Unrelenting: Private Equity Activity Remains Robust

Jordan: Hi, I’m Jordan Virtue.

Nathan: And I’m Nathan Kanter, and this is Blakes Sound Business.

Jordan: Nathan, did you know that Canadian private equity has been going strong throughout the pandemic?

Nathan: I did know that, Jordan, thanks to the Blakes Canadian Private Equity Deal Study, which represents the most in-depth analysis of Canadian private equity buyout and investment transactions in the legal industry.

Jordan: And joining us today to tell us more about the study’s findings are Partners Rory ffrench from our Toronto office and Joanna Myszka from Montréal.

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Jordan: Rory, what are some key aspects of our most recent private equity deal study? Is there anything that listeners should know about?

Rory: This is our third edition. Originally, we were gearing up for early 2020 for publication, but obviously, with the significant event that occurred and shook the markets, we opted to delay the publication to capture 2020 deals, so that we could analyze the COVID impacts and how they were actually affecting deal terms.

As with our prior edition, our study remains focused on Canadian private equity, being there needs to be a private equity fund or one of their portfolio companies participating on the buy or the sell side or as the target. Our deals continue to be sourced from our proprietary data set rather than publicly available data sources like SEDAR.

In terms of what’s new, one of the key features are the COVID insights. This is what has attracted the attention of most of our readers, and we’ve highlighted those insights throughout the study. We’ve also included additional analysis in a few different places to respond to reader input, such as additional breakdowns of data between deals that use rep and warranty insurance and those that don’t, as well as deals broken down according to the type of party dynamics.

Jordan: Joanna, can you give us a snapshot of the more common deal structures and deal sizes captured in the study, as well as industries we covered?

Joanna: Sure, happy to. So, in terms of deal structure, the vast majority of deals captured by our study were share transactions. In fact, 100% of the transactions with PE sellers were share deals.

While deals involving strategic players were more likely to include asset transaction components, the majority of deals we surveyed were in fact share deals.

In terms of deal size, while almost 20% of transactions had a purchase price in excess of C$500-million, the Canadian PE market is predominantly focused in the mid market, so, you know, 80% of deals are C$500-million or less.

In terms of industries, not surprisingly, tech and media took over as the most active industries.

With respect to the players, most of the sellers, about 60% in our study were Canadian, and the vast majority of buyers were PE funds or their portfolio companies. And while there was an upward trend of U.S. buyers from 2016 to 2019, there was a decline in 2020, which we assume is largely due to some reticence or hesitation from U.S. buyers in terms of completing cross-border deals in the pandemic context when the ability to conduct an on-site due diligence was more difficult.

Jordan: Rory, on the topic of earnouts, I understand they’re a big thing these days. How do they play into M&A deals?

Rory: Earnouts are a very useful tool for a lawyer to have in their toolkit when we’re trying to bridge valuation gap between a buyer and a seller. The problem is they’re complicated, and when it involves trying to create a scenario for sellers to have some level of insight and control over what a buyer’s doing during the earnout period post-closing, it creates a tension between the buyers and the sellers that can be difficult to resolve.

Pre-COVID, we were seeing strong seller-friendly conditions, and so, you had a lot of sellers that were pushing back very hard against the idea of having earnouts, but with COVID, we saw greater uncertainty, and with greater uncertainty, we saw greater deltas between the buyers and sellers as to what their valuations would be, and so earnouts became an attractive way to try and resolve that value gap.

Our data proved this out. You saw a lot of articles that got written early COVID about how earnouts may become more popular, and in fact, they did. So, if you looked at our data overall in 2017, only 9% of deals had an earnout, but in 2020, that number jumped to 38%. And if you looked more specifically at founder-to-private-equity deals, that number jumps from 9% in 2017 to 63% in 2020, so a significant jump. And that’s not surprising to us because when you think about a founder selling their business, often founders have a very strong sense of the value of the business that they think they have built and that they’re ready sell, and so, it’s not surprising to us that there was a big gap there because they weren’t willing to accept less to sell their business than they knew it was worth.

Nathan: Joanna, there’s also been a lot of talk about rep and warranty insurance and how its gaining momentum in Canadian private M&A deals. Can you share some of the discernible trends?

Joanna: So, the Canadian market has definitely been steadily catching up to the U.S. market with respect to the prevalence of rep and warranty insurance. The product is here, and it’s been here for a while. Frenetic M&A activity in 2021 and in 2020 definitely changed the dynamics around rep and warranties insurance. It impacted its availability, the cost, timelines for obtaining the product and, generally speaking, the process of getting the insurance bound.

And we saw insurers become much more rigorous in their process in terms of issuing the policy. It kind of led to almost this tripartite negotiation between the buyer and the seller, as well as the buyer and the insurer, with respect to indemnification matters.

What we’ve seen is that most policies provide for a three-year coverage period for general reps and warranties, with six years coverage for fundamental reps and pre-closing taxes.

Average policy limits are approximately 15% of enterprise value, and policy deductibles sit at about 1% of enterprise value with average premiums showing actually an upward trend from 2.6% in 2018 and 2019 to 3% in 2020.

Nathan: Rory, what about so-called “public-style” private transactions? Did the deal study provide any insights on this front?

Rory: Indeed, it did, and this is very much related to what Joanna was saying. Because rep and warranty insurance has become so prevalent in the market, it’s not surprising that we’ve gone just from having rep and warranty insurance being a source of recourse to being the primary or perhaps sole recourse.

There’s really two variations of a no-recourse deal. There’s a true no-recourse deal where the vendors are really not liable for any breaches in reps and warranties, and the sole recourse for the buyer is to look to the insurer.

A partial no-recourse deal exists where there’s no recourse to the sellers for general reps and warranties, but there would be for the fundamentals. For that, there would be residual indemnification to ensure that there is traditional coverage for, let’s say, the matters that go to the core of the transaction.

If you looked at our data, you would see that there are increases in both types of variations from 2015 to 2017, so a three-year period. General reps and warranties — there was no recourse in about 8% of deals, and fundamentals, it was about 5% of deals. But if you look at the next three-year block — 2018 to 2020 — general reps and warranties have gone form 8% all the way up to 20% of deals where there’s no recourse, and fundamental reps only went up to 8%.

The continuing gap between where you’re seeing, sort of, true no recourse and partial no recourse demonstrates the continuing hesitation in the Canadian market to let sellers off the hook for those matters that really are going to the core of the transaction.

Nathan: Thanks, Rory. Joanna, any final thoughts from the study you’d like to share?

Joanna: Sure. I think just the whole concept of “What is a fundamental rep?” is interesting. So, the prevalence of other operational reps or general reps being included in the basket of fundamental reps and receiving that special treatment for survival and indemnification purposes has actually steadily decreased during our study period. And it kind of reflects the change in rep and warranty insurance to cover only traditional or the classic fundamental reps.

And this market trend has actually creeped into deals where there is no rep and warranty insurance, and we see now sellers pushing back quite strongly against the inclusion of non-traditional fundamentals being afforded fundamental treatment.

So, the parties will often bridge the gap by creating this category of special reps, often will include intellectual property or privacy-type reps, and those reps will be subject to longer survival periods beyond the typical 12 to 18 months for general reps, extending up to two and sometimes three years and also with higher monetary caps.

We’ve also actually seen this in the rep and warranty insurance context, though anecdotally.

Jordan: Thank you, Rory and Joanna. It’s been great having you with us today. Very interesting to hear how COVID didn’t negatively impact dealmaking activity after all.

Nathan: I agree, Jordan. Listeners, for more information on our Private Equity group, and our new podcast, please visit blakes.com.

Jordan: Until next time, stay well and stay safe.