As we prepare for 2024, what can we expect in Canadian M&A in the year ahead?
At the start of 2023, we faced a confluence of variables we viewed as somewhat unprecedented, and the result proved to be one of the slower M&A markets in recent memory. As the calendar turns to 2024, there are numerous grounds to be cautiously optimistic about a healthy rebound.
Macroeconomic Conditions
On the positive front, 2023 saw inflation stabilize and recede, although it remains higher than central banks and the market would prefer. The steady rise of interest rates over 2023 has also flatlined, and the question has evolved from how high they will climb to how long they will stay there. Outside of an unexpected recession they are not anticipated to drop in the near-term and the market is adjusting to this new, but hopefully temporary, normal. Indeed, consensus appears to be growing that rates could begin to ratchet down as early as Q3 2024. This would be a powerful stimulant for M&A, including by loosening 2023's tighter than usual credit markets.
However, geopolitical tension remains high. War in the Middle East has joined the war in Eastern Europe. Taiwan remains a troubling potential flashpoint. In each case the backdrop is an apparent broader global realignment and friction between the West on one side and Russia and China on the other. A further layer of complexity and uncertainty is added by the U.S. election that will dominate headlines during 2024 and likely present widely different possibilities regarding U.S. economic and political policy based on the ultimate outcome. That said, the U.S. economy looks to remain strong over the year with all the positive effects this would entail.
M&A Dealmaking
What will be the impact of the these macroeconomic conditions on M&A dealmaking in Canada? Might we see a second straight year of depressed deal flow? One possibility is that continued uncertainty will cause some buyers to adopt a "wait and see" approach. Other sellers may be brought to the table by necessity rather than opportunity, no longer able to wait out better market conditions. Still others, encouraged by a greater sense of normalcy, may confidently spearhead resurgence. For example, one recent analyst survey indicates greater enthusiasm among private equity firms for take-privates than there was a year ago notwithstanding continuing challenges in financing. Another analyst survey reports that an overwhelming majority of CEOs canvassed expect to actively pursue some form of transactions in the next 12 months and that that they are allocating more capital to their M&A budgets in anticipation. An interesting related question is whether revitalized M&A activity brings with it a corresponding increase in M&A shareholder activism, including if some bigger-picture uneasiness remains.
We expect a good portion of deal volume to continue to be weighted toward the middle-market and lower middle-market. We don't necessarily expect a giant wave of mega-deals, but would not be surprised if numerous significant strategic tie-ups punctuated the landscape, and in any event we expect more activity on this front than in 2023. Hotspots of increased activity will likely endure or form, particularly where supported by longer-term trends or government stimulus, such as in information and communications technology, cleantech, infrastructure, agribusiness and critical minerals. ESG considerations look to remain integral to certain M&A activity, whether as the focus of due diligence or by contributing to deal drivers. New areas of increased activity could include housing development and its supply chains as Canadian federal and provincial governments continue to focus on Canada's crisis in housing supply. By contrast, government policy could stifle activity in certain sectors, such as in oil and gas where new federal regulatory proposals are set to impose caps on emissions. Overall, however, we expect the combination of the market's adjustment to the interest rate environment, pent-up deal appetite, and the likelihood of lower rates sooner than later to contribute to steadily increasing M&A volumes over the year.
Private Equity vs Strategics
The cost and availability of credit have endured as key challenges to negotiating buyout deals. Yes, valuations have decreased, but not sufficiently to compensate for increased borrowing costs. The growth of private credit has helped fill the funding gap, but again, not to the extent needed to sustain a buoyant buyout market. A notable result has been private equity (PE) sponsors increasing their level of equity contributions to finance purchase prices, which have begun to breach 50%, a threshold generally not crossed since the 2008 financial crisis. PE-backed exits also remain slow amid low exit values and with the average length of buyout holding periods having grown increasingly longer. Continuation funds and GP-led secondaries are therefore likely to remain popular fixes where appropriate. By contrast, the initial public offering (IPO) exit market remains in a holding pattern, and as it does the pipeline of late-stage startups continues to grow. Private equity has also faced some fundraising challenges, including in the face of restricted limited partner (LP) capital supply and competition from the bond market as some asset allocators at institutional investors have become attracted to upticks in long-term yields. Private equity is also facing a so-called "wall of maturities" as portfolio companies must refinance existing debt. This may be a reckoning that forces hard choices: provide further support by infusing more equity, suffer dilution by selling a stake, or exit outright in a suboptimal market.
Strategics, by contrast, face fewer complications and thus may be better positioned for dealmaking. For example, while private equity wrestles with the cost of debt, strategics may have access to more financing options such as cashflow from operations, corporate bonds and/or larger stockpiles of dry powder. Their focus could include hyper-targeted acquisitions aimed at improving competitiveness in priority areas. Other possibilities include using M&A to pursue ESG or digitization agendas or supply chain resilience. Strategics' proportional share of M&A dealmaking relative to financials could therefore grow again for the third straight year, a noteworthy reversal from the past decade-plus.
M&A Deal Terms & Disputes
As transactions move forward we may continue to see the hallmarks of less frenzied M&A markets and greater parity among buyers and sellers, including longer negotiation periods, more extensive due diligence and more balanced terms. Creative deal-structuring should also remain key, including to bridge continued valuation gaps between buyers and sellers and to solve for financing obstacles. In private equity, management rollovers are likely to remain common as sponsors require managers to invest capital earned in the buyout into the target, and perhaps in increasingly greater amounts. Regardless of industry, earn-outs will likely continue to be leaned on. An open question here is whether the uptick in the frequency of earn-out clauses over 2022-2023 will result in a corresponding materialization of post-closing earn-out disputes, and experience in the United States (and Delaware court filings) is already signalling towards this end. Vendor financing and take backs should also remain a possible solution, at least where the seller is a strategic.
The increased prevalence of representation and warranty insurance (RWI) over recent years mitigates against the likelihood of post-closing disputes, and we understand that payouts on claims (where occurring) have generally been encountering little insurer pushback. However, more balanced leverage between buyer and sellers may act to reduce the frequency of complete "no recourse" public M&A-style liability structures in RWI deals. We expect the use of RWI to continue its expansion into lower-middle market deals, as do we expect further evolution and sophistication in the impact of RWI on the way parties approach and negotiate transactions. Given recent developments in caselaw, we are curious to see if Canadian M&A practice trends toward Delaware in respect of drafting for buyer damages (i.e., the potential to claim for lost shareholder premium) in pre-closing public M&A disputes (Crispo) or control over privileged target communications in post-closing private M&A disputes (Dente). Another possible evolution could be increased recourse to alternative dispute resolution (i.e., arbitration) rather than the courts for certain post-closing disputes (e.g., whether earn-out triggers have been met and/or whether associated earn-out efforts undertakings have been satisfied).
Competition & Regulatory Issues
Regulatory issues may act as a dealmaking headwind. Continued geopolitical tensions will of course keep potential foreign investment hurdles fixed front and centre. But more recent developments may keep competition considerations even more front of mind. In late November 2023, the federal government proposed significant and wide-ranging amendments to the Competition Act that include the potential of expanded merger notification requirements.
In late October 2023, Canada's Competition Commissioner, in speaking to the Canadian Bar Association, made specific reference to private equity in promising "continued scrutiny" of "evolving business practices". The focus of the Commissioner's comments were "roll-up" or "tuck-in" acquisitions, and have been interpreted as signalling the Competition Bureau's intent to follow the lead of U.S. antitrust regulators on this front. Potential consequences range from private equity buyers suffering from competitive disadvantage vis-à-vis strategics as potential merger divestiture purchasers, to the Bureau requiring information that extends beyond the immediate transaction, to greater Bureau scrutiny of interlocking directorates that may result from the acquisition. The potential for expanded anti-competitive regulation may encourage the acceleration of some transactions so they can close before the reforms are implemented.
These proposed policy changes are expected to continue to impact M&A negotiations and transaction terms, including more attention to and more bespoke drafting around (1) required regulatory approvals, (2) associated efforts undertakings, (3) the allocation of regulatory risk, (4) "hell or high water" clauses, (5) break fees and reverse break fees, and (6) applicable "outside" (or "longstop") dates. Deal dynamics may also be impacted, including consideration of who may (or may not) constitute a preferred bidder in a competitive auction process.
Executive Summary
While 2023 was a down-year in M&A deal volume, there are numerous reasons to be cautiously optimistic about a healthy rebound in 2024. Market actors are adjusting to the new normal of higher interest rates and as they do so deal appetite should increase steadily based on a combination of incremental comfort, pent-up demand, and manifest opportunity. On the other hand, should any of the larger macroeconomic challenges facing the market show signs of imminent resolution, a broader M&A revival could prove surprisingly swift.
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