Canada: Will We See More Distressed M&A In Canada?

The term "distressed M&A" refers to mergers or acquisitions that are completed when the target company is facing insolvency or is already insolvent. In this article, Peter A. Saad and Gordon Chan of Loopstra Nixon LLP discuss the likelihood of an increase in distressed M&A deals for Canada over the next 12 months, and the various factors that may come into play.

Uptick in interest rates and tightening labour market conditions

As has happened in other parts of the world, there has been an uptick in interest rates in Canada. While there are currently a lot of businesses in Canada on low fixed rate interest loans in the 2–3% range, these loans are coming to maturity in the near future. With the looming maturity dates and inflation hitting the labour market in a significant way, these challenges will certainly put pressures on business operations.

Labour market conditions in Canada are tightening. In Ontario, for example, there was recently a minimum wage hike, reflecting government policy of increasing wages to try to counter inflation. Unfortunately, however, this is happening at a time when employers simply cannot afford wage increases in general.

A perfect storm for distressed M&A?

The increased interest rates and tightening labour market conditions pose the question: is it close to a perfect storm for distressed M&A deals in Canada? The answer is: not quite. More pertinent questions include the following: Has this economic storm actually hit Canada yet? If not, when might this happen? In other words, has the Canadian M&A market bottomed out? What stage of the business cycle has it reached? Where does it go from here?

Established businesses versus recent acquisitions and COVID-19

First, it is likely that already-established businesses are going to be able to remain stable and weather the coming economic storm in Canada. However, recent acquisitions who are early in their debt cycle are going to face numerous problems when this storm hits the country. While this factor is not a unique development for Canadian recently acquired businesses, the fact that they are not alone will be cold comfort for them.

Second, there is the question of whether there was an uptick in distressed M&A during or following the COVID-19 pandemic. In Canada, the answer seems to be no. The business environment was effectively booming throughout the pandemic. Moreover, consumer activity remains high in the country to date. What has changed, though, are labour conditions in the country. Specifically, the current shortage of labour and the relatively high cost of labour in Canada are now being compounded by the elevated interest rates.

Higher prime rates and increased SG&A expenses

Third, it can now be observed that much of the projected M&A activity a few years ago was based on sensitivities and interest rate analysis at the time. These projections have now been blown through. To clarify, the prime rate, also known as the prime lending rate, is the annual interest rate used by Canada's leading banks and financial institutions to set interest rates with respect to variable loans and lines of credit, including mortgages with a variable rate. Several years ago, few predicted or expected that the prime rate would rise dramatically from 2.45% (at the onset of the COVID-19 pandemic in April 2020) to the current rate of 7.2%. Commentators at the time were using a projected prime rate of 5% and 6% in models of late 2023, although that was still essentially a doubling of the rate at the time.

Given the current prime rate of 7.2% in Canada, it appears inevitable that there will be an increase in activity and opportunities to be had in distressed M&A deals in the country over the next 12 months. Potential buyers that have maintained discipline and have the cash on hand will be reaping the benefits of these opportunities.

Fourth, there is now general tightness in the market for businesses in Canada, especially in relation to increased SG&A (selling, general and administrative) expenses. This is demonstrated by the increasing prevalence of businesses applying for financing on deals that would typically be approved but are now being denied. As more and more loans start coming up for maturity, the concern on this point is now significant amongst businesses.

The next 12 months

Overall, it is probable that distressed M&A will continue to rise in frequency in Canada over the next 12 months as market conditions continue to tighten. It is also probable that this spike in distressed M&A will take place across a range of different sectors, rather than in any sectors in particular. We can expect the spike will impact business differently depending on their financing needs.

For example, in relation to the increased SG&A expenses for businesses, there will most likely be an accompanying decrease in gross margins, because the cost of goods is increasing. If a business has taken out a variable loan, it will be subject to a rate of interest that has doubled, while businesses that took out fixed loans will be up for renewals at ostensibly higher rates. This is the scenario that is almost certainly going to play out in Canada over the next 12 months.

Conclusion

In conclusion, with regard to economic fundamentals, Canada has been experiencing extremely favourable conditions for business in recent times. As a result, there has been no significant uptick in relation to distressed M&A in the country as of yet. However, considering those economic fundamentals, prompts the question: at what point will the economic storm hit Canada and flood the country with a slew of distressed M&A deals?

Despite the fact that market commentators have been expecting a significant increase in distressed M&A deals in Canada for at least a few years now (since the onset of the COVID-19 pandemic), the economic dam has nevertheless held steady so far. However, as loan renewals start coming up in Canada, it appears increasingly likely that this economic dam will break at some time over the next 12 months. When it does, the Canadian market will experience a large flow of distressed M&A deals. As for the actual extent of this flow of distressed M&A, and whether the deals will be occurring in any particular sectors more than others, only time will tell.

Originally published by Chambers and Partners.

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