Private equity M&A: strong appetite for exchangeable share structures

The use of exchangeable shares has become more prevalent in Canadian M&A transactions recently, particularly those involving private equity funds. We anticipate the use of rollover equity in the form of exchangeable shares to become even more popular in acquisitions of Canadian targets by foreign acquirors in 2025 and beyond.

The desire for equity rollovers may also be driven, in part, by changes to the capital gains inclusion rates in Canada, as exchangeable share structures provide meaningful tax deferrals for sellers through tax deferred rollovers. Equity rollovers also provide a mechanism to “bridge the valuation gap” between buyers and sellers.

As Canada continues to be an attractive investment destination for foreign capital, these structures, while complex, are likely to be increasingly used in cross-border M&A transactions. Accordingly, buyers and sellers should familiarize themselves with the advantages and disadvantages of exchangeable share structures in Canada.

Exchangeable share structures

An exchangeable share structure is commonly used in the context of an acquisition of a Canadian company by a foreign acquiror. The structure is designed to enable Canadian shareholders to have the same economic rights and benefits as holders of equity interests in the foreign acquiror into which the exchangeable shares may be exchanged. Exchangeable share structures provide Canadian-resident shareholders of a Canadian target company with the ability to defer taxes on capital gains. Consideration, or partial consideration, is provided to Canadian sellers in the form of shares of a Canadian incorporated entity, which occurs on a tax-deferred rollover basis under the Income Tax Act (Canada). The shares are exchangeable, subject to certain conditions, into equity of the foreign acquiror. Canadian sellers may also receive special voting shares in the capital of the foreign acquiror. As a result, Canadian sellers can vote at the foreign acquiror level, but hold their economic rights in the Canadian entity.

The exchange of target company shares for exchangeable shares permits the sellers to rely on the capital gains deferral rules. Canadian tax rules do not provide for an “outbound rollover” rule, and Canadian-resident sellers generally need to receive shares of a Canadian company, or interests in a partnership with only Canadian-resident partners, as consideration to be eligible for tax deferral treatment. The tax-deferred rollover exists until the time at which the exchangeable shares are exchanged for the corresponding equity interests in the foreign acquiror, most commonly when the business is sold to another buyer.

For further details on the basic structure of an exchangeable share transaction, including important governance considerations, refer to our previously published overview.

Most exchangeable share structures involve exchangeable shares that are exchangeable into stock of a foreign company. However, in some cases, exchangeable shares can be exchangeable into limited partnership interests in a partnership — for example, where the acquiror is a foreign-based private equity fund that is organized as a limited partnership in a foreign jurisdiction. 

Increasing use of exchangeable structures

With historically high levels of undeployed capital — and amidst a heated market for assets south of the border — there is significant interest from foreign private equity sponsors looking to deploy capital in Canada. We are witnessing this trend across multiple industries, including in the Canadian tech sector and other traditional industries, such as energy and infrastructure. As the underlying drivers of these trends continue into 2025, it is important for foreign-based private equity sponsors to familiarize themselves with exchangeable share structures to remain competitive in the Canadian marketplace.

There are many benefits of exchangeable structures and, therefore, many reasons to conclude that interest in these structures is likely to continue in the years to come.

First, an equity rollover can create alignment between management and the private equity sponsor. The rollover provides sellers with the opportunity to maintain ownership in the target business and other future businesses the private equity sponsor may acquire in the same or similar vertical, and to benefit from its success following completion of the acquisition. This aligns sellers with the fund’s equity cycle and return objectives. For this reason, an equity rollover has become a common aspect of the private equity playbook. For new entrants that do not have an existing footprint in Canada, it will be even more important to foster alignment with the local management team to effectively navigate the Canadian legal and commercial landscape.

It is important for foreign-based private equity sponsors to familiarize themselves with exchangeable share structures to remain competitive in the Canadian marketplace.

Second, despite recent interest rate reductions, the valuation gap between buyers and sellers continues to persist, as evidenced by higher valuations of private companies relative to their publicly listed peer group. Following a year of increased election activity in many major markets, including the U.S., it will likely take some time for dealmakers to fully digest the expected level of macro and other geopolitical risk, and how that is expected to translate to the M&A market. This compounds the challenges of business valuation. To bridge this valuation gap, sellers may be more willing to accept a lower valuation if they can continue to participate in the long-term value creation of the business. The rollover of their equity into the acquiror’s business provides a means to access potential upside of the combined entity. This can be especially attractive for bootstrapped or founder-led targets who wish to maintain some level of exposure to the next stage of their company’s life cycle.

Although tax deferral always has been a relevant factor for sellers, recent proposed changes to Canada’s capital gains inclusion rates are likely to precipitate greater interest in tax deferral structures, such as an exchangeable share structure. In particular, under proposed legislation first announced as part of Budget 2024, for dispositions occurring on or after June 25, 2024, the capital gains inclusion rate will generally be increased from 50% to 66 2/3% for corporations and trusts, and for individuals to the extent their capital gains exceed $250,000 in a taxation year. This proposal could materially increase a Canadian-resident seller’s tax burden in the absence of tax deferral treatment. Sellers who receive equity consideration may be more motivated to require a structure that allows for tax deferral as a condition of entering into a transaction.

Finally, by lowering the cash consideration, a private equity sponsor would otherwise need to pay to the sellers, the sponsor can reduce its called equity capital from limited partners. In a leveraged acquisition, the sponsor can draw less from the bank and pay less interest. Even though interest rates have declined, they remain relatively high on a comparable historical basis. As a result, rollover equity remains a relatively cheap source of deal financing for private equity sponsors.

Outlook for exchangeable shares going forward

The popularity of exchangeable share structures is likely to increase in the coming years. Foreign acquirors looking to invest in Canada will be seeking to provide competitive bids that place them on an even footing with domestic buyers who are able to offer Canadian sellers rolled equity on a tax-deferred basis. These structures will become even more important to Canadian sellers with the recent proposed increase to the tax burden from capital gains.

Certainly, there is complexity in exchangeable share structures that increases legal and tax advisor costs for the transaction. This complexity does require thoughtful and advanced planning. However, the increased costs and complexity may be offset by less cash required to close the transaction, lower financing costs, and greater alignment with management of the target business.