No Match Found
By David Planques
2017 was a very big year for Canadian mergers and acquisitions (M&A). The year started with significant uncertainty surrounding the impact the new US administration’s policies might have on trade and the broader North American and global economies. In spite of this, Canadian dealmakers carried 2016’s strong M&A momentum into 2017, with deal volume increasing year over year.
Looking back over the M&A data from the last year, there are three prevailing themes:
Both aggregate deal value and volume increased substantially year-over-year in all valuation bands except “mega deals” over $5B in value, which represents a small volume of Canadian deals and consequently is inherently “lumpy”. Even with ample cash on hand and access to other capital, some would-be dealmakers decided to wait and see with large-scale transactions.
However, strong M&A activity outside of mega deals was driven by a number of factors that encouraged buyers to transact, including continued low interest rates, confidence in the economy and an abundance of dry powder. Sellers’ motivations were driven by many factors, but common themes included succession-driven M&A for family businesses as well as corporate and private equity sellers taking advantage of high valuations to realize gains.
The technology sector continued to be M&As most active industry sector in 2017, with a 34% increase in deal volume over 2016.
The majority of these deals were in IT services and consulting, which saw a 63% increase in deal volume over 2016, and software, which saw a 25% increase. In particular, there were a number of deals in payment solutions, CRM and ERP software, artificial intelligence (AI), security applications and data analytics—a sign that Canada remains an active player, developing, growing, buying and selling attractive companies in these industries.
This activity was bolstered by traditional corporates seeking out deals in the tech space. As technology seeps into each sector with innovative "hacks" (new, efficient and productive methods of doing something), tech and non-tech corporates alike, are looking to acquire technology to increase their competitive advantage.
US deals continued to account for the lion’s share of Canadian outbound* M&A (60% of volume). This is consistent with the upward trend we’ve seen since 2008. Notably, real estate saw nearly twice the number of outbound deals to the US year-over-year. The technology sector also increased by 45% from 2016, with the vast majority (90%) of those acquisitions being by corporate buyers.
Of the 114 outbound deals to the US in the technology sector last year, 41% of the Canadian buyers were in industries outside of tech which follows an overall trend of cross-sector deals, particularly in tech M&A. Why US tech targets? The size of the market plays a role, and not only can companies secure attractive funding, but the infrastructure in US tech hubs breeds growing, scaling businesses. All this means the US is the largest, most fertile ground for Canadian buyers to pick up interesting tech targets. Although, as noted above, there have been great tech deal opportunities in Canada also.
*Outbound deals are defined as a Canadian acquiror with a foreign target.
According to PwC’s 21st Annual Global CEO Survey released last week, 44% of Canadian CEOs are planning to engage in M&A activity in the next year to drive corporate growth and profitability. In the US, that number is a bullish 69%, adding fuel to the belief that the North American M&A market will remain strong throughout 2018.
Three factors that could significantly influence Canadian M&A activity in the year ahead are:
As the year progresses, we will start to observe major changes resulting from the US Tax Cuts and Jobs Act. The devil here is in the details: businesses will be affected differently depending on their capital structure and industry. The Act will have a significant impact on Canadian businesses undertaking M&A. Here are four critical provisions to think about:
Corporate tax rate reduction
The US federal corporate tax rate has been reduced from 35% to 21% before state taxes, eroding Canada’s competitive tax position. The change aims to attract corporate investment to the US away from other countries (including Canada). This reduction in taxes will likely result in higher after-tax cash flows for US corporations; we expect this to drive up company values and deal prices in the coming years. As US valuations increase, the gap between US and Canadian multiples—a gap that has always existed—may increase.
Territorial tax system / Toll charge
The move to a territorial tax system, accompanied by a one-time “toll charge” on previously untaxed earnings and profits—15.5% on cash and equivalents and 8% on other earnings, eliminates the disincentive for US multinationals to repatriate offshore cash. While some of this repatriated cash may be used for share buybacks and dividend increases, we expect this influx of “surplus” cash will spark a “buying spree” among multinationals flush with repatriated cash.
Going forward, buyers will have to exercise a good deal of due diligence on potential targets with cross-border structures, and heavily scrutinize any tax planning put in place by sellers to eliminate offshore earnings and profits.
Immediate expensing (Cost recovery)
The Act also allows for 100% expensing for certain new and used depreciable assets acquired and placed in service after September 27, 2017 and before January 1st, 2023. The provision should prove particularly valuable for private equity buyers focused on after-tax cash flows in the early years. It should also increase demand for equipment and boost valuations of capital intensive industries.
Business interest expense
Deductibility of net interest expense will be limited to 30% of adjusted taxable income for most corporations, partnerships, and US branches. Adjusted taxable income is roughly equivalent to tax EBITDA until January 1, 2022 when it changes to tax EBIT. This change may limit the use of financial leverage on some transactions. In combination with the reduction in US tax rates, this will impact the acquirer’s cost of capital, which will need to be modelled into deals to determine the cash flow and valuation implications. We also expect to see multinationals move debt to non-US jurisdictions to take advantage of more favourable deductibility rules.
US taxpayers will be entitled to a 37.5% deduction applied to their “foreign derived intangible income” (FDII), giving US companies more incentive to export goods and services, and less incentive to set up companies in Canada to reach our markets.
While the exact impact of the tax reform remains to be seen, it’s clear that many structures for Canadian companies investing into the US will be less effective, as opportunities to deduct interest will be reduced. That said, every business and sector will be affected differently; and modelling can help to identify where companies should focus their tax planning. As with any significant market change, there will be new opportunities and benefits for organizations across all sectors.
The tech sector will continue to be very strong in 2018, and we expect both deal volume and valuations to rise over the next 12 months.
One trend we expect to see more of is non-tech companies buying disruptive tech as either a value creation strategy and/or a defensive strategy. Such deals can add value across a number of vectors, including access to highly skilled teams, technology or intellectual property, new markets and cross-sell/up-sell opportunities. These value drivers can be critical to companies striving to remain competitive against tech companies and other disruptive entrants. Earlier this month, we saw TD Bank acquire artificial intelligence firm Layer 6 AI. Continued investment in machine learning and AI should mean more of these deals in the near future.
56% of Canadian CEOs plan to collaborate with entrepreneurs and start-ups in order to drive corporate growth and profitability in 2018.
Over the past five years, more than $10B* has been invested in emerging AI tech south of the border. In Canada, a record $252M* was invested in AI last year alone, and we would expect the trend of strong investing in AI to continue, including more M&A activity. The global investment activity in machine learning and AI provides clear direction that value extraction from data is a core focus of the tech industry.
*according to PwC analysis of CB Insights data
Will the US administration follow through on the election promise to cancel NAFTA if they can’t wring concessions from Canada and Mexico? Time will tell.
In the meantime, life (and business) goes on: Canada continues to lodge complaints with the World Trade Organization (the most recent accusing the US of multiple violations of anti-dumping and anti-subsidizing rules), and should expect to continue relying on Chapter 19 of the existing agreement to resolve trade disputes.
While the continued resultant uncertainty may cast a pall over industries that enjoy protected status under NAFTA, we see Canadian companies continuing to “power through”, and use US-bound M&A as a way to establish or grow a presence in the US. Theoretically, this could insulate them from protectionist legislation and give them easier access to the strong US economy. The uncertainty should prompt a fresh look at business strategies, and a certain “hedging of bets” in the event that NAFTA is terminated.
Overall, we expect that Canadian M&A activity will remain robust as the favourable economic outlook for Canada provides dealmakers with the confidence to transact. Business transformation through the use of M&A will be a common theme and we expect to see increased M&A activity in tech and disruptive tech sectors as companies continue to position themselves to compete in the digital economy.