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 Competition Act and the Investment Canada Act have 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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Grow on! Examining the forces behind increased M&A activity in Canada

The Canadian market has seen a surge in M&A activity since 2017 and it looks as though 2018 will follow suit. According to a PwC Canada 2018 M&A mid-year review, in the first half of 2018 alone, Canada hit CAD$93 billion  in M&A activity and outbound deals increased by 8% as compared to the first half of 2017, largely due to a surge in cannabis sector deals. While we have noted this increase previously, recent legislative changes regarding cannabis warrant another look to determine the robustness of this trend. For example, in health-care, overall deal value and deal volume have increased by 233% and 48%, respectively, which is significant given that cannabis falls into this category.

More notably, the coming into force of the Cannabis Act on October 17, 2018, and the recent announcement of the Ontario government regarding the privatization of the cannabis industry, may explain current and future increases in M&A activity. Both of these developments have attracted excitement at the prospect of new opportunities. There have already been 48 cannabis deals in the first half of 2018, valued at CAD$5.2 billion, which demonstrates the magnitude of this opportunity. It is also being speculated that an increase in supply may force underfunded cannabis companies into bankruptcy or to exit the market, which would provide opportunities for better funded companies to acquire assets or merge in order to support growth.

The federal legalization of cannabis is far-reaching and everyone wants a piece of the pie. The government of Ontario recently announced on August 13, that it will follow suit and has plans to immediately introduce online retail channels for cannabis, which will be followed by a private retail model by April 1, 2019, all of which will aim to eliminate the illegal market for cannabis. The government of Ontario plans to work with private sector businesses to build  a safe and reliable system for consumers. For instance, it is proposing to introduce Official Ontario Cannabis Retailer Seals to help consumers identify legitimate retailers where federally quality assured products can be found. This presents an opportunity to retailers to obtain such seals, thereby increasing their legitimacy and the value of their businesses, and to use this for growth and for leverage in M&A transactions.

This is a trend worth tracking. This is only the beginning of the impact of the legalization of Cannabis on M&A activity in Canada – there is much that remains to be seen.

The author would like to thank Saba Samanianpour, summer student, for her assistance in preparing this legal update.

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Quebec opens its door to InsurTech: opportunities to grasp

The insurance industry is changing. A more digitally savvy customer base and the emergence of new technologies are reshaping the sector. Enter technology-led companies known as “InsurTechs.”

In Québec, this innovative business approach along with a substantial legislative change is expected to increase M&A transactions.

Mindful of offering a regulatory environment that is flexible and apt to respect the evolution of technologies and consumers’ needs, the province adopted Bill 141, An Act mainly to improve the regulation of the financial sector, the protection of deposits of money and the operation of financial institutions, on June 13, 2018. This legislation, eagerly awaited by industry participants, is meant to modernize the regulation of the financial sector, and more specifically, to help financial institutions adapt to an evolving market and changing consumer needs, all while improving consumer protection.

The adoption of this bill represents an important step forward in the evolution of the InsurTech sector in Quebec. Bill 141 establishes the regulatory foundation upon which this industry will stand, and will shape its development in the years to come. Pursuant to this new regulatory framework, from June 13, 2019 onwards, insurers will be authorized to distribute certain insurance products without the involvement of a representative. This widens the door to the digital distribution of insurance. To that end, however, an insurer will have to meet certain criteria.

The arrival of InsurTech in Quebec will significantly influence insurers’ strategic orientations and should lead to a rise in M&A activity in the next three years, according to a recent KPMG report. Indeed, this new regulatory flexibility provides insurers with the opportunity to modernize their insurance product offering. Insurers will be able to reinvent their products and distribution methods in order to enhance customer experience and tailor their business models to their customers’ digital consumption habits. Industry participants hoping to capitalize on this legislative opening may draw on the experience of their counterparts in the United Kingdom, where the InsurTech industry is burgeoning, as evidenced by the significant investments of some major insurance companies looking to modernize their services.

The author would like to thank Simon Du Perron, Amelie Guillemette, and Pier-Olivier Brodeur, summer students, for their assistance in preparing this legal update.

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Materiality scrapes in private M&A transactions

Representations and warranties in private M&A transactions are typically heavily negotiated, with sellers often attempting to qualify their representations with materiality to avoid being found liable for immaterial breaches and for immaterial damages. It is also common during the course of negotiations for parties to agree to the inclusion of indemnity baskets. These provisions provide that the seller will not be liable for a breach of its representations unless the loss suffered by the purchaser as a result of such breach exceeds a certain minimum (or, “material”) amount.

The Double Materiality Scrape

To counteract the seller-favourable implications of materiality qualifications and indemnity baskets, purchasers often attempt to include a double materiality scrape in the acquisition agreement. Such a clause excludes (or “scrapes”) materiality qualifiers in the seller’s representations for purposes of determining (a) whether a breach of a representation has occurred; and (b) the amount of indemnifiable losses resulting from that breach. An example of such a provision is as follows:

  • For purposes of determining whether there has been a breach of a representation or warranty, and for purposes of determining the amount of losses resulting therefrom, all representations and warranties qualified by “materiality” shall be disregarded.”

Purchaser’s Position

The rationale from a purchaser’s perspective of including such a clause is that materiality is already addressed in the indemnity basket. As such, without a materiality scrape the purchaser would be subject to a “double materiality” standard. In other words, it would first need to overcome the materiality qualifier in the representation, and then prove that the losses sustained as a result of that breach exceeded the minimum amount set out in the indemnity basket. Additionally, purchasers rationalize the inclusion of materiality scrapes on the grounds that they reduce the time spent negotiating materiality qualifiers in the representations and warranties, and can also avoid post-closing disputes over the meaning of “material” if the seller is found to be in breach of a representation qualified by materiality.

Seller’s Position

Sellers, on the other hand, typically resist broad materiality scrapes, arguing that such clauses render the materiality qualifiers in their representations pointless. Moreover, sellers will often contend that these clauses saddle them with an unreasonable burden of having to disclose everything they can possibly imagine in the disclosure schedule to ensure they are not in breach of a representation that would more appropriately be qualified by materiality.

Middle Ground Approach – the Single Materiality Scrape

When parties are at an impasse with respect to the inclusion of a double materiality scrape, one possible “middle ground” approach is to agree to a single materiality scrape. This clause states that the materiality qualifiers will continue to apply to determine if the seller has breached a representation but, if a breach is found to have occurred, the materiality qualifier will be ignored for purposes of determining damages. As a result, subject to the indemnity basket and any other indemnity limitations set out in the acquisition agreement, the purchaser will be entitled to recover the full amount of its damages resulting from such breach.

Materiality Scrapes Trending Higher

According to the most recent Private Target Mergers & Acquisitions Deal Points Studies published by the American Bar Association for Canada and the U.S., materiality scrapes are becoming increasingly common in private M&A transactions. Where the parties agreed to an indemnity basket, only 11% of the agreements in Canada included a materiality scrape in 2012, but by 2015 these clauses were found in 39% of transactions reviewed. Likewise, only 14% of such deals in the U.S. included materiality scrapes in 2004, but by 2017 85% of transactions included these clauses.

In respect of the “middle ground” approach discussed above, the most recent deals studied indicate that their use has been diminishing in favour of the double materiality scrape in recent years. Specifically, in 2014, 100% of the deals studied in Canada with materiality scrapes were single materiality scrapes, and by 2014 that number fell to 43%.  Likewise, in the U.S. 72% of transactions with materiality scrapes were limited to single materiality scrapes in 2006, but by 2017 that number fell to 57%.

These trends suggest that the double materiality scrape is gaining in popularity, perhaps due to the increasingly robust North American M&A market, where purchase price premiums paid by purchasers come with corresponding demands for increased levels of protection.

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Note to investors: tariffs and opportunities abound in metals and manufacturing

Global trade tensions continue to be a source of uncertainty. The role of the United States as one of the most influential economies across the globe has presented limitations on the ability of many business sectors to easily absorb the trickle down effects of recent trade tariffs implemented by the Trump Administration. While this seems to present a problem for most companies that rely on international trade and distribution of products as the crux of their business, tariffs, at least if kept in place only temporarily, could create opportunities for distressed investors.

Two examples of the industries directly impacted are Canadian steel and aluminum producers. The Trump Administration has applied tariffs of 25% on certain steel products and 10% on some aluminum products. These figures would not be as damaging if the size of the US market for Canadian steel and aluminum exports were relatively small. However, 95% of Canadian steel exports and 88% of aluminum exports were destined for the United States in 2017. The negative demand shock triggered by the tariffs, while partially offloaded by increased prices, will decrease revenue and erode operating margins for steel and aluminum producers.

For investors with the view that tariffs are temporary, there was certainly an opportunity to buy the dip in Canadian steel and aluminum. However, if tariffs persist the continued margin pressure could drive especially smaller producers of goods affected by the tariffs into distress. This could be a welcomed opportunity for distressed investors or strategic investors looking to consolidate.

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

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Excess cash, excess tax – what’s on your balance sheet?

Canadian federal income tax law provides numerous benefits to companies that engage in an “active business”. Whether a particular endeavour undertaken is an “active business” is, of course, a question of fact and depends on individual circumstances. Some scenarios are clearly those of an “active business”, such as the case of manufacturing and production, retail, mining, sales and shipping and receiving. Others are clearly more of a passive nature, such as merely owning real estate and collecting rent on the property, without any substantive management. Many could be considered somewhere in between.

When a company is in fact engaged in an “active business” and all or substantially all of its assets (generally meaning 90% or more) are principally used in that business, the Income Tax Act allows the sale of the shares by an individual shareholder to be free of capital gains tax, up to the individual sellers amount of their lifetime capital gains exemption (provided certain other criteria are met). The Act also allows investment in the shares of said company by registered plans, such as RRSPs, RESPs and RRIFs, providing another means to raise capital. The business may also be eligible to claim the small business deduction and thereby pay tax at a considerably lower combined federal and provincial tax rate.

In order to meet the “all of substantially all” test, however, 90% or more of the assets in the business must be used principally in the active business. This can be an issue when it comes to cash and near-cash instruments, such as short-term deposits and investments in securities. After all, unlike the property, plant and equipment of a company, which are much easier demonstrated to be used to carry on the active business, the cash held by a company may not do anything more than sit untouched and earn interest income.

The courts have generally determined that the question to ask is whether the cash, as any other asset, is actually employed in the business, such that it is put at risk and the withdrawal of such may destabilize the business. Cash to provide working capital and pay for running expenses is an example of this. Merely sitting untouched, however, with a remote possibility that it may have to be drawn upon (as in the case of a need to pay back a long-term loan or advance) will not suffice. If faced with the latter, the cash may have to be withdrawn, with potential tax consequences.

Accordingly, numerous taxpayers have been caught off-guard when they seek to take advantage of the aforementioned benefits, but are denied such on the basis of the asset mix on their balance sheet. While strategies are available to reduce this risk, they are best employed early on, and your balance sheet should be kept a close eye on.

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