Q3 review: global M&A volume dropping, despite record highs

Thomson Reuters recently released a report on global mergers and acquisitions in the first nine months of 2018. According to the report, global M&A volume fell 32% in Q3 2018 compared to Q2 2018. The number of deals – 35,543 – in the first nine months of 2018 dropped 9% compared to the same period of 2017. Overall, however, global M&A activity has remained strong in 2018: in the first nine months of 2018, M&A activity reached a new record of nearly US$3.3 trillion. This represents a 37% increase compared to the same period of 2017.

Increase in mega deals and cross-border M&A

More than 100 “mega deals” – deals worth more than US$5 billion – accounted for $1.4 trillion, or approximately 43%, of the value of total announced M&A deals. This is more than twice the amount of mega deals seen in the same period last year.

Cross-border M&A, which totalled US$1.3 trillion (accounting for roughly 41% of M&A activity in the first 9 months of 2018), experienced its strongest first three quarters since 2007 (in which cross-border activity accounted for 44% of total M&A activity during the same period).

United States and Europe saw the largest increases in M&A activity

According to Thomson Reuters’ figures, the biggest increases in M&A activity occurred in the United States (US$1.3 trillion, up 50% from last year) and Europe (US$941.2 billion, an increase of 64% from 2017). European deals accounted for 29% of overall M&A activity, the highest percentage since the first nine months of 2012.

Announced Canadian M&A activity totalled US$201.7 billion in transaction value, representing a 19.3% increase compared to the first nine months of 2017. Announced Canadian M&A activity was, however, down 5.3% from the previous quarter. Completed Canadian deals are down 20.6% compared to the same period last year.

Energy and power sector leads the way

In terms of industry sectors, energy and power, healthcare, and technology are leading the way in 2018. M&A activity in the energy and power sector totaled US$548.1 billion, an increase of 56% compared to 2017 levels. Technology and Healthcare M&A each accounted for 11% of overall M&A activity by volume.

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

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Beware the zombie invasion (stock exchange edition)

On September 18, Deloitte released a new report which outlines a roadmap for the competitive business climate in Canada. Included in the report is a warning that “Canada may have a zombie problem.” Luckily, Deloitte isn’t raising concern about hordes of flesh-eating undead, but rather the relatively large number of “zombie companies” that exist on Canadian stock exchanges. The report identifies “zombie companies” as those who do not have enough earnings to cover their interest payments and found that out of the 2,274 companies listed on the Toronto Stock Exchange and the TSX Venture Exchange, 16% could be considered “zombies” compared to the OECD average of 10%. According to Deloitte, the reason to be concerned about these “zombie companies” is that they are locking up significant amounts of capital and talent to the detriment of more productive firms.

How did these companies come about?

The report suggests that management of Canadian companies tends to be more risk-averse and that attitude might be contributing to keeping low-productivity companies afloat. Out of the companies they surveyed, Deloitte found that only 22% are pursuing international expansion “to a great extent” and that 48% of companies “aren’t exploring international opportunities at all” despite the obvious and well-known growth opportunities that exporting presents.

In addition to overly risk-averse management, there are two other factors that have been identified as partially contributing to this phenomenon. Most obviously, interest rates have been extraordinarily low for a decade. This can prop up low-productivity firms by reducing their debt carrying costs. Extremely low interest rates are also likely to discourage lenders from seeking more lucrative opportunities, since there are few opportunities to make money. Furthermore, in a study released in December 2017, the OECD ranked Canada’s insolvency regime among the most cumbersome and inefficient. At the same time, the report found that insolvency reform can facilitate productivity growth.

There is also a possibility that Canada’s outsize share of zombie companies is due in part to Canada’s many exploratory resources firms who are not always expected to have positive working cash flow. Indeed, a KPMG study determined that mining and oil & gas companies make up 70% of zombies listed on the Australian Securities Exchange.

Is there an end in sight?

There are signs that there may be light at the end of the zombie invasion. According to Deutsche Bank, the incidence of zombie companies worldwide may be on the decline in 2018 due at least in part to rising interest rates. As monetary policy tightens in Canada, we may see some less productive firms pushed into the restructuring process which could free up resources for more productive firms and provide an opportunity for distressed investing.

Furthermore, Canada’s junior resources sector has proven to be a hot commodity in the reverse takeover world, especially when it comes to the booming technology and cannabis industries. It would be welcome news for Canadian markets if Canada’s glut of low-productivity zombie firms begun transforming into more innovative companies.

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

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Oil & gas update: AER hints at more changes

In recent years the Alberta Energy Regulator (AER) has been making changes to its liability management system. In early August, the AER hinted more changes are on the way. In a news release, Jim Ellis, the regulator’s CEO, explains that a gap has been clearly identified in the current liability management system, and that the AER is working to fill it.

But what is this “hole” in the system? Imagine Company A and Company B decide to do a deal. Company A buys a couple of profitable wells along with a lot of unprofitable, unwanted wells from Company B. The deal transfers all liability for the bad wells to Company A, and Company B is off the hook for any of those wells’ end of life obligations. The AER approves the license transfer under the current liability management system, and the deal is complete. So far so good; everyone is happy. Then, out of nowhere, Company A files for bankruptcy. Once in bankruptcy, the AER has no real control over what happens with those bad wells. Usually, the bad wells make their way to the Orphan Well Association for decommissioning at the expense of the rest of the industry and government. This is the gap the AER is looking to fill.

The AER has limited legislative authority to oversee corporate transactions. As discussed in a previous post, the AER has been tightening eligibility requirements for license applications. It appears the belt will continue to tighten.

The AER has a new strategic plan that prioritizes liability management, and they have already begun work on a number of initiatives to this end. In addition to the now familiar liability management rating (where a rating higher than 1.0 is needed to hold a license without posting security for any end of life obligations, and a rating higher than 2.0 is required to transfer a license without risk of being required to post security for end of life obligations) the AER is going to begin looking at additional financial, behavioural and inventory risk factors to help them identify companies that may not be able to meet their assets end of life obligations.

What this will mean for the Alberta oil and gas investor going forward is still unclear. What is clear is that transactions are changing: the process is taking longer, contracts are evolving to compensate for regulatory uncertainty, and companies are becoming more diligent about who they do business with.

Although the AER is mindful that a balance must be struck between protecting the public interest and allowing companies operational freedom, investors can expect additional layers of due diligence will be needed going forward. The goal of the additional due diligence will be keeping costs low and deals on schedule. Getting legal counsel involved early will minimize the risk that the AER will stop a deal after significant money and time have been spent, or, worse yet but not unheard of, require a closed deal be reversed.

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Evaluating the representation of women in the M&A industry

Is M&A still a male dominated industry? Back in its 2011 article, Reuters referred to M&A as a “man’s game”. They found that only 15% of executives and senior level managers in US investment banking and securities dealing industries were women. A 2011 survey found that 83% of female finance executives perceived the glass-ceiling to be a very real and prevalent factor preventing them from moving forward. Further there were a small number of women graduating from business schools choosing to enter the financing and accounting market – nearly half the number of the men in the recruitment process.

As of 2016, the representation of women in M&A was improving but still dubbed “sparse” by a Forbes report. The number of CEO positions on the Fortune 500 list rose from 2.2% in 2011 to 5% in 2016. The report found that there was no longer a shortage of women in entry level M&A positions, but the hurdle was in moving up the chain. In fact, 40% of first and second year M&A lawyers in the US were women, but only 15% represented senior equity partners.

A set of interviews recently published by Mergermarket regarding the evolving role of women in M&A shows that many of the factors that were identified back in 2009 as barriers for women to enter – and stay in – the M&A industry still hold true today: the classic STEM gender issue, concerns regarding work-life balance, lack of networking opportunities and role models, and conscious and unconscious biases.

Despite the unique challenges facing women in M&A, there continues to be progress.

The distinct characteristics of female players in the M&A domain are being recognized and celebrated. Collaboration, creativity, relationship-building and heightened emotional and social intelligence, are just a few attributes that set women apart at the negotiating table. In her interview with Mergermarket, Jennifer Muller, Managing Partner of Houlihan Lokey, discusses studies that have shown that “diversity improves performance because it makes people a bit uncomfortable which forces everyone to be on their game and perform their best.” A report by the Harvard Business Review emphasizes that companies with a higher number of women on their boards made fewer bids and paid less for acquisitions.

While the industry is still a long way from gender parity, the narrative about women in M&A is different now. Women are heading up M&A groups in the biggest investment banks in the world. Clients and investors are recognizing the value of diversity in viewpoints to solve problems and showcasing stories highlighting women who are attaining successes in the M&A field act as testimonials for females in the industry.

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

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Corporate governance 101: increasing minority shareholder voting power

If you are a minority shareholder you may feel a lack of control over corporate matters because majority shareholders, well, hold the majority of the voting rights. Certain shareholder agreements can help alleviate this lack of control and provide you with greater voting power.

Shareholder Agreements

Simply put, a shareholder agreement is a private contract between two or more shareholders of a corporation that supplements the corporation’s governing statute(s) and constating documents (i.e. articles of incorporation and by-laws). A shareholder agreement, particularly where it is not a unanimous shareholder agreement, should never contradict or conflict in any way with the corporation’s constating documents or governing statute(s). Instead, these documents should all speak to each other and form a consistent framework for effective corporate governance and operation.

A shareholder agreement codifies your rights and obligations as a shareholder. These agreements may be simple documents that address a single matter, or they may be comprehensive documents that address a variety of matters.

Increasing Your Voting Power

Voting rights are important to all shareholders, but especially to minority shareholders. Since majority shareholders typically hold decision making power, minority shareholders may be faced with unwanted results. As a minority shareholder, you can increase your voting power by entering into either of the following:

  • a Voting Agreement (also known as a Pooling Agreement); or
  • a Voting Trust Agreement.

A Voting Trust Agreement is an agreement where two or more shareholders transfer their shares to an agreed upon voting trustee. The voting trustee then votes on behalf of the shareholders according to the terms and conditions of the voting trust agreement.

A Voting Agreement is an agreement where two or more shareholders agree to vote their shares a certain way, essentially as a voting-block, for a single matter or multiple matters moving forward.

By entering into either a voting agreement or a voting trust agreement, minority shareholders are able to increase their voting power by creating a voting-block, and ultimately obtain greater control over decisions that require shareholder approval.

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Speed matters: four tactical approaches to speeding up divestitures and maximizing value

With pressure to increase shareholder value from low productivity assets, many companies are exploring the idea of divestures. Yet, a recent article by McKinsey & Company suggests that only 29 percent of divestitures achieve win-win scenarios, whereby both the parent company and divested business achieve excess total returns to shareholders (TRS) following the separation. What stands out about these companies? Speed appears to be the source of their success.

According to a study of major divestitures between 1992 and 2017 by McKinsey, separations completed within 12 months of announcement achieved higher excess TRS than those that took longer. A speedy separation, however, requires careful thought and planning in advance of a public announcement. In particular, the article suggests that successful divestors typically incorporate four tactical moves to maximize speed.

1. Establish a dedicated team that efficiently manages deals to completion

The skills required to execute a divestiture with speed and precision differ enough from those used in M&A that even sophisticated acquirers may slow down a divestiture. McKinsey suggests that establishing a dedicated divestiture team in charge of managing the separation from beginning to end helps ensure an efficient transaction process. Candidates for this team should have a general-management background, a keen view of investor expectations, and a clear understanding of the true sources of value for the parent and divested companies.

2. Share incentives for managers in both the parent and divested companies

A common mistake made by leaders in a parent company is adopting an “out of sight, out of mind” mentality with the company it is seeking to divest. The divested company needs to reflect the parent company’s objectives in order for a sale to take place smoothly, and managers in divested businesses can easily shift their priorities towards the future of the separated business if pushed to the sidelines. By aligning incentives of the departing business’s managers to the characteristics of the sale, a parent company can ensure that each stage of the separation will be managed with care.

3. Implement a test-and-learn approach that avoids delays from restructuring

While financial and legal issues are central to successful divestitures, the managerial and operational complexities cannot be overlooked. In order to avoid errors or delays down the line, divestors should think carefully about how to “rewire” business functions and set up new governance structures. Before a public announcement, McKinsey suggests putting critical processes in a divested business through pressure tests, in both optimal and less-than-optimal conditions, to determine the best approach and minimize operational delays in the departing business unit.

4. Limit use of transition-services agreements

Many companies rely on transition-services agreements (TSAs), in which the parent company agrees to provide infrastructure support, such as accounting, IT, and HR services, to ensure that operations are not interrupted. Research has found, however, that overusing these agreements allows managers of divested business units to forgo building self-sufficient business functions. Minimizing the use of TSAs, and building time limits into them, prevents these operational delays.

While these tactical elements can assist divestors in efficiently completing their transactions, they speak to a larger suggestion that a good team and careful consideration before an announcement goes public creates a higher chance of success down the road. Divestiture transactions offer a lot to value-minded board of directors, but only so long as employees, customers and investors maintain faith in a company’s strategic plan. Being objective, and utilizing a ‘moved slow to move fast’ strategy can work towards ensuring this value is achieved.

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

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Frequency and size of M&A insurance claims continue to rise

AIG, in its recently published 2018 M&A Claims Report, explored the rising number of representations and warranties (R&W) claims in the M&A market by examining AIG policies written between 2011 and 2016. During this period, AIG wrote policies for approximately 2,000 deals, representing a total deal value of over $700 billion from which more than 400 claims have resulted as of the date of the report. The insurance provider observes trends in the frequency and size of claims based on deal size, industry sector and geography, and posits that R&W insurance has become the “new normal” in M&A transactions.

Almost one in five policies AIG wrote during the period of the study has received a claim notification which is a slight increase from AIG’s 2017 M&A Claims Report we reported on previously. AIG attributes this increase, as well as the following trends observed from the data, to a better understanding on the part of policyholders of how the product works as R&W insurance becomes more common place in transactions, as well as to the relatively more complex nature of larger transactions:

  • Frequency of claims increases with deal size, with the largest claims being made in relation to transactions with a deal size of over USD 1 billion
  • Claim size increases with deal size and has increased across the board
  • Claims are coming in earlier with 33% of claims notifications being made during the first six months

Across industry sectors globally, AIG observed the following frequency of claims for the five most common breach types:

  1. Financial statements: 18%
  2. Tax: 16%
  3. Compliance with laws: 15%
  4. Material contracts: 14%
  5. Employee related: 9%

For the first time, AIG also included statistics in its report on breach type by industry sector. The following are the top three types of breaches observed for each of the following industry sectors:

  1. Manufacturing: financial statements (17%); material contracts (16%) and tax (13%)
  2. Health & pharma: compliance with laws (31%), tax (20%) and financial statements (15%)
  3. Technology: tax (25%), intellectual property (19%) and financial statements (12%)
  4. Financial services: financial statements (25%), material contracts (23%) and compliance with laws (13%)

AIG’s observations with respect to trends in the R&W insurance market are useful for purchasers and their advisors for focusing their due diligence processes on heightened areas of risk and negotiating better deals.

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NAFTA and how free trade negotiations are impacting Canadian M&A activity

The President of the United States recently made headlines when he announced that the United States and Mexico had reached a new bilateral trade deal to replace the North American Free Trade Agreement (NAFTA) and that the countries were prepared to move forward without Canada. Although Canada rejoined the NAFTA negotiations thereafter, the US announcement perpetuated the lingering uncertainty regarding the future of the trade relationship between Canada and its southern neighbour. This uncertainty already seems to have impacted M&A activity coming into, and out of, the “Great White North” and will likely continue to do so until resolved.

According to PricewaterhouseCoopers’ half-year review of Canadian M&A activity, outbound deal volume from Canada into the US rose by 8% in the first half of 2018 compared to the same period last year, while overall inbound deal volume regressed. Certain commentators are attributing these trends to the ambiguous NAFTA situation and the looming threat of trade wars. Outbound deal flow may continue to increase in part because companies faced with the possibility of tighter trade rules and additional protectionist measures might seek to establish a presence directly in the America market through M&A rather than by relying on exports. Inbound deal volume, on the other hand, could remain stagnant until the NAFTA question is resolved as a significant portion of Canada’s appeal as an M&A destination stems from the easy access that it offers to the US market. Without a robust NAFTA providing tariff-free entry for goods and services from Canada into America, Canada could continue to see decreased inbound deal activity from all parts of the world.

Until the dust settles on the NAFTA talks, Canadian companies may be well advised to plan ahead by reviewing their supply chains to identify any potential exposure to increased duties and tariffs. Corporations may want to start evaluating acquisition opportunities in the US or consider partnering with suppliers in other countries with which Canada has free trade agreements in place. For example, the recently signed Comprehensive Economic and Trade Agreement could provide interesting business opportunities in Europe. In these uncertain times, it is crucial for Canadian companies to develop strategies to be able to adapt quickly to whatever form a renegotiated NAFTA might take.

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Foreign investment laws and increased scrutiny of M&A transactions

2018 is on pace to be a year with one of the highest total values of blocked or cancelled M&A deals in the past two decades. While this data, which was compiled by Thomson Reuters and reported by the Financial Times, is based on public M&A transactions, the reasons and insights behind it can nonetheless be applied to the private M&A context.

One of the main ways that deals have been blocked is through foreign investment laws. These laws take different forms in different countries but examples include the Investment Canada Act or the Committee on Foreign Investment in the United States. Deals in industries that are politically sensitive or which have antitrust or national security concerns have also come under increased scrutiny under these types of review processes recently as have deals involving utilities, large intellectual property portfolios or heavily regulated companies.

The nationality of the purchaser can also be a factor in weighing whether a deal will come under enhanced government analysis. For instance, the Investment Canada Act has different review thresholds depending on the jurisdiction of the purchaser and whether the purchaser is a state-owned enterprise. Other foreign investment regimes outside of Canada have similar systems in place.

For both purchasers and targets, having an understanding of how these risks can affect the potential execution of a transaction can be beneficial in terms of setting expectations and timelines. In most cases, the earlier any of these potential issues are flagged in the process, the better the chance that any applicable review process will not derail or delay a transaction. In any case, the key takeaway is to, at the very least, keep these issues and mind and determine if they might play a role in a transaction at an early stage.

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Canadian venture capital investment continues to increase in H1 2018

The Canadian Venture Capital & Private Equity Association recently published its 2018 first half (H1 2018) report on Canadian venture capital (VC) and Canadian private equity (PE) investment. While Canadian PE investment remains feeble, Canadian VC investment has continued to climb to incredible heights.

A review of the increasing trends in Canadian VC investment, with respect to the volume and size of deals as well as the stages and sectors engaged, reveals that VC investment in Canada is very robust and showing no signs of slowing down. With H1 2018 already outpacing last year, VC-seekers should be excited and motivated by the current state of VC investment in Canada and the innovative environment that it is cultivating.

Significant findings

  • Canadian VC investment continues its five-year ascent: At the close of Q2, the year-to-date Canadian VC investment stands at CAD $1.7B, representing a 7% increase from the first half of 2017.
  • ICT sector continues to receive majority of Canadian VC funding: information and communication technology (ICT) attracted just under two-thirds (64%) of total VC dollars invested in H1 2018.
  • Increased investment in later-stage companies: later-stage companies received 54% ($901M) of total VC dollars invested in H1 2018, compared to only 41% last year.

Overview of Canadian VC investment activity

In H1 2018, approximately CAD $1.7B had been invested across 308 deals, representing an average deal value of CAD $6M—a 13% increase over the CAD $5.3M average deal size in the five-year period between 2013-2017. In total, there were seven CAD $50M+ mega deals – amounting to almost CAD $500M. This parallels the volume of mega deals evident over the previous two-year period.

Ontario continues to be the primary jurisdiction for deal activity with both the quantity of investments (116 deals) and deal amounts (CAD $907M) exceeding the combined total for all other provinces, excluding Quebec. Toronto-based companies (CAD $793M over 89 deals) accounted for over a quarter of the deal volume (29%) and nearly half the total funding (47%). Montreal (CAD $254M over 64 deals) and Vancouver (CAD $264M over 38 deals) rounded out the top three cities, both with respect to deal volume and total investment.

Canadian VC Investment by sector and stage

Canadian VC investment continues to be concentrated in the ICT sector (CAD $1B over 189 deals) with the total funding (64%) and deal volume (61%) greater than the cumulative totals for the life sciences (CAD $204M over 48 deals), CleanTech (CAD $192M over 28 deals) and agribusiness (CAD $79M over 15 deals) sectors. In fact, of the nine largest deals by value in H1 2018, six were within the ICT sector.

Early- and later-stage companies continue to receive significantly more funding compared to seed companies, despite being involved in a fewer number of deals (106 deals involved seed companies compared to 97 apiece for both early- and later-stage companies). Interestingly, there was a noticeable predilection towards later-stage companies, which received 54% (CAD $901M) of total dollars invested compared to only 41% from last year. This investment shift resulted in early-stage companies receiving only 37% (CAD $612M) of investment dollars, down markedly from 52% in 2017.

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

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