Amid the softening of M&A activity in both Canada and the U.S. and alongside ongoing macro-level challenges, we are seeing bright spots of opportunity as dealmakers take creative approaches to executing transactions. Below is our assessment of the state of play for M&A deal activity—as well as emerging areas of risk for 2024.
Despite the more difficult transaction environment, investors are sourcing attractive targets from distressed assets and high-growth sectors, including technology, fintech, AI, agriculture and clean energy as well as more defensive sectors such as infrastructure. The Canadian federal budget and other provincial measures are being employed to draw investment into clean energy innovation and projects, which may be an appealing option for those looking for available capital. Similarly, the United States passed the Infrastructure Investment and Jobs Act which allows for up to $1 trillion for infrastructure spending in the U.S. (we report on additional findings in the Torys Quarterly and PE Pulse 2023).
Current state of debt financing
With historic increases in interest rates, economic uncertainty and high-profile U.S. bank failures, debt financing sources have taken a more cautious approach to financing acquisitions and other investments. Lenders on both sides of the Canada-U.S. border have increased their focus on credit analysis. While leverage levels have tended to be lower than in prior periods, covenant structures have not materially changed. Borrowers, including pension plans and private equity sponsors, have relied heavily on lending relationships, as banks and other lenders are more likely to use their capital to fund borrowers and sponsors with whom they have history (and a broad source of fees). While non-syndicated loans have dominated activity in the first half of the year, we have recently seen an uptick in syndicated loans, such as U.S. Term Loan Bs sold to institutional investors. In addition, we have seen signs that U.S. non-bank fund lenders, who have a large share of the U.S. acquisition finance market, as well as Canadian non-bank fund lenders, may both become increasingly important sources of debt capital for M&A transactions in Canada.
Many borrowers have faced compliance challenges with existing credit agreements. As interest rates have risen well above the levels modeled, borrowers with financial maintenance covenants risk being offside these covenants even without a business deterioration. As borrowers review the financial definitions in their credit agreements, they should ensure that they are utilizing all EBITDA and other borrower-favorable add-backs. Borrowers have also reviewed equity cure provisions and explored amendments to provide covenant holidays, reset covenant levels or adjust financial definitions to make more surgical adjustments related to a particular borrower’s business. Other borrowers have faced challenges meeting debt service costs due to increased interest rates, and have explored maturity extensions and refinancings of various structures. See more here.
Five areas of risk for M&A in 2024
1. Increased regulatory scrutiny
Regulators are applying more scrutiny to foreign investment transactions as well as strategic combinations.
In Canada, the foreign direct investment regime is focused on investments involving critical minerals, critical infrastructure, personal data and advanced technology. At the same time, competition regulators and policy makers have formed the view that many markets have become uncompetitive and that increased merger enforcement is needed.
Overlaying both these trends are political imperatives. In the case of foreign investment review, the enforcement climate is influenced by a broader geopolitical economic re-alignment pursuant to which Canadian and other Western governments are seeking to de-couple critical industries from a global economic framework in which China is becoming an increasingly important player. Similarly, domestic politics is influencing competition enforcement and change, with regulators and politicians under pressure to act in response to cost of living issues. Although recent rapid increases in consumer prices are distantly and indirectly linked to competition law, if at all, the pressure to be seen to be doing something is translating into important enforcement and legislative changes.
In Canada, the government is proposing legislative changes that would increase the number of mergers subject to review and reduce enforcement burdens on the agency (read more here). The Competition Bureau, for its part, is regularly reviewing non-reportable transactions; engaging in in depth reviews in cases that would historically have been routine; and showing an increased willingness to challenge deals in court. In net effect, these developments are increasing costs and regulatory uncertainty for companies seeking to transact in Canada. The Investment Canada Act is also about to become more burdensome, with pending amendments potentially subjecting a large number of foreign investment transactions to mandatory pre-closing reviews (read more here).
At the same time, U.S. antitrust authorities have continued to bring and maintain high-profile enforcement cases, particularly in the technology arena, health care and private equity. In some cases, U.S. antitrust authorities are advancing novel theories to support objections to mergers. Altogether, these developments are having a chilling effect on dealmaking given the prospect of longer and more complex reviews.
Adding to this are changes in the pipeline to the U.S. HSR Act premerger filing process. If adopted, these changes will impose additional requirements—and likely longer timelines—for transacting parties to supply detailed information about their businesses and the transaction. And for the first time in over a decade, the agencies entrusted with enforcing U.S. antitrust laws have proposed major changes to their “handbook” to assess whether proposed combinations of, and investments in, businesses should be challenged as anti-competitive. Reflecting the current administration’s efforts to step up antitrust enforcement, the revised merger guidelines are likely to have a meaningful impact on companies doing business in the U.S., particularly those players (including PE firms) seeking to expand their reach through M&A transactions.
Activist activities in the U.S. and Canadian market, including M&A transaction-related activism, remain strong. In the U.S., the number of both M&A-targeted campaigns and board seat-targeted campaigns in H1 of 2023 launched by activist investors was significantly higher than recent years. Canada also saw a major spike in activist activity. See our companion piece on unsolicited M&A response readiness for more.
3. Cross-border litigation risk
Following a series of decisions that had consistently narrowed the jurisdictional reach of U.S. courts, the U.S. Supreme Court recently departed from long-standing jurisprudence. The Court clarified that companies can be susceptible to suit on any claim in each state where it has registered to do business and that state treats such registration as a consent to be sued in its courts. Companies will need to be mindful of the implications of formally registering to do business in a state, particularly when the state treats registration as a consent to general jurisdiction.
A federal district court recently issued a stark reminder that U.S.-listed issuers should be mindful of how public disclosures characterize the “merit” of threatened claims or filed litigation to avoid potential liability under U.S. federal securities laws. The U.S. District Court of Massachusetts recently denied a defendant’s motion to dismiss securities fraud claims. The defendant had been accused of failing to properly disclose whether an earlier-filed lawsuit against the company had “merit”. The court held that the defendant indeed misled investors because statements in its SEC filings describing litigation as “without merit” could be “false and misleading” under U.S. federal securities law, if the issuer is aware of viable legal arguments against it.
Earlier this year, the Ontario Court of Appeal weighed in on the consequences of and remedies for a force majeure. The decision illustrates the wide latitude parties have to allocate risk for force majeure events in their contracts, including tailored remedies that may provide immediate relief to only one party. Here, a lack of specificity in describing the scope of relief for both parties in the event of a force majeure led to a result that neither party may have reasonably foreseen. When drafting or reviewing force majeure clauses, counterparties should consider closely how these clauses allocate risk.
4. Ongoing influence of ESG on transaction
Evaluating ESG criteria has taken on increased significance for all M&A transactions, but especially for those deals involving larger public and multinational companies. Buyers, targets and other stakeholders will have different ESG priorities to evaluate at each transaction stage, including potential challenges to deals based on ESG grounds. Parties will need to ensure that M&A transactions have a clear ESG narrative, identify appropriate ESG targets and performance indicators, and take the deal’s ESG weaknesses and strengths into account within the larger context of the organization’s ESG commitments and strategy.
Private fund sponsors and others are also feeling the pressure to meet the demands of a diverse base of investors and stakeholders when it comes to ESG strategies. Furthermore, shareholder litigation on ESG grounds is testing the ability for shareholders to influence corporate ESG policies. In the long-term, compliance policies and regulations will likely move towards unification, which will allow for a more standardized ESG approach. Until then, a flexible internal strategy and a clear ESG narrative surrounding investments and transactions will be beneficial (read more here). While fund sponsors are trying to keep up with investors’ growing requests for ESG-related diligence, investment restrictions, reporting and disclosure, they also face a conflicting challenge primarily in the United States—the anti-ESG movement (see more about several trends in the U.S. private funds market).
Diversity, equity and inclusion best practices
The CSA is in the process of updating corporate governance disclosure requirements and other diversity best practices guidelines. As regulatory policies regarding DEI increase, so too are litigation cases in this area. Class actions at home and abroad present new challenges for leaders, but thorough documentation of employee matters and closely monitoring operations may protect employers from exposure to litigation in this area. ESG disclosures that focus on diversity, equity and inclusion criteria have in many cases gone mainstream; perhaps unsurprisingly, workplace class actions are increasing in lockstep around these matters. As companies prepare for future ESG reporting, they should also take proactive steps to prepare for possible litigation in this area. Some steps include thorough termination and compensation documentation and detailed harassment policies, among others.
5. Technology considerations
The regime governing artificial intelligence (AI) regulation is poised to change significantly in the coming years, with the introduction of AI legislation and automated decision-making rules in Canada, and the roll-out of new legislation in the EU, the United States and other jurisdictions. When buyers look to consider organizations that leverage or plan to leverage the use of AI systems, they will want to be mindful that targets are up to date with the evolving legal frameworks that govern their design, development, distribution and use of these systems.
Consumer AI services like chatGPT are also entering the workplace as support tools. At the same, regulators around the world are investigating whether these tools violate privacy and other laws. Companies in Canada and the U.S. should develop internal policies on whether, and to what extent, these tools can be used for business purposes, and ensure employees understand the various risks of doing so. Acquirors looking at targets that are planning to implement or have already implemented internal AI will want to ensure thorough diligence around this aspect of the target’s operations.
Cybersecurity and data privacy
With the digital transformation underway across the globe, cybersecurity, data protection and the deployment of technology are now critical enterprise issues that require dedicated attention, expertise, capital and resources. As a fast-evolving facet of doing business, buyers will want to continue to be particularly mindful of these areas of a target’s operations and governance mandates. The ongoing risk management acquisition diligence risk framework should be updated regularly to identify and manage emerging cyber and data protection risks, with a reliable compliance program and protocol for reporting and escalating incidents so that appropriate oversight be effectively maintained.
In the United States, the past year has been marked by a flurry of data privacy activity. Recent policy and enforcement initiatives by the Federal Trade Commission, cybersecurity regulations adopted by the SEC, numerous states legislating new privacy rules, and developing international data privacy standards make clear that data privacy and protection is a priority for governments—and therefore must be prioritized by businesses.
To discuss these issues, please contact the author(s).
This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.
For permission to republish this or any other publication, contact Janelle Weed.