SPAC in Canada: too small a market for too small a timeframe?

A special purpose acquisition company, (SPAC), is a publicly traded shell company created with a purpose of purchasing a future target. The Canadian SPAC is modelled largely off of the US model. One of the many important characteristics that is shared between both jurisdictions is the defined timeline to make an acquisition. In a SPAC, the units offered to investors are typically exercisable at a premium to the IPO unit price after a qualifying acquisition is completed.

Interestingly, if a SPAC does not make an acquisition within 36 months after the launch of the IPO, the SPAC is liquidated. A further governance structure in place is the requirement of the approval of the majority of investors to complete an acquisition, which can present a challenge in the context of a three year time line.

Raised capital for Canadian SPACs is at approximately Cdn$1 billion as of 2016. The total value of funds for SPACs that have not completed a qualifying acquisition as at May 31, 2017 is Cdn$455 million. About Cdn$1.2 billion has been raised for all SPACs in Canada as at May 18, 2017. While most investors in Canadian SPACs are institutional investors, these vehicles still pose a risk in terms of their short turnaround time frame, particularly in the context of a smaller Canadian market.

As an example, venture capital and private equity deals provide an indication of the type of market size Canada is hosting:

  • Most of the venture capital deals that took place in Q1 of 2017 were in Ontario, at 37 with a total value of Cdn$246 million.
  • In 2016, the total number of deals in Canada amounted to 534 deals at a value of Cdn$3.2 billion.
  • Private equity deals that are Cdn$500 million and up have been declining since a peak in 2014, with a total of 40 deals between Cdn$500 million and Cdn$2.5 billion.

While the size of the investment for many of the larger deals could be suitable for the current SPAC players in the Canadian space, an increased use of SPACs may run into the issue of a more limited market size for larger, more scalable deals.

Most of the deals in 2016 involved early stage companies. This trend has continued through Q1 of 2017 with the highest number of deals in early stage companies.This means that the clock has to tick longer before a return can be realized. It also means that it may be more difficult to win the approval of the majority of unit holders to move in on these companies, whether at the venture capital stage or as a private equity investment. There simply are not as many larger companies that are prime targets, which means that the success of SPACs in the future may be limited unless the trend for more deals continues. Even in that capacity, the governance structure and time frame that SPACs must follow ensures that these deals have to be of high quality and high potential value.

SPACs can be a useful tool to facilitate acquisitions, yet the current course of modelling the SPACs off of the US model may not be the most suitable approach in a smaller market such as Canada. It is possible that SPACs in Canada may benefit from a greater degree of flexibility in their regulatory structure in order to better adapt to a growing venture capital market, and what appears to be a comparatively stagnant private equity market. Generally speaking, these vehicles need to be aware of the size and type of Canadian investment opportunities going forward.

The author would like to thank Milomir Strbac, Summer Student, for his assistance in preparing this legal update.

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Mergermarket report highlights global real estate M&A trends and forecasts

In its June 2017 edition of Venue Market Spotlight (the Report), Mergermarket explored current and projected developments in the real estate M&A sector by surveying 25 global dealmakers.

Overall market activity

Of the respondents surveyed about market activity in the next 12 months, 44% predict that real estate M&A activity is on the decline, 24% believe that activity will increase “somewhat,” and 24% predict that activity will remain the same. The Report posits that opinions were geographically influenced. Of the respondents with optimistic outlooks, the majority were based in either the Asia-Pacific (APAC) region or in Europe.

The majority of respondents predict that the APAC region will be the area most likely to see increased real estate M&A within the next year. This is likely because of the proposed introduction of real estate investment trusts (REITs) in countries like India and China. Europe and North America are also regions pegged to see strong M&A activity in the coming year. Experts indicate that the rationale for an active European market is the migration of investments out of the UK into other EU countries in the wake of Brexit.

Active sectors and drivers of activity

According to a quarter of respondents, office, residential, and healthcare sectors will be the most lucrative sectors of the real estate M&A market. The office and residential sectors are growth sectors and are rife with assets that can be targeted for acquisition. These types of assets are not typical investments but produce stable returns. Therefore, office and residential investments are useful for diversifying portfolios and reducing risk. Technological advancements in the healthcare industry will likely encourage real estate investments in that sector as well.

Rent hikes serve as the predominant driver of real estate M&A activity. Accordingly, increases in office space acquisitions are expected as companies relocate in attempts to cut overhead costs. Other drivers of activity include the desire for portfolio diversification and the search for investment refuges amidst economic instability.

REIT and non-REIT activity

The majority of respondents believe that the REIT market is stable. Despite competition from private equity (PE) firms and corporate investors, REITs are producing regular revenues that are safe, steady, and profitable.

Respondents predict that PE firms and corporate investors will be the most active non-REIT acquirers within the next year. With large capital holdings, PE firms are poised to purchase the assets of those scrambling to sell. Corporate investors will enter the market in their search for strategic assets that facilitate the growth of their operations.

Conclusion

The Report concludes that against the backdrop of Brexit, the volatility of the American political climate, and other common market barriers, real estate M&A remains a steadfast, stable, and attractive sector for investors across the globe.

The author would like to thank Sarah Pennington, Summer Student, for her assistance in preparing this legal update.

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Due diligence defence for distribution of securities in breach of securities law

In furtherance of a proposed merger or acquisition, it is common place for an issuer to complete a concurrent private placement in order to, among other things, fund its working capital and current operations, complete the transaction or satisfy regulatory or administrative requirements post-transaction i.e., exchange listing requirements upon completion of a reverse-take over.

Notwithstanding such reason, it is absolutely necessary to the future of the issuer, its directors and officers and any agents, finders, or promoters, to appreciate and understand their responsibilities upon conducting a private placement, as illustrated in the recent British Columbia Securities Commission (Commission) decision, Re SunCentro, 2017 BCSECCOM 58 (SunCentro).

The SunCentro decision

In SunCentro, SunCentro Corporation (the Issuer) relied upon the “family, friends and business associate” prospectus exemption to issue securities to investors introduced by two finders, YDS Energy, Resources and Humanitarian Relief Corporation (YDS) and Donald Weiss (Weiss, and together with YDS, the Finders), as well as an officer and director of SunCentro, John Leonard Carswell (Carswell). However, none of these investors qualified for the exemption and, accordingly, the Commission pursued administrative proceedings against each of the Issuer, Finders (and their directors and officers), as well as Carswell as sellers of the securities (see sections 1(1) and 61(1) of the Securities Act (British Columbia) (the Act) and 1.10 of the Companion Policy to National Instrument 45-106 Prospectus Exemptions (CP 45-106)).

The Commission importantly held that contraventions of the Act pursued in the administrative context are strict liability offences and, therefore, a due diligence defence was available to the Issuer, Finders and Carswell. The Commission referred to section 1.9 of CP 45-106 in providing the following guidance on the “reasonable steps” sellers must take to satisfy their responsibilities in ensuring the prospectus exemption is properly available in order to be afforded a due diligence defence:

  • while sellers should obtain and retain documentation of certain key facts, including obtaining representations and warranties and/or confirmation of a purchaser’s financial or other personal status, such steps will not be sufficient in and of themselves;
  • sellers should understand the terms and conditions of the exemption that they intend to rely upon;
  • sellers should adopt appropriate policies and procedures to ensure that persons acting on their behalf understand the terms and conditions of the exemptions being relied upon (including ensuring such persons are able to describe the terms of the exemption to purchasers, know what information and documentation must be obtained from purchasers to confirm the conditions of the exemption have been satisfied and take reasonable steps to verify that each purchaser meets the criteria set out in the exemption); and
  • sellers should take steps to verify the factual basis of the information being relied upon including asking questions of purchasers.

Notably, the Commission emphasizes the above list is not exclusive or conclusive and the “reasonable steps” a seller must take will vary depending upon the facts and circumstances of the purchaser, the offering and the exemption being relied upon as well as the seller’s offering.

Weiss and Carswell Investors

In connection with the distribution to investors introduced by Weiss and Carswell, the Commission held that the Issuer had taken all reasonable steps to ensure the prospectus exemption was available, which included verifying the investors met the criteria of the prospectus exemption by relying on express or implied assurances from a board member.

Accordingly, the Issuer was entitled to rely on the due diligence defence for distributions to these investors. Weiss and Carswell, however, were unable to rely on the due diligence defence since there was no evidence that either had taken any “reasonable steps.” In fact, Weiss simply found investors and forwarded them on to the Issuer.

YDS Investors

While the Issuer board adopted many of the steps referred to in the list above, the board failed to obtain a full understanding of the prospectus exemption it was attempting to use for distributions to investors introduced by YDS, incorrectly interpreting “affiliate” to include YDS:

Having sought legal advice on the availability of an exemption, having determined that there remained an open legal question arising from that advice and having chosen to reach its own conclusion about the question, it is hard to view the SunCentro board as having taken reasonable steps to avoid a contravention of section 61 with respect to the distributions to the YDS investors.

Accordingly, the Issuer was unable to rely on the due diligence defence for distributions to these investors. Further, Yawar Sattar Khan (Khan) and David Kenge Kato (Kato), who were directors and officers of YDS, were also unable to rely on the due diligence defence as they failed to take “reasonable steps” to determine whether the prospectus exemption was available to them. In particular, they relied on the expertise of the directors and officers of the Issuer, including Carswell, but such persons were not lawyers. Khan and Kato also did not ask any questions of the legal counsel retained by the Issuer. Indeed, their failure to seek legal advice played a significant role in the Commission’s finding that they did not take reasonable steps to avoid a contravention of the Act.

SunCentro is a rare case that illustrates the steps that an Issuer must take in order to avoid liability for contraventions of section 61 of the Act. The case underlies and emphasizes the importance of obtaining professional legal advice when conducting a private placement. Norton Rose Fulbright’s Canadian deal lawyers can assist in ensuring you are able to complete your transaction while meeting any legal responsibilities along the way.

The author would like to thank Sadaf Samim, Summer Student, for her assistance in preparing this legal update.

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Customers and sales: the truth in the numbers

Deal Law Wire - Norton Rose FulbrightMergers and acquisitions typically involves a considerable amount of legal, financial tax and relevant industry due diligence by a purchaser. Consider a transaction where a buyer purchases a private company that sells products or services. The buyer would want to know what it is buying and what obligations it is assuming, but also data regarding the sales potential of the company. This is particularly relevant if the company’s sales record is waning.

Due diligence regarding customer lists and sales data is incredibly important. A purchaser must understand the company’s customer base, including the level of concentration of the largest customers and the avenues through which sales are generated. It is then important to determine the revenues from various customers, the terms of any sales agreements, whether there are any mechanisms to ensure customers will remain with the company upon purchase, among other considerations.

It can be daunting for a purchaser to wade into deep blue waters if proper due diligence is not conducted to determine what, if any, surprises are waiting in terms of being able to sell a product or service once the business is acquired. In acquisition transactions, due diligence allows the purchaser to identify risks that are not necessarily reflected on a target’s financial statements, particularly if it is a private company. Knowing the sales potential of a company through due diligence affects the crafting and scope of representations, warranties and covenants in the purchase agreement and can provide crucial leverage in negotiations.

Consider a financial services company that has a list of ongoing clients. In this case, it would be important to know if the material customer relationships are shaky, have been destroyed, or never existed in the first place. From a business standpoint, if the cash flow from a business is not adequate, this would in part be connected to the sales history and financial forecasts of the company. As discussed in an earlier post, a buyer’s investment into the deal is connected with the commitment of a deal. By neglecting to assess historical sales data and customer retention statistics, a purchaser may not be buying what it bargained for. Ultimately, due diligence helps a purchaser answer two important questions: (1) what are you selling and (2) will you still be able to sell it?

The author would like to thank Milomir Strbac, Summer Student, for his assistance in preparing this legal update.

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So you want to buy a baseball team

It’s October, 2015. You’re at the Roger’s Centre, watching the Toronto Blue Jays play the Texas Rangers in game five of the American League Division series. The game is tied 3-3 after a wild and tense seventh inning. Jose Bautista is up to bat with two runners on base. Bautista hits a no-doubter home run and you hear a crowd cheer louder than you’ve ever heard before; 50,000 people collectively experiencing the joy that is the whole reason anyone watches sports in the first place. You think to yourself, “Wouldn’t it be great to own a baseball team?”

So what do you have to consider?

The value of baseball teams has risen drastically in the last twenty years. In 2004, Frank McCourt acquired the Los Angeles Dodgers for $430 million. Eight years later, he sold the team for $2 billion. In 2002, Jeffrey Loria acquired the Florida (now Miami) Marlins for $158.5 million. This summer he will reportedly sell the team for as much as $1.6 billion, ten times as much as he paid for it.

However, before even considering the costs, there is the fact that there are only thirty Major League Baseball. At any given time, the supply of MLB teams available for purchase is very small. Furthermore, even if you outbid other potential investors, you must comply with the MLB rules and regulations for ownership and the sale must be approved by the league. There is no guarantee that being the highest bidder means acquiring the team.

So, maybe after finding that there are no MLB teams available, you decide instead to look for a minor league team. That’s what Vancouverites Jake Kerr and Jeff Mooney did in 2007, when they purchased the Vancouver Canadians for only $7 million.

At the time, the Canadians were not affiliated with any MLB team and were a money-losing franchise. On top of that, the stadium they played in, Nat Bailey Stadium, owned by the city, was in a state of disrepair. The stadium a team plays in is a major consideration when acquiring a baseball team. Is the stadium leased or does the previous owner own the stadium as well? Is the stadium in good shape or will it need significant repairs? Many owners, like Loria, or the Liberty Media Corporation, owners of the Atlanta Braves, negotiate deals with their home cities for funding of new stadiums (the prudence of such deals for cities is a whole other topic).

Kerr and Mooney themselves negotiated a 25-year lease for Nat Bailey Stadium with an agreement that they would invest $2.5 million in repairs and that the city would match it. In 2010, the Canadians became an affiliate of the Toronto Blue Jays, and won their league championship each of the next three years, setting team records for attendance in the process.

So you want to buy a baseball team. First you need to find one that’s available. If it’s an MLB team, the cost might exceed a billion dollars. Then you need to consider the state of the stadium or whether you’ll be able to fund a brand new stadium. You’ll also have to consider the state of the league’s collective agreement. While MLB has not had a strike since 1994, the players are unionized and any time the collective agreement is coming up for renewal, you have to keep in mind the possible consequences of a strike. You have to keep in mind the league’s rules and regulations, the state of the team’s attendance, and any deals for the team’s media rights. You also have to think about the state of the team’s brand and goodwill. It’s one thing to buy the New York Yankees. It’s another to buy the Tampa Bay Rays, who consistently place last in attendance in MLB.

Once you’ve got through all that and close the deal, you’ve only got one thing left to worry about. Winning.

The author would like to thank Kevin Schoenfeldt, Summer Student, for his assistance in preparing this legal update.

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Budding M&A and financing activity in the marijuana industry

In September 2016, this blog noted that analysts were predicting higher levels of M&A activity in the marijuana industry. Early last month, we commented that the launch of several Canadian marijuana “streaming” companies – which provide financing to start-ups in exchange for a portion of the start-up’s future product at a fixed price (or a percentage of the start-up’s future profits from that product) – promised to provide an alternative avenue of raising capital for start-ups.

According to data published by Viridian Capital Advisors, a strategic and financial advisory firm dedicated to the cannabis industry, investment and M&A activity in the global industry increased in 2016 and has continued to increase in 2017.

Viridian’s 2016 data indicates that (all dollar amounts in USD):

  • There were 315 capital raises in 2016 (247 by public companies, 68 by private companies) totaling $1,213.3 million ($940.5 million by public companies, $272.8 million by private companies).
  • Equity raises outperformed debt raises in both the number of transactions and dollars raised: there were 186 equity raises totalling $1,006.1 million, compared with 129 debt raises totalling $207.1 million.
  • The “Cultivation & Retail” sector raised the most capital in 2016 ($473 million), outpacing all other sectors, including the “Biotech/Pharma” sector (which raised $344.5 million).
  • A total of 99 M&A deals were closed in 2016 (79 by public companies, 20 by private companies). M&A activity increased in nearly every sector in 2016 (compared with 2015).
  • The “Cultivation & Retail” sector was the most active, with cultivators seeking economies of scale as the commoditization of cannabis exerted downward pressure on prices and margins.
  • Public companies were the most aggressive acquirers, with stabilizing stock prices used as currency for acquisitions.

Viridian’s 2017 data shows that from January 1 through June 30, 2017 (all dollar amounts in USD):

  • There have been 188 capital raises (119 by public companies, 69 by private companies) totalling $1,290.6 million ($978.6 million by public companies, $312.0 million by private companies).
  • Equity raises continue to outperform debt raises in both the number of transactions and dollars raised: there have been 147 equity raises totalling $1,090.5 million, compared with 41 debt raises totalling $200.1 million.
  • Part of the increase in capital raises is due to the new structure of capital being brought to the Canadian cultivation market through “streaming” arrangements from several new financing groups.
  • The “Cultivation & Retail” sector has raised the most capital (with approximately $600 million raised), followed by the “Biotech/Pharma” sector (approximately $310 million raised).
  • A total of 81 M&A deals (72 public, 9 private) have closed. From January 1 to June 30, 2016, only 38 deals had been completed.
  • With 21 deals completed, the “Cultivation and Retail” sector has been the most active; and it has been much more active than it was from January 1 through June 30, 2016 (during which time only 6 deals had been completed). The second most active category has been the “Infused Products & Extracts” category (16 deals completed), followed by the “Investments/M&A” category (11 deals completed).

Norton Rose Fulbright Canada LLP is uniquely experienced in the industry, having recently advised MedReleaf Corp. (TSX:LEAF) on its initial public offering and secondary offering of 10.6 million common shares at CDN$9.50 per common share for gross proceeds of CDN$100.7 million. The team was led by Marvin Singer, Paul Fitzgerald, Jacob Cawker and Sean Williamson.

The author would like to thank Scott Thorner, Summer Student, for his assistance in preparing this legal update.

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Canadian M&A activity at 10-year high due to oil-sands sell-off

The value of Canadian M&A activity in the first half of 2017 was the highest in a decade, according to a recent report from Bloomberg. The approximately $132 billion in total transaction value is the highest since the first half of 2007, when approximately $156.6 billion in transactions were completed.

According to the report, one of the most significant drivers of deal value was a sell-off of Canadian oil sands investments by foreign energy companies in the wake of declining prices for crude on global markets. Recent examples of such transactions include Royal Dutch Shell’s divestment of its interests in the Athabasca Oil Sands Project, the Peace River Complex and other undeveloped projects in Alberta. These assets were sold to Canadian Natural Resources for approximately $11.1 billion in March, 2017. Also in March, ConocoPhillips’ sold its interest in the Forster Creek Christina Lake project and the majority of its Deep Basin assets in Alberta and British Columbia to Cenovus Energy Inc. for approximately $13.3 billion. In January 2017, Norway’s Statoil ASA sold all of its Alberta oil sands operations to Athabasca Oil Corporation for total consideration of approximately $530 million, and up to a further $250 million in contingent payments.

The Bloomberg report notes that the cost of maintaining oil sands projects and the difficulty in operating them has led to the current increase in sales to parties who are closer to, and more familiar with the unique nature of such assets, specifically companies based in Calgary.

Despite the trend of oil sands assets being sold off by foreign companies, Environment Minister Jim Carr recently said during a trip to China that the current economic environment presents an opportunity for foreign investment in the Canadian energy space, which the Canadian government would welcome. However, the current market price for oil and the recent change of government in British Columbia impacting the future of the Trans Mountain pipeline would appear to be factors leading foreign companies to shed their investments in the oil sands in the near term, leading to buying opportunities for others with a longer term view of the industry.

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Investment Canada Act update: new thresholds and national security in the news

Threshold now $1 billion

As a result of recent amendments, most direct acquisitions of control of a Canadian company now only require prior approval of the Minister of Innovation, Science and Economic Development under the Investment Canada Act if the enterprise value of the Canadian business exceeds $1 billion.  That is expected to reduce the number of transactions that will require a foreign investor to persuade the Minister that the deal is likely to be net benefit to Canada before it can be completed.

As outlined in an earlier post, under amendments to the Investment Canada Act first introduced in 2009 and finally put into effect in 2015, the net benefit review threshold for 2017 was to be $800 million, with a subsequent increase to $1 billion in 2019. However, in a move intended to increase the amount of foreign investment in Canada, the Trudeau government recently passed amendments, effective June 22, 2017, that accelerated the increase in the threshold by two years.

The new $1 billion threshold applies to the enterprise value of the Canadian business being directly acquired by:

  • a WTO investor that is not a state-owned enterprise; and
  • a non-WTO investor that is not a state-owned enterprise if the Canadian business was controlled by a WTO investor immediately prior to the acquisition.

The review thresholds have not been increased for WTO investors that are state-owned enterprises. Such an acquisition would be reviewable where the book value of the assets of the Canadian exceed $379 million. This figure adjusts annually based on inflation. As well, the direct acquisition of control of a Canadian business by investors from non-WTO members (except as above) and the acquisition by any non-Canadian (regardless of origin or state-owned status) of a Canadian business that is considered a “cultural business” as defined in the Act are subject to review where the book value of the target’s assets exceed $5 million.

Under the Canada-European Union Comprehensive Economic and Trade Agreement (CETA), Canada committed to significantly increase the threshold for review to $1.5 billion for investors from members of the European Union in most industry sectors. Given most favoured nation clauses in other bilateral free trade agreements Canada has signed, several of Canada’s other trading partners, including the United States, Mexico and South Korea, are poised to benefit from this provision as well. It is now expected that CETA will take effect in late September, 2017, at which time the threshold will increase for certain investors to $1.5 billion.

National security review in the spotlight

In addition to “net benefit” reviews, it is important to remember that all investments by non-Canadians in a Canadian business are reviewed to determine whether they could be injurious to Canada’s national security, regardless of the enterprise value or book value of the target and the size of the interest being acquired (i.e., a minority interest could be reviewed).

The nature and extent of the national security review has been in the news lately given the Trudeau government’s clearance of Hytera Communications Corp’s proposed acquisition of Norsat International Inc. When critics suggested that the transaction would raise national security concerns, the government defended its position by saying that the transaction was reviewed under the Investment Canada Act. While true, this statement doesn’t reflect the fact that there are two levels of review under the Act. First, there is an initial screen undertaken to assess whether there are reasonable grounds to believe that a transaction could be injurious to Canada’s national security. The government has 45 days to make that determination.

After that initial review, the Minister has three options:

  • If the Minister has no concerns, the parties are free to conclude their transaction if it has not yet been completed.
  • If the Minister has reasonable grounds to believe that the transaction could be injurious to national security, the Investor will be notified that a review may be ordered pursuant to section 25.2(1) of the Act. If the transaction has not yet been completed, it cannot be completed until a final resolution has been reached.
  • If the Minister considers that the investment could be injurious to national security, a review will be undertaken pursuant to section 25.3(1) of the Act. Again, if the transaction has not yet been completed, it cannot be completed until a final resolution has been reached.

The second option provides the Minister with an additional 45 days to decide whether to order a full review under section 25.3(1). It would appear, based on the public disclosures made by Norsat, that following some 90 days of review, the Minister advised that no section 25.3(1) review would be ordered. Leaving aside the question of whether a full review was necessary, it is important for potential merger parties to understand the nature of the national security review process and the powers of the government to block, unwind, or impose conditions on transactions that raise national security concerns, further details of which can be found here.

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The importance of cybersecurity in the M&A due diligence process

Deal Law Wire - Norton Rose FulbrightGiven the increasing frequency of cybercrime and online security breaches, cybersecurity has moved to the forefront of importance when evaluating M&A prospects. Acquirors want to ensure that they are receiving the full value of what they are purchasing and protect themselves against any possible data breaches that can result in reputational, legal, or financial harm.

A report by the New York Stock Exchange Governance Services surveyed 276 directors and officers of public companies to determine how the growing presence of cybersecurity threats has had an impact on their M&A due diligence process. The report indicates that:

  • 66% of respondents include a security audit of the target’s software applications;
  • three-quarters of respondents place the quality of intellectual property as a top consideration in their due-diligence process and say that a high-profile data breach would have serious implications on a pending transaction; and
  • 84% of respondents said that the discovery of a major vulnerability relating to a target’s software assets would “likely” or “very likely” affect their final decision.

These data breaches can have serious implications for a business. Every major industry utilizes technology in a way that can result in serious damage to the company if a breach were to happen. We have seen recent high-profile data breaches across the board, from insurance companies and retail giants to universities across the United States.

Finding out the vulnerabilities of a company is one of the main reason for performing due diligence. During the due-diligence process, acquirors must not only examine possible data breaches that may have happened, but also look forward at the potential costs to bring a company “up to code” with their cybersecurity.

While companies are beginning to realize the importance of cybersecurity in the M&A due diligence process, they often don’t have the technical skills to adequate assess a company’s vulnerabilities. As a result, it may be necessary to develop their internal resources to overcome this weakness, or look to third-party specialists and consultants to assist with the due diligence process.

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What a Bank of Canada interest rate hike means for dealmakers

On July 12, 2017, the Bank of Canada raised its overnight lending rate to 0.75 per cent from 0.5 per cent. This was the first such increase in almost 7 years, after a prolonged policy of fiscal stimulus in the wake of the economic recession.

While the need for an interest rate hike in the current economic climate is certainly contentious, the fundamental effects of rising interest rates are well known. At a macro level, borrowing and spending cash becomes more expensive, and saving becomes relatively attractive. The effect of an interest rate hike on M&A activity has been discussed on this blog previously. However, in 2017 we now have a present-day testing ground in the United States, whose Federal Reserve raised the current federal funds rate to 1.25% in June. The June announcement was the latest in a series of rate hikes that began in September 2015, when the Federal Reserve increased rates from 0.25% to 0.5%.

The U.S. experience

The effect of these rate hikes on U.S. M&A activity has been… negligible. According to MergerMarket’s Deal Drivers Americas 2016 report, the overall drop in M&A activity in 2016 has primarily been attributed to global political and economic uncertainty, as well as the high standard set by a record-breaking 2015. The same publication cited the cost of money – still low by historic standards – as a factor that had actually promoted dealmaking. One top U.S. banker explained the market’s apparent ambivalence towards the interest rate hikes as follows:

Interest rate hikes signal that an economy is alive and well, and recovering, which gives confidence to dealmakers to engage in transactions. Even though interest rates are going up, they’re going up at such a gradual rate that they are not impacting the fundamental cost of funding.

One commentator on Forbes offered a parallel explanation:

Many companies in the market to buy are armed with strong balance sheets that are loaded with cash, not merely from continuing operations, but also from having taken advantage of low market interest rates to issue debt. The more cash potential acquirers have on hand, the less need there is to borrow to complete a deal.

Implications for Canada

The U.S. experience above suggests that the Bank of Canada’s interest rate hike won’t cause any dramatic changes in Canadian M&A activity. The cost of capital will remain low for the near future. That being said, the rate hike is an historic signal that the economy may be shifting gears. With the long-term prospect of more expensive loans, buy-side dealmakers should be cognizant of alternatives to debt-financed transactions. Furthermore, future buyers should consider building their “war chests” now, in anticipation of opportunities that may arise in a market where funding is more expensive. Sell-side players should be aware that they may encounter downward price pressure, especially in larger transactions where debt finance is difficult to avoid.

The author would like to thank Eric Vice, Summer Student, for his assistance in preparing this legal update.

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