Canada: Private equity in Canada: The right place at the right time?

Nicholas Dietrich, Tina Woodside & Sam Johnston
Gowling Lafleur Henderson
Toronto

Canada's economy during 2009 and the first half of 2010 weathered the recession rather well, offering fertile ground for investment by private equity players, including buyout funds still possessing sufficient dry powder to engage in take private transactions, Canadian pension funds increasingly disintermediating private equity funds by doing direct deals, and sovereign wealth funds looking to make strategic investments abroad.

A number of factors have been attributed as principal reasons for this performance, including low government debt going into the recession, an enviable and stable banking sector willing to lend to corporates and consumers, a build-up of cash on corporate balance sheets and in acquisitive Canadian pension funds, relatively good numbers in new housing starts and job creation and, significantly, an economy rich in natural resources and commodities, a key driver of current M&A activity. Indicative of these favourable factors is the very recently announced US $38.6 billion massive hostile takeover bid by BHP Billiton Plc for Potash Corporation of Saskatchewan. At the time of press, it was unknown whether Potash's search for a white knight would stimulate an auction for the miner, but market sentiment favoured a trumping bid, notwithstanding a 20 percent premium to pre-announced share price.

In one sense, the BHP bid was less a harbinger than a continuation of high-profile foreign interest in key Canadian sectors in recent pre and post recession years, including acquisitions of Algoma Steel by India's Essar Steel Holdings; of Dofasco by Luxembourg-based Arcelor shortly before Arcelor itself was acquired by Mittal Steel; of Fairmont Hotels by Saudi Prince Al-Waleed bin Talal and a consortium which included a prominent Canadian pension plan; of Hudson's Bay Co by US based NRDC Equity Partners; of Alcan by UK's Rio Tinto; of Inco by Brazil's Vale and of Shell Canada by majority owning parent Royal Dutch Shell.

Large foreign acquisitions of Canadian companies, such as BHP's of Potash, are subject to review by the Federal Government under the Investment Canada Act (ICA) and the establishment of "net benefit to Canada" of the acquisition. Such acquisitions can also be subject to a relatively new national security review (not unlike CFIUS in the US, but without any guidance as to what constitutes "national security"), even for minority investments that do not constitute a change of control. Moreover, where the purchaser is a state-owned enterprise (SOE) owned or controlled directly or indirectly by a foreign government, new SOE guidelines will apply and impose additional considerations such as Canadian standards of corporate governance (transparency and independent directors) and commercial orientation (free market principles). Undertakings from acquirors in such situations can be expected. It should be noted that a number of SOE acquisitions and investments have been approved over the past year, including that of Abu Dhabi owned International Petroleum Investment Company in Nova Chemicals; Korea National Oil Corporation in Harvest Energy; PetroChina in several oil sands projects owned by Alberta Oil Sands Corp; and Sinopec's minority interest in Syncrude Canada. At the time of press, news reports suggested that Sinochem and China National Offshore Oil Corp (CNOOC) were considering a competing bid for Potash, something which could trigger an SOE review.

Generally speaking, the Federal Government has consistently approved these types of acquisitions. It has blocked only one transaction in the history of the ICA, being the sale by MacDonald Dettwiler and Associates of its space division to a US firm in 2008, citing national security concerns, including Canadian sovereignty in the Arctic, a hot political issue. However, it has become more vigilant in enforcing production level and job creation/retention undertakings, such as in its current legal action against United States Steel Corporation which had acquired Stelco in 2008 and provided such undertakings as part of the approval process. In late July 2010, the Federal Court of Appeal refused US Steel's application to stay proceedings on alleged grounds that enforcement provisions, such as a monetary penalty of $10,000 per day for non-compliance, violated the Canadian Charter of Rights and Freedoms and the Bill of Rights.

These general observations regarding a favourable business environment for cross-border private equity and M&A appear to be supported by the numbers and commentary provided by private equity media trackers to date.

Looking first at 2009, "conditions for getting transactions closed improved steadily in 2009", according to data compiled by Financial Post Crosbie: Mergers & Acquisitions in Canada (Crosbie). Q4 results included 254 announced transactions worth $33 billion (Cdn.), the highest level of activity in over a year and 52% above a cyclical low in Q1. Colin Walker, Managing Director at Crosbie, cited "greater confidence in the economic outlook, improving valuations, and greater availability of financing in many market segments." Crosbie observed three themes throughout 2009: "international acquisition activity by Canadian buyers, increased acquisition activity involving government related entities (especially among larger deals), and strong activity in energy related sectors". Crosbie noted that the value of Canadian acquisitions abroad, totalling $41 billion (Cdn.) and reflecting the competitive strength of Canadian buyers internationally, exceeded the value of foreign takeovers in Canada for the first time since 2004.

The steadily increasing quarter-over-quarter results for 2009 continued to accelerate into the first half of 2010. A total of 513 transactions worth $58.9 billion (Cdn) was recorded by Crosbie. Crosbie noted that "the contribution of cross-border transactions increased significantly to 74 percent in the second quarter returning to pre-economic slowdown levels after more than two years of hovering around the 50 percent mark". Crosbie attributed the strong rebound to the availability of capital, strong oil & gas/commodity interest and the return of mega deals. In Canada, it is likely that these trends will continue throughout the remainder of 2010.

The already existing and anticipated continuation of the rebound in M&A and private equity activity will be influenced by a number of legal developments, in addition to the treatment of foreign investment discussed above.

A key ingredient in a target's take-over bid defence system is the use of shareholder rights plans, more commonly known as "poison pills". Indeed, Potash Corp's bid-responsive poison pill is likely to be challenged by BHP because of the massive dilution resulting from a single investor's acqui-sition of more than 20 percent unless the target board lifts the pill in a negotiated transaction. Such matters are regulated provincially rather than federally under Canada's constitution, and Saskatchewan's Financial Services Commission will likely seek advice from other provincial securities commissions when BHP challenges, as expected, Potash's plan as an unjustifiable defence tactic. There is also the overlay of National Policy 62-202 "Take-Over Bids – Defence Tactics" which attempts to protect the interests of a target's shareholders against director and management entrenchment, and has been used by bidders to persuade securities regulators to kill pills.

The current situation in Canada relative to the US (where judicial tolerance of poison pills and acceptance of a "just say no" defence for target boards seems more the norm) appears to be in a state of flux as a result of the very recently released decision of the British Columbia Securities Commission to quash and cease trade Lions Gate Entertainment Corp's poison pill put in place by the board to thwart a hostile bid by Carl Icahn. The traditional rejection and intolerance of "tactical poison pills" (those put in place after announcement of a hostile bid) by BC seems at odds with recent decisions in Ontario (where the Ontario Securities Commission allowed a pill by Neo Material Technologies to stand in the face of a takeover bid by activist fund Pala Investments Holdings con-trolled by Swiss-based Russian investor Vladimir Iorich) and in Alberta (where the Alberta Securities Commission declined to cease trade a pill by Pulse Data in response to a hostile bid by US competitor Seitel). A common element however in both Neo and Pulse Data was that shareholders had voted to approve the pills in the face of the hostile bid. Some commentators have suggested that "the only inference that can be drawn from the shareholder vote, given the context and timing, is that they were voting to reject the offer" and that accordingly Neo and Pulse Data are aberrations rather than a trend, and Lions Gate reflects traditional treatment of poison pills, namely that they should terminate after affording a target board a reasonable opportunity to solicit competing bids, particularly if no competing bids arise. Interestingly, Potash Corp has stated that it has not scheduled a shareholder vote prior to the current expiry of the BHP bid. Other commentators have suggested that Neo and Pulse Data reflect a deference to the business judgment rule by target directors to act in the best interests of the corporation; however that notion remains untested in Alberta and Ontario.

The second approach appears to draw support from the Supreme Court of Canada's decision in BCE Inc v 1976 Debentureholders (BCE), which surprised many observers in late 2008 when reasons were released, by disaffirming the notion of maximising shareholder value as the sole objective of the board once a target is in play, something clearly at odds with US jurisdictions which follow the Revlon and Lyondell line of cases which uphold shareholder paramountcy in change of control situations. The Supreme Court in BCE maintained paramountcy of the "best interests of the corporation" and suggested a non-exclusive shopping list of factors: "In considering what is in the best interests of the corporation, directors may look to the interests of, among other things, shareholders, employees, creditors, consumers, governments and the environment to inform their decisions" noting also that "courts should give appropriate deference to the business judgment of directors who take into account these ancillary interests, as reflected by the business judgment rule". Moreover, the Supreme Court went even further and suggested that directors are required to act in the best interests of the corporation "viewed as a good corporate citizen". This additional overlay has perplexed many M&A and private equity practitioners and will undoubtedly lead to additional mischief as competing bidders vie for Canadian targets in the current vintage of take-over deals. However, the continuing attractiveness of Canadian companies to private equity players should overcome any perplexity caused by recent changes to the rules of the game.