In recent years the U.S. M&A market has, on the whole, become increasingly seller-friendly, driven by significant competition for quality assets, the ability to offload deal risk at moderate cost to third parties via transaction insurance, and despite occasional scares, a healthy macro-economic environment.
Although Canadian private M&A practice generally tends to align with U.S. developments, recent deal studies from the American Bar Association show several key areas where market practices differ.1
Divergence in indemnity practices
The most significant differences in market practice in Canada and the U.S. identified by the ABA studies pertain to indemnification terms. In particular:
Longer Canadian survival periods. Survival periods for basic representations and warranties of 2 years or more were more common in Canada (25% of transactions reviewed) compared to the United States (9% of reviewed deals);
Fewer baskets in Canada. 19% of transactions involving Canadian targets did not include any basket amount for even basic representations and warranties (such as a deductible or other “tipping basket” or combination thereof), compared to only 2% of transactions reviewed in the most recent U.S. study;
Deals with Canadian targets were more likely to include a “first dollar / tipping” basket rather than a deductible: 37% of transactions involving Canadian targets included a deductible (either alone or in combination with other baskets) as compared to 44% of deals with first dollar recovery, whereas 72% of transactions reviewed in the U.S. study provided for deductibles compared with 26% providing first dollar recovery;
Smaller basket sizes in the U.S. 27% of all baskets for basic representations and warranties on transactions involving Canadian targets exceeded 1% of transaction value, compared to only 5% of deals reviewed in the U.S. study; and
Larger Canadian escrows and caps. Deals reviewed in the Canadian study tended to have larger indemnification escrows and indemnity caps than found under the U.S. study:
21% of the indemnity escrows in transactions involving Canadian targets were greater than 15% of the purchase price, compared to only 2% of indemnity escrows in the U.S. study; and
34% of indemnity caps in transactions involving Canada targets were 15% of deal value or less, compared to 89% of indemnity caps in the U.S. study.
Taken together, these differences are quite notable. While they are, in part, attributable to differences in transaction sizes in the two studies, we believe this divergence in indemnity terms is also driven by a combination of greater competition in the U.S. for assets, leading to more seller-friendly terms, and a greater proportion of deals covered in the U.S. study with private equity sponsors involving RWI.2
Increased interest in earn-outs and similar structures in Canada
Earn-outs are frequently used by buyers and sellers to bridge gaps in the perceived value of a business. Earn-outs are often time consuming and expensive to negotiate and, not infrequently, give rise to deal litigation, particularly where the earn-out period extends several years post-closing.
According to the ABA’s findings, earn-outs appeared more frequently in the U.S., in 28% of the transactions reviewed, than in Canada (16% of transactions reviewed). However, in our recent experience, we have seen an increased interest in Canada in earn-outs or other similar structures to bridge value gaps and allocate risk. This is likely attributable, at least in part, to the larger value gaps created by high valuations, and in particular, a greater potential for a disconnect between sellers who expect to sell assets at ever-rising transaction multiples and buyers concerned with quality of earnings or other issues identified through due diligence investigations. Although earn-outs are often viewed by deal parties with great skepticism, we expect increased interest in earn-outs and similar structures to continue for so long as the current deal environment persists.
The studies also suggest that the basic parameters of earn-outs are quite similar in Canada and the U.S. The two most common metrics used for purposes of earn-outs were revenue (36% of earn-outs in Canada and 32% in the U.S.) and earnings/EBITDA (29% in both studies). Only a minority of earn-outs reviewed in either study included covenants directed at how a purchaser may run the business—in the form of either an express covenant to run the business consistent with past practice (14% of Canadian earn-outs and 21% of U.S. earn-outs), or conversely, an acknowledgement of the seller that the purchaser may operate the business in its discretion (29% of Canadian earn-outs and 33% of U.S. earn-outs).
MAEs more heavily negotiated south of the border
Consistent with past findings, the latest ABA studies indicate that “material adverse effect” (MAE) qualifiers continue to be defined more expansively in the U.S. as compared to Canada. In particular:
Only 69% of Canadian MAE definitions included forward-looking concepts (e.g., events that “could reasonably be expected” to cause certain outcomes), compared to 96% of MAE definitions in the latest U.S. study. However, transactions involving Canadian targets were more than twice as likely to include references to the “prospects” of a target (35% of Canadian deals compared to 15% in the U.S. study), which is a similar forward-looking concept;
22% of Canadian MAE definitions did not include any carve-outs, compared to only 11% of U.S. MAE definitions; and
Many of the most common carve-outs from MAE definitions appear to be less frequently used in Canada, including a financial market downtown (58% in Canada compared to 84% in the U.S.), changes in accounting (53% and 89%, respectively), and war or terrorism (66% and 92%, respectively).
These findings suggest that MAE definitions are more heavily negotiated in the U.S. market than in Canada, with the more seller-friendly transaction environment in the U.S. resulting in more expansive carve-outs. This is supported by the fact that 10% of transactions reviewed in the latest Canadian study did not even define what constitutes a MAE, compared to 1% of U.S. transactions. However, the relative size of transactions included in the ABA studies also should not be overlooked. It would not be unexpected for larger transactions, as are found in the U.S. study, to contain more detailed and heavily negotiated definitions of what constitutes a MAE.
Decline in disclosure schedule updates as RWI market matures
Only 14% of the Canadian transactions reviewed permitted or required updates to disclosure schedules prior to closing, compared to 28% of U.S. deals reviewed. However, 46% of U.S. transactions which permit or require disclosure schedule updates limit the purchaser’s right to indemnification in respect of these updates, compared to only 23% in Canada. This suggests that disclosure schedule updates are more frequently utilized in the U.S. as a means of insulating sellers from liability for information omitted at the time of entering into the purchase agreement or for new developments thereafter.
That being said, we would expect any updating of disclosure schedules to be less common for transactions involving RWI, as any new disclosure provided to buyers would be typically excluded from recovery under the RWI. In fact, the emerging (and increasingly universal) practice in the U.S. is that disclosure schedules on deals with RWI are not updated to avoid tainting the buyer for purposes of the “no claims declaration” at closing. This may in part explain why, in the most recent U.S. study, the percentage of transactions permitting or requiring disclosure schedule updates decreased markedly, from 42% to 28%. Disclosure schedule updates may become even less frequent in the future as the RWI market continues to mature on both sides of the border.
1 In December 2019, the American Bar Association released the latest version of its Canadian Private M&A Deal Points Study. The study covers 90 transactions from 2016 and 2017 in respect of Canadian private targets acquired or sold by public companies. While deals included in the study range in value from $5 million to $2.65 billion, with nearly 30% of transactions over $200 million in value (up from 20% in the 2016 study), the study remains heavily weighted toward smaller transactions, with nearly half of transaction values under $50 million.
For purposes of this article, the results of the Canadian M&A study have been compared with those of the ABA’s previously released U.S. study covering transactions entered into in 2016 and the first half of 2017.
2 Unlike the previously released U.S. study, this latest Canadian study did not identify the number of transactions reviewed where representations and warranties insurance (RWI) was obtained. Although the RWI market in Canada has matured in recent years, RWI remains more widely used in the U.S. which may in part explain the differences identified in these studies.