.
  • Available on a long-term basis. Earn-out provisions are becoming increasingly popular in private M&A transactions (a more detailed discussion can be found here), and their terms range anywhere from one year to more than four years post-closing. Shareholder representatives, instead of target executives, can fill the role of monitoring earn-outs on behalf of target shareholders, especially if the earn-out period is long.
  • Shareholder communication. Shareholder representatives can provide updates to shareholders and answer any shareholder inquiries to improve shareholder communication post-transaction.

Target management should consider hiring shareholder representatives for share purchase transactions when their company is a widely held corporation. Shareholder representatives may assist target executives to focus their attention on their core business and to avoid conflicts of interest with shareholders.

The author would like to thank Lucy Liu, articling student, for her assistance in preparing this legal update.

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Canada and the EU: update on CETA

Negotiations between Canada and the European Union (EU) on the Comprehensive Economic and Trade Agreement (CETA) began in 2009. In October 2013, an agreement was reached in principle and last month, it was reported that the legal review of CETA has finally been completed. Some reports indicate that CETA could come into effect next year.

In October, 2013 this blog commented on the possibility that CETA “may be good for business in M&A”, specifically citing the proposed increase in the threshold for government review of foreign direct investment by EU companies in Canada as compared to other non-domestic companies. However, despite the opportunities that might arise in Canada as a result of CETA, Canadian companies looking to pursue opportunities in Europe will need to be mindful of recent developments.

For example, backlash in the EU surrounding the CETA chapter dealing with disputes between companies and governments (known as ISDS) has led to significant changes in the text of the CETA. Over the past year, it has been reported that there were “concerns [in the EU] that the investor-state dispute settlement chapter would give big companies the power to sue governments for creating regulations that affect their profits.” On February 29, 2016 a revised version of CETA was released that dramatically altered the chapter at issue. Notably, the ISDS system was replaced with an international investment court, made up of a tribunal and an appellate tribunal composed of fifteen members elected by the EU and Canada.

Concerns of rising “corporate power” are also directly reflected in the activities of the EU. For example, in the March/April 2016 edition of Foreign Policy magazine, the European Union’s Commissioner for Competition, Margrethe Vestager, was featured and the article stated that “[a]s the EU’s antitrust czar” Ms. Vestager has waged “an aggressive, high-profile war against corporate power.” The magazine specifically reported that Ms. Vestager had recently ruled that a decade old “corporate tax-break system that Belgium had designed…to slash taxes on multinational corporations’ profits by up to 90 percent” was illegal.

Most recently, the upcoming referendum in the United Kingdom on a British exit from the European Union has added an additional element of uncertainty to the potential impact that CETA might have for Canadian companies. International Trade Minister Chrystia Freeland has not commented on the impact “Brexit” might have but, as the reports referenced above indicate, Canadian companies looking to take advantage of CETA by engaging in European based M&A activity will have to monitor developments in Europe over the next several months carefully.

The author would like to thank Andrew Nicholl, articling student, for his assistance in preparing this legal update.

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