Facing significant and powerful incentives to expend capital and consummate transactions, global private equity investors have had a number of compelling reasons to fix their sights on Canada. On the aggregate, the volume of Canadian-based activity has reflected that keen interest.

Private equity funds (also known as financial sponsors) have become increasingly visible and frequent participants in all facets of the Canadian economy. Such sustained global interest is attributable to several factors including:

• large-scale and long-term demand for capital in Canadian energy, mining and infrastructure projects;
• Canada’s relatively high incidence of privately-held companies facing generational and succession challenges;
• divisions of public companies and related non-core asset packages that are ripe or otherwise available for divestiture; and
• the formal termination of the Canadian income trust as a competitor to private equity for deal flow.

Private Company Investments

Investments in Canadian-based private companies can be structured in a number of ways, depending largely on the financial sponsor’s investment preference or style and its underlying fund structure and tax orientation. Funds seeking a minority interest in a target company, either alone or as a co-investor, often secure treasury issuances of either equity or debt securities of the target portfolio company. The use of mezzanine instruments has been facilitated by the recent elimination of Canadian withholding tax on cross-border interest payments. Private company investments are typically limited to issuances of sales to either accredited investors (under applicable Canadian securities laws) or others (i.e., target company employees) who have valid securities law exemptions.

Economics of Investment

Significant investments are frequently structured around four principal areas of focus. First, the economics of the investment – specifically, whether the acquired securities in the target are equity, debt or a combination thereof – is a function of due diligence, negotiating leverage and the target’s risk profile. Equity investments will take the form of common shares where the sponsor is satisfied with a pari passu standing with existing common shareholders. Financial sponsors at times, however, favour preferred share investments which provide a blank canvas upon which to craft the target corporation and financial sponsor’s economic relationship.

Preferred shares may provide for preferential dividends (as cash pay or payment-in-kind forms of property), anti-dilution protection and a liquidation preference. Such shares can offer a mechanism for distributable cash on an exit transaction or liquidation event to be returned to the preferred shareholder in priority to common shareholders. Preferred shares must strictly comply with Canadian corporate law principles and respect the rights of shareholders with inferior rights. Governance and fiduciary duty considerations inform these negotiations.

Shareholders Agreement

Secondly, a shareholders agreement (whether unanimously executed or otherwise) reflects the financial sponsor’s views about governance; pre-emptive rights; and tag-along, drag along and other liquidity rights. A shareholders agreement can facilitate the financial sponsor’s exit from a portfolio investment within a prescribed time period. A shareholders agreement can also address qualification (i.e., registration) rights.

Incentive Programs

Third, either a modified or new management incentive program can be structured through the use of stock options, performance warrants or performance shares to incentivize management to create significant near-term value in the target. This approach gives effect to the investor’s time value of money and reinforces alignment between the private equity investor and the management team. These programs typically are weighted towards performance-vesting criteria through which management can earn a significant equity stake or profits interest in the business upon the realization of certain cash-on-cash or internal rate-of-return criteria to the financial sponsor. Delicacy and effective tax-planning are critical components in structuring such programs.

Tax Structuring

Finally, effective tax structuring is paramount for an efficient portfolio company investment and exit. Non-residents of Canada should heed Canada’s recently revised thin-capitalization rules, withholding tax and other substantive considerations. Tax structuring will often lead the overall transaction.

PIPE Transactions

Private Investment in Public Equity (PIPE) transactions allow Canadian reporting issuers to quickly and efficiently raise capital via private placement financing. Familiar with PIPE transactions particularly in the Canadian mining and oil and gas sectors, financial sponsors typically acquire equity or equity-linked securities, often at a discount to the market price, directly from the issuer on a private placement basis. Typically, they can resell their securities at the end of the statutory hold period (typically four months), subject only to control person restrictions.

Applicable stock exchange rules limit the type of transaction that can be effected without obtaining shareholder approval. The TSX, for example, requires shareholder approval of a financing if (among other things):

(i) the transaction will materially affect control of the issuer (presumptively satisfied if a new shareholder acquires more than 20 percent of the voting securities of the issuer);

(ii) shares are acquired at a discount that exceeds certain permitted thresholds;

(iii) the aggregate number of listed shares issuable in the transaction exceeds 25 percent of the issued and outstanding shares prior to closing of the transaction (in cases where the shares are acquired at a value that falls within a permitted discount);

(iv) the securities acquired are convertible into listed shares and contain anti-dilution features that exceed TSX thresholds; or

(v) the transaction involves the issuance of securities to insiders that exceeds permitted thresholds.

In addition, while financial sponsors may acquire certain investor, pre-emptive and approval rights, control of the issuer must be carefully considered. Finally, although PIPE transactions take place under exemptions from applicable Canadian securities laws (which would otherwise impose a prospectus requirement on the issuer), any issuance that results in a shareholder acquiring 10 percent or more of an issuer’s voting securities will trigger “early warning” and insider reporting obligations.

Going-Private Transactions

In a going-private transaction, a reporting issuer (i.e., a public company) is taken private by an investor or group of investors. Private equity sponsors, management and/or significant shareholders often lead the investor syndicate. Such transactions are motivated by a financial sponsor’s interest in a target entity at an attractive valuation and the selling shareholders’ concurrent interest in liquidating their position (or rolling their equity into an ongoing investment). Private equity-sponsored going-private transactions in Canada are frequently executed as club deals, an important part of which is negotiating the rights and obligations among the investor syndicate members.

Target boards need to be particularly mindful of process in such transactions, especially where there are real or apparent conflicts of interest. Having an independent or special committee of the board, along with obtaining a fairness opinion, are measures that are frequently sought and may be required in certain cases.

Canadian court-based plans of arrangement have become the most frequent mode of execution for going private transactions. Plans of arrangement are governed by applicable federal or provincial corporate law statutes, and shareholder approval by special resolution (i.e., 66 2/3 percent) is the standard. Shareholder dissent (i.e., appraisal) rights are typically provided in the approval process. If the transaction is subject to OSC Rule 61-501, enhanced disclosure, independent valuation and majority-of-the-minority shareholder approval requirements must also be secured. Other regulatory requirements (i.e., under the Competition Act, Investment Canada Act, etc.) may also apply to the subject transaction.

Conclusion

Private equity investment in Canadian-based target companies is on the rise. Such investment may take the form of a private company investment, a PIPE transaction or a going private transaction.

Bennett Jones Private Equity Group

The Bennett Jones Private Equity Practice Group draws on the firm’s significant strengths in mergers and acquisitions; securities; domestic and cross-border tax structuring; and senior debt, high-yield and mezzanine financings in advising both domestic and global financial sponsors and other investors. Our practice is focused on leveraged buyouts, recapitalizations and restructurings, primarily on behalf of leading Canadian and foreign private equity sponsors across a wide variety of industries. We also advise private equity fund sponsors as well as institutional investors on the complex issues that are involved in the fund formation process.