CORPORATE/COMMERCIAL: HIGHLY REGARDED: An Introduction to Ontario
Capital Markets Conditions in Ontario
Ontario’s economy and business environment remains broadly reflective of Canada as a whole. The country’s most populous province, encompassing the business centres of Ottawa and Toronto, Ontario – and Canada in general – has a longstanding reputation as a comparatively stable and welcoming place to do deals, which it maintained even during (and in the aftermath of) the COVID-19 pandemic. Unlike numerous other economies, low interest rates and relatively straightforward access to capital have helped Canada to maintain a steady, reliable and consistent course since the 2008 financial crisis, and the market continues to progress.
That said, with the elevated interest rates seen in Canada (and in many other developed economies) in recent years, there is currently real pressure on financial covenants. Financial covenants can be included in loans by lenders to set certain conditions and guarantees that the borrower must adhere to. Essentially, the goal of financial covenants is to protect the lender’s investment and provide assurance that the borrower will stay on track for full repayment of the loan. Given the currently high interest environment in Canada, it is increasingly important that financial reports and forecasts of companies and business owners should involve the careful analysis of any financial covenants that are built into debt agreements.
In addition, the elevated interest rates in Canada and around the world have led to significantly higher costs of borrowing through traditional avenues. As a result, the nature and requirements of many corporate and commercial deals have increased in complexity. This has compelled buyers and sellers to explore alternative (and occasionally innovative) methods of bridging the gap between the traditional financing that a buyer can access and the purchase price being requested by the seller. One particular alternative method that has recently seen a significant uptick in Canada is the use of seller notes. Also known as a seller financing or vendor take-back note, a seller note is essentially a financing tool in which the seller of a business provides a loan to the buyer for part of the purchase price. Through the use of seller notes, sellers are able to offer financial assistance directly to buyers, which in turn removes the need for buyers to rely solely on traditional financing options such as bank loans or external investors.
Overall, there continues to be activity in the Ontario market – and in the Canadian market as a whole – with an as yet undiminished flow of corporate and commercial deals. However, there is also growing tension, with recessionary fears persisting in the market, and bank stress tests and increased financial covenant analysis leading to elevated scrutiny of deals. As such, it remains necessary for deal-makers to employ more creative, nuanced and practical approaches to doing deals, while patience continues to be a necessary virtue given the continuing extension of deal timelines.
Navigating Choppy Waters
Canada’s historically low interest rates, set by Canada’s central bank (the “Bank of Canada”) have, until recently, provided ideal conditions for high levels of growth and business activity. Swift action and rate adjustments by the Bank of Canada early in 2020 also meant that the impacts of the COVID-19 pandemic experienced by many other countries and markets failed to materialise in Canada. This allowed for a largely stable flow of deals to be done during an extremely turbulent couple of years. However, fears of a global recession in 2022 spurred the Bank of Canada to double down on its policy of quantitative tightening, and (at the time of writing in September 2023) it had recently increased its interest rates for the tenth time since March 2022. As a result, Canada now has the highest policy interest rate among the G7 countries. This continues to impact the nature and requirements of many corporate and commercial deals.
The Changing Nature of the Deal
The recent increases in interest rates have been the biggest driving factor in the changing nature of deals in Canada. While the appetite for transactions remains strong, particularly on the part of sellers wishing to exit markets, rising interest rates means that the availability of funds to service debt has been diminished, which is affecting the loan-to-value ratios of transactions. The rising interest rates are a drain on the financial covenants, which means the same asset is unable to carry as much debt – or service as much debt – as it would have historically. The metrics used in calculating a buyer’s leverage have not changed, but the rapid rise in interest rates means more of the repayments are interest as opposed to principal. This has created something of a conundrum between sellers who do not wish to – or cannot – change their prices, and buyers who cannot access the capital to get a deal done. There is an incongruity between seller expectation and buyer capability. But, as with many conundrums, there are solutions to this, particularly for those who are willing and able to be creative, pragmatic and savvy.
Time to Get Creative and Bridge the Gap
With the tightening of financial covenants, what would previously have been a straightforward deal now increasingly requires deal-makers to apply all the tools and skills at their disposal. Boilerplate transactions are becoming more and more a thing of the past, meaning that outside-the-box thinking and negotiations are a must, if seller expectations and buyer capabilities are to meet in the middle. The ability and willingness of the sellers and their representatives to help bridge the gap between the price they are expecting and the leverage available to buyers is now a key factor in a deal’s success. The bridging of this gap can take the form of a variety of addendums to the deal, as well as a range of alternative structures. Chief among these alternatives are: (i) earn-outs, where a contractual provision is included, enabling the seller to lower the initial purchase price, on condition that they receive further compensation once the acquired business reaches certain financial goals; and (ii) vendor take-backs (ie, seller notes) and promissory notes, in which the seller provides leverage to the buyer, often in the form of a loan, to bridge the gap between the purchase price and the buyer’s capital base in order to complete the acquisition. These are just a few examples of the tools that can be used to resolve seller expectation and buyer capital, but are in no way exhaustive.
Deals for the Deal-Makers
Whatever the tool or structure involved in corporate or commercial transactions, just as important is the need to manage the seller’s expectations. Without the seller’s willingness to sit down and consider a more creative way of approaching a transaction, the only options are lowering their asking price or continuing to hold the asset until market conditions evolve. Legal advisers now need to factor in a strong ability to work with their clients and/or the sellers to manage expectations and help formulate new and alternative plans towards a successful deal. Those professionals best able to communicate with the various stakeholders will add immense value to facilitating successful transactions. In a market in which flexibility and pragmatism are now gospel, the pool of firms and lawyers in Canada with the ability to make these deals happen today is shrinking. When the market is easy, everyone is a deal-maker; when the market is difficult, only the real deal-makers make the deal happen.