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Doing Business: Private equity to drive 2007 M&A activity

|Written By Jim Middlemiss

Now that the government has effectively shut down the income trust market, what will drive Bay Street in 2007? Weep not for big law firms.

The market is not expected to cool down anytime soon.

Torys LLP, Blake Cassels & Graydon LLP, and KPMG LLP have all weighed in with studies examining upcoming mergers and acquisitions activity in 2007. They expect activity to increase and predict that private equity deals will play a more prominent role in capital market activity this year.

That likely spells good news for not only Bay Street firms serving Canada's biggest corporations, but also those many law firms servicing the entrepreneurial classes. They stand to gain as clients hire them to help tap private capital to expand their businesses or sell their current operations. So the year is shaping up well.

It's not like last year was an M&A dud. Au contraire. According to KPMG, the value of all M&A deals in Canada during 2006 hit US$173.6 billion, rising 26 per cent from 2005. The top five deals accounted for one-third of that activity or US$60 billion. They included:

•    Xstrata PLC's US$18-billion acquisition of Falconbridge Ltd.

•    Cia Vale do Rio Doce SA's US$1- billion acquisition of Inco Ltd.

•    Barrick Gold Corp.'s US$10-billion acquisition of Placer Dome Inc.

•    Goldcorp Inc.'s US$8.7-billion acquisition of Glamis Gold Ltd.

•    Arcelor SA's $5.2-billion acquisition Dofasco Inc.

That was even though the government killed income trusts with two months left in the year, which kiboshed a number of pending deals and put the brakes on future activity, which is too bad. That activity put a lot of Mercedes in lawyers' driveways.

Income trusts were the rage for the past five years - accounting for one-third of all IPOs - and the market capital of the more than 200 income trusts swelled to more than $190 billion prior to the government's announcement that it would eliminate their tax favourable status.

Despite the income trust blow and the fact it is the highpoint in the M&A cycle, experts expect that bandwagon will continue to roll. You can thank private equity capital for that. In the past two years, U.S. private equity firms have raised more than US$357 billion and Canadian firms have raised more than Cdn$7 billion.

The markets are awash in private equity waiting to be deployed. Private equity firms have already become a bigger player in deals, to the benefit of the Canadian market. The Blakes study found that 5.4 per cent of deals in 2005 involved private equity. By the third quarter of 2006, that had grown to 14.1 per cent.

It interviewed 125 United States, foreign and Canadian investment bankers and executives to get a sense of what will drive the capital markets in 2007. They agree private equity deals will increase.

 The proliferation of private equity players means there are more bidders at the table. While deals used to attract two or three offers, now there can be as many as 10 parties expressing interest. Each one requires legal representation and for the party selling the asset, it means competitive bids and upward pressure on valuations - a good thing for the seller and a not so good thing for the buyer.

In its study, Torys notes that private equity will have growing impact this year in various areas. The first is going-private transactions. As public companies look to get out from under daunting market regulation, private equity is the savior.

The amount of private equity capital available and the fact many firms are banding together to do "club" deals - where they join forces to bid and pitch deals - means the size of a going-private transaction is almost meaningless. Such a transaction is also legally complex, which adds to the legal fees, a bonus for law firms.

Also playing in Canada's favour for going-private transactions is the income trust situation - with plummeting values more will look to return to the corporate model and many will choose to go private rather than stay public. Others will fall victim to takeover fights or will simply sell their operations.

As well, Torys notes that Canada's capital markets are weighted to family-owned companies, which can deliver majority ownership to a private equity group without the need for an auction. That too will fuel deals in 2007.

Torys also expects pension funds to continue to invest more of their assets in private equity. That will spur them to do their own deals and they will also play a more prominent role in club deals.

Demographics are another factor giving rise to private equity deals in the coming decade. The first wave of baby boomers is hitting their 60s and those who have built successful businesses need to start thinking about an exit strategy. They will either have to pass the company down to their kids or sell out to management, a competitor, or an investment bank.

In fact, with as much private equity kicking around as there is, lawyers would be wise to look over their client base and see how that opportunity can be mined for gold. Many private equity firms are looking for deals in the $10- to $20-million range - typical of the mid-market companies dotting Canada's landscape.

Maybe you have a successful client who is in a position to grow their business by purchasing a competitor or maybe they want to retire and sell. Better to be proactive and talk to clients about the opportunity as a trusted advisor, rather than wait for some investment banking types to crash the party and pluck the client out from under you. If you're going to lose the client, you might as well play a prominent role, rather than sit on the sidelines.

So what industries will be hot in 2007? For that we can look to the Blakes study. Its respondents felt that M&A activity of all types will rise in the coming year. The hottest sector will remain energy, followed by mining, and industrials and manufacturing.

The latter category will be a sweet spot for business law firms of all sizes, as the study notes that transactions in this sector tend to be in the US$20- to $150-million range. One-third of the Canadian investment bankers surveyed predict that deals in the industrial and manufacturing sector will attract more interest from foreign firms.

As for technology and telecom, interestingly, U.S. investment bankers are more optimistic than Canadians about the prospects for technology and telecom companies. Twenty per cent of U.S. bankers expect it will be the sector with the most consolidation, whereas 40 per cent of our investment bankers predict it will be the industry with the least amount of consolidation.

Don't expect financial services to be a big M&A target here in Canada. Everyone surveyed felt there will be "limited consolidation" over the next 12 months.

So there you have it. As you prepare to build your marketing plan for the coming year, better factor in private equity if you haven't already done so. While it may have been the purveyor of Bay Street firms a few years ago, it is hitting the mainstream and it's likely that private equity bankers will be scouring the land looking for deals. Just maybe, one of those opportunities lies in your own backyard.


Jim Middlemiss is editor of Canadian Lawyer magazine and co-author of Your Guide to Canadian Law.

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