Will the deals keep up?

By Philip Symmonds + Andrew Prodanyk

How the government’s change in tax policy coupled with the rise of troubled trusts will affect M&A activity for income funds

Income fund M&A was a busy area in 2007. Although the market was not as frenzied as some commentators had predicted, about 25 income fund transactions with a total dollar value of approximately $23 billion were reported in the wake of the Canadian government’s announcement, on October 31, 2006, to eliminate the tax-advantaged status of income funds. Many additional funds have commenced strategic review processes, with the expectation that many current income funds will go private, as market conditions — including the recent, highly publicized negative developments in the Canadian and US credit and currency markets — permit.

As the 2011 effective date of the new tax rules draws nearer, each remaining fund will need to determine whether the trust structure continues to maximize value for unitholders. As a result there are a number of principal legal issues that arise in the context of an income fund M&A transaction.

Structure
Two structures are typically used for an income fund acquisition. The first is an acquisition of units from unitholders. This is accomplished by the buyer signing a support agreement with the fund and making a public takeover bid to all holders. In the support agreement, the trustees agree to support the bid by recommending the transaction to unitholders.

This structure can be attractive to the fund’s trustees. The documentation is prepared by the bidder with a trustees’ circular prepared by the fund. The change of control that results from the transaction is unlikely to trigger consent requirements under most contracts, and as a result, third-party cooperation is generally not required. Finally, the task of securing unitholder support falls to the acquiror and the transaction requires reduced involvement from the fund or the trustees once it has been announced.

Where more than 90% of unitholders tender to the offer, most declarations of trust will permit the compulsory acquisition of units not tendered following a takeover bid without the necessity of a unitholder meeting. Where more than 66.7% of the units of a fund are tendered to the offer, the bidder will still be able, in most cases, to do a second-step squeeze transaction without the necessity of a unitholder meeting. Where the second-step squeeze transaction can be effected without a meeting, an acquisition by way of takeover bid can generally be completed in about 60 days from the signing of a support agreement (allowing for some time to prepare the circular).

The second structure, and one that can be appealing to buyers, is to purchase the underlying assets of a fund. In the case of the older Fund on Corp. structures, that will mean purchasing the shares and debt of the corporation “beneath” the fund. In the case of the Fund on Fund on LP structures, that will mean purchasing the limited partnership. Following the purchase, the proceeds are distributed to unitholders and the fund is wound up.

To execute the second structure, a unitholder meeting is held to obtain approval (generally by 66.7% of unitholders) for the sale of all or substantially all the assets of the fund. In this structure, the documentation burden falls on the fund, which must prepare and pay the costs of mailing an information circular to the unitholders and holding the meeting. If there is to be a rolldown of assets into a vehicle to be purchased, this could trigger consent requirements under assignment clauses in contracts. Depending on those consent requirements, an acquisition by way of purchasing assets can also generally be completed in about 60 days from the signing of a purchase agreement. If one allows time up front for due diligence and for the negotiation of acquisition documentation (this part of the process is elastic in terms of timing), this means an income fund acquisition is generally a four- to five-month proposition pillar to post (although it will be longer if the upfront period for diligence and negotiation is longer).

The timetables for completing a takeover bid and an asset purchase are similar, especially when the second-step transaction can be completed without a meeting in the case of a takeover bid. Given these factors, the choice of structure will, in most cases, be driven by the buyer’s tax considerations, with factors such as consent requirements being important subsidiary concerns.

Risk allocation
Because trustees will want to resign immediately post-closing and distribute all proceeds received, they will have limited appetite for post-closing obligations. As a result, some of the conventional conditions that might be available on a private M&A deal generally are not workable in the income fund context. For example, holdbacks and earn-outs will be difficult to make work because unitholders expect their cash in one lump sum. Post-closing adjustments, such as working capital adjustments, are also generally not workable for the fund, because once money has been distributed, there is no one with whom to make the adjustment. Although representations and warranties from the operating company may provide disclosure, they are of no risk-allocation value because the buyer will own the entity that has given the representation. All of this puts a premium on comprehensive due diligence that covers the period up to or near closing and drives buyers to price in risks up front.

Deal-protection issues
Deal-protection mechanisms on public M&A transactions balance the buyer’s desire to commit to its transaction against the seller’s duty to be able to respond to superior offers.

The typical arrangement provides that the seller is prohibited from soliciting or facilitating a competing offer (typically defined as an acquisition proposal) but is given a limited right to provide confidential information to a bidder where the offer is reasonably likely to result in a better offer (typically defined as a superior proposal). The seller then has the right (the fiduciary out), again under limited circumstances, to accept the better offer, typically after providing the buyer with a right to match. However, the seller is required to pay a break fee in order to do so.

These provisions are always highly negotiated in an income fund transaction. To the extent there is a typical pattern, it is that the break fee is triggered in three circumstances: where the fund terminates in order to enter into an agreement with respect to a superior proposal; where the buyer terminates because the fund is proceeding with an alternative transaction; or where the transaction does not succeed (because the required number of unitholders has not voted in favour or tendered) but an alternative transaction is consummated within a set period of time.

The first case arises where the fund has received and wishes to agree to a superior proposal. In that case, the fund terminates and pays the break fee. The second case essentially allows the buyer to ensure that it gets paid the break fee where the target declines to terminate the agreement itself. This right is triggered if the fund withdraws or modifies its recommendation or approves a competing transaction. To prevent the trustees from seeking to avoid payment, the fee is often also payable if the trustees fail to reaffirm their recommendation within a set period of time after an alternative transaction is announced.

The third case covers the situation in which an alternative acquisition proposal is on the table but the trustees do not actually recommend that transaction, instead allowing the first proposal to be voted down by unitholders (or for unitholders not to tender). In that circumstance, the break fee is usually triggered if the alternative transaction is actually consummated within a period of time following termination (the preponderance of precedents fall in at 12 months). This is a form of anti-avoidance provision that prevents the trustees from avoiding paying the break fee by not actually changing their recommendation, instead relying on the economic incentive of unitholders to vote down or not to tender to the first buyer’s transaction.

Break fees on M&A transactions typically range from 2% to 3%, but can be higher or lower depending on the size and complexity of the transaction. The fee is generally paid when the superior transaction is entered into, not when it is completed. For trustees, this creates two issues. First, any break fee is problematic to the extent it has the potential to affect distributions, so there is inevitably pressure to push the break fee lower. Nevertheless, in the transactions since the government’s October 31, 2006 announcement, break fees have ranged from 1.7% to 4%, with most of the transactions clustering at about 3%. Second, if the break fee is paid and the alternative transaction is not ultimately consummated, the fund is “out” the cash and distributions will suffer. Hence, the fund may push to have the break fee paid only if the alternative transaction is actually completed.

Subsequent acquisition transactions
Where a bidder in a takeover bid acquires more than 66.7% of the units, it will generally be in a position to effect a subsequent acquisition transaction to squeeze out the minority. Two structures have been used to affect the second-step squeeze in income fund transactions. The first involves amending the threshold for a compulsory acquisition from 90% to 66.7% where the declaration of trust contains the 90% compulsory acquisition provisions. The process requires the bidder to give notice that it intends to utilize the compulsory acquisition procedures; the bidder is then required to pay for the units and the unitholder is requiredto tender its units in 21 days. If the unitholder does not tender its units, the trustees will cause the transfer of the units.

The second structure involves the sale of assets (e.g., the shares and debt of the underlying corporation) by the fund for cash, the redemption of fund units and the windup of the fund. The second structure is the “out from under” asset purchase structure discussed above but implemented after the takeover bid. This transaction generally requires unitholder approval by way of a 66.7% vote, but the bidder would be in a position to carry such a vote if its bid is successful and includes a 66.7% minimum tender condition.

Several unique aspects of the subsequent acquisition transaction in the income fund context are worth noting. First, many declarations of trust contain provisions that permit unitholder approval to be obtained by way of a resolution signed by 66.7% of unitholders — that is, without a unitholder meeting. Second, the letter of transmittal that goes to the unitholders can provide the bidder with a power of attorney that permits the bidder to sign the resolution that would approve the subsequent acquisition transaction. The letter of transmittal’s power of attorney can also permit the bidder to acquire the units when notice is provided to unitholders (notwithstanding that payment is not made until later). All of this means that if more than 66.7% of unitholders tender to a bid, a bidder will be in a position to effect its subsequent acquisition transaction almost immediately after takeup.

Developments to date and outlook
To date, only a few large transactions have been completed, involving REITs as well as the acquisition of UE Waterheater Income Fund by Alinda Capital Partners in April 2007. Most recent transactions have involved small- to mid-cap funds, with acquirors being both financial and strategic buyers. While a significant majority of transactions have been friendly, a few hostile transactions have taken place as well. As more deals are completed, market norms will continue to develop and more standard documentation will result. On the whole, this should result in fewer obstacles and a reduction in execution risk. The Canadian government’s change in tax policy, together with the rise of troubled trusts, is almost certain to result in increased M&A activity for income funds in coming years.

Philip Symmonds (psymmonds@torys.com), a partner at Torys LLP in Toronto, practises corporate and securities law. Andrew Prodanyk (aprodanyk@torys.com) is an associate in Torys’ corporate department in Toronto

Technical editor: Peter Hatges, CA, CBV, CF, partner with KPMG LLP in Toronto and the national leader of corporate finance in Canada. He is also a member of the CICA’s Corporate Finance Working Group