High society: Canada braces for cannabis M&A boom

The recreational drugs trade is rarely thought of as a sector for M&A lawyers to capitalise on, but in Canada that is exactly what is happening.

The Canadian government has just introduced laws that will legalise marijuana for medicinal and recreational purposes, creating opportunities for lawyers to act on M&A deals for companies looking to meet consumer demand. With the deadline for legalisation set for July, Canadian lawyers are already getting busy.

Alongside the opportunities for consolidation for license producers, this launch of a market worth some CAD$30bn (£16.9bn) has created regulatory issues around production, distribution and safety.

Here, our panel of experts discusses the impact of these radical new laws on what is usually considered a conservative market.

Q: What impact will the Canadian decision to legalise recreational and medicinal marijuana will have on M&A?

Mark Trachuk, co-chair of Osler cannabis practice group: The decision to legalise adult cannabis use is federal in scope, which makes it unique compared with other jurisdictions. In the US cannabis is still a Schedule I narcotic, making it a controlled substance criminalised at federal level. This puts Canada at the cutting edge of the industry and has tremendous implications for capital markets and M&A transactions in the sector

The Canadian capital markets have embraced the sector on levels reminiscent of the dotcom era in terms of both market cap and valuations. In Canada, we have a listing regime that is receptive to junior companies and allows them to go public on our principal junior exchanges (the TSX Venture and the Canadian Securities Exchange) using a reverse takeover structure resulting in freely tradeable shares, which avoids the time and expense of clearing a prospectus and completing a conventional IPO. This has allowed over 100 cannabis companies in Canada to go public in the past few years.

Once public, companies are readily able to pursue acquisitions using public stock as currency. This has greatly accelerated M&A activity in the cannabis sector and we’re starting to see a wave of consolidation.

“Once public, companies are readily able to pursue acquisitions using public stock as currency. This has greatly accelerated M&A activity in the cannabis sector” Mark Trachuk

Although production capacity is the  principal driver of M&A activity currently, vertical integration and the acquisition of proprietary intellectual property relating to cannabis production will also be key drivers for acquisitions.

Mindy Gilbert, partner, Davies Ward Phillips & Vineberg: Medical marijuana has been legal in Canada since the early 2000s. The decision to legalise recreational cannabis is expected to result in, and has in fact resulted in, an increase in licensed producers, or ‘LPs’.

There are now 90 LPs (up from approximately 67 in October 2017). This increase will create an even further fragmented market.

To date, LPs have faced challenges financing their operations. Canadian banks have been reluctant to lend and many of the Canadian bank-owned investment banks have been unwilling to raise capital. This lack of access to capital, coupled with the fragmented industry, suggests the industry is ripe for consolidation.

We are already seeing consolidation. For example, in January, following a hostile takeover attempt, Aurora Cannabis and CanniMed Therapeutics agreed a friendly merger resulting in the combination of two Toronto Stock Exchange-listed companies.

We have also seen other types of M&A in and around the industry, including foreign acquisitions or investments in Canadian cannabis companies and acquisitions and investments by Canadian cannabis companies in international cannabis producers.

Alexis Levine, partner, Blake Cassels & Graydon: There is a fair bit of consolidation strategic combination activity in the market as licensed producers adjust their business models to the emerging capital and regulatory landscape.

This includes vertical integrations, geographic expansion, capital-driven transactions, and strategic acquisitions.

Q: How much M&A work is the legislation expected to generate?

Trachuk: Given the large number of new companies in the space we expect to see exponential growth in M&A activity in the sector. Large global strategic investors are starting to show interest, including beverage and tobacco producers which will bring new capital and expertise to the industry, and accelerate growth as global brands begin to be introduced.

We also believe there are opportunities for foreign acquisitions of Canadian cannabis companies as a way for foreign investors to get a foothold in the sector. Given that Canada is at the forefront of legalisation of full adult cannabis use, and our capital markets have opened up to finance the industry, Canadian companies may also seek acquisitions abroad including in the US and Europe.

We expect Canada to be the global leader in the cannabis industry, but with big opportunities for US investors and other foreign capital to participate.

“We expect Canada to be the global leader in the cannabis industry” Alexis Levine

Levine: There are 89 licensed producers of cannabis today. The sector has relatively low margins and significant regulatory requirements, so well-capitalised producers will have an advantage. While the amount of M&A work that will be generated is simply a projection, there is a consensus that there will be meaningful consolidation.

The market will likely end up with fewer than 10 leading producers and a number of smaller players.

Q: What will be the regulatory impact of the law, and what are the key issues surrounding the legislation?

Trachuk: The biggest question is what the distribution model will be. This will vary in each province.

In Ontario, Canada’s largest province by population, the model proposes government distribution using government-owned and run dispensaries and internet sales. Other provinces are considering licensed dispensaries with the prospect of there being franchise opportunities and the outsourcing of internet sales. However, it is anticipated that distribution models will evolve as demand grows and we move into broader extract-based product lines like edibles (expected to become available in Canada in 2019) and other consumer platforms.

In addition, regulatory issues surrounding dosage, testing, safety, and best practices for production, distribution and security are evolving. For example, recently the federal government decided to abandon certain vault requirements previously required as part of the Access to Cannabis for Medical Purposes Regulations licensing.

Health Canada also indicated that licensed producers will no longer be subject to 24-hour video surveillance inside the rooms where cannabis is being cultivated, propagated or harvested; however, access points to such rooms will still require 24-hour video surveillance. As the science and production practices evolve, regulation will too.

Gilbert: One of the goals of the Cannabis Act is to eliminate the illicit market. Distributors to the recreational market will need to ensure that pricing is competitive with products sold in the illicit market. Furthermore, distribution will need to be convenient for consumers to compete with the broad reach of the illicit market.

“One of the key issues surrounding the legislation is that each provincial government will regulate price and distribution” Mindy Gilbert

One of the key issues surrounding the legislation is that each provincial government will regulate price and distribution, including the number of retail locations. This will create a patchwork of regulation across the country. In some provinces the government will control the sale of recreational cannabis through government-owned entities. In other provinces it will oversee sale through the private sector. The number of retail outlets will vary by province.

The act will also place significant restrictions on the marketing, promotion and branding of products. This will make it difficult for producers to differentiate their products, rendering price the principal basis on which they can compete. Controlled distribution and government-determined pricing may squeeze margins, making it hard for smaller producers to compete, and for all to compete with the illicit market.

Levine: The final federal regulations and many of the provincial retail regulations are not yet available, but the sector will affect a variety of legal areas. Key issues to watch are the availability of provincial retail licenses, whether outdoor cultivation will be allowed, and cross-border impacts of US federal laws.

Q: Do you expect to see an impact on the rules relating to the financing of M&A transactions and if so, what?

Trachuk: One of the biggest issues facing cannabis issuers has to do with disclosure requirements. Regulators have prescribed certain disclosure – including as it relates to Canadian cannabis producers with US assets – but these requirements continue to evolve. Also under the disclosure umbrella are accounting issues including the valu­ation of plants at various stages of the growth cycle.

Gilbert: The Toronto Stock Exchange recently announced that listed cannabis companies with investments in, or commercial relationships with, US market participants risk losing their listing. In addition, regulators recently announced disclosure rules for cannabis companies with investments in, or relationships with, US market participants. However, these announcements are limited to cannabis companies with US involvement.

To date, it has been challenging for all industry participants to obtain bank financing. One area of uncertainty is the ability of a lender to take security over the assets of a cannabis company, including its licence to produce cannabis. Under the current draft legislation, it is unclear whether a licence could be transferred to a lender in a seamless and efficient manner pursuant to an enforcement action. This lack of certainty may impact an acquiror’s ability to finance a proposed acquisition.

Q: What deals has your firm been involved in during the run-up to the legislation becoming law?

Trachuk: Osler has been involved in a range of unannounced transactions relating to pre-IPOs, reverse takeovers, land acquisitions for production, M&A, potential mergers, private investment in public companies and reviewing and working on different distribution models.

We have also worked on some of the lar­gest public transactions in the sector including representing Constellation Brands in its strategic investment and minority stake in Canopy Growth Corporation and assisting AltaCorp in its advisory role in the Cannimed/Newstrike merger and the hostile bid by Aurora for Cannimed.

Gilbert: We advised Bank of America Merrill Lynch in the investment by Constellation Brands in Canopy Growth. We’re also advising other market participants on confidential transactions.

Q: Separately, what have been your biggest deals in other sectors and which other sectors would you say are particularly hot?

Trachuk: Last year and the beginning of 2018 saw private equity interest in Canada, particularly in the real estate and tech sectors. Notable Osler transactions include acting as Canadian counsel to a consortium led by Blackstone in which private equity funds managed by Blackstone – together with Canada Pension Plan Investment Board and GIC – have entered into a partnership with Thomson Reuters for Thomson Reuters’ Financial & Risk Business.

Other deals include representing Blackstone in connection with its acquisition of Pure Industrial Real Estate Trust; representing SmartREIT and Strathallen Acquisitions in the acquisition of OneREIT and acting for Layer 6, an artificial intelligence company based in Toronto, in its acquisition by the Toronto Dominion Bank.

Gilbert: In the real estate sector, we recently acted for SmartCentres REIT in its CA$1.1bn acquisition with Strathallen Acquisitions of OneREIT. In mining, we acted for Barrick Gold Corporation in connection with a transaction with Shandong Gold that included the sale of a 50 per cent interest in the Veladero gold mine for $960m (£700m); the negotiation of a 50/50 joint venture arrangement in respect of the Veladero gold mine; the negotiation of a strategic co-operation agreement to explore the joint development of the Pascua-Lama deposit located along the Chilean-Argentinean border; and the evaluation of additional investment opportunities on the highly prospective El Indio Gold Belt on the border of Argentina and Chile.

“We recently acted on the negotiation of a joint venture in respect of the Veladero gold mine” Mindy Gilbert

We also acted for Barrick on its sale of a 25 per cent stake in the Cerro Casale Project to Goldcorp, and the negotiation of a 50/50 regional joint venture over the Cerro Casale, Quebrada Seca and Caspiche projects in Chile’s Maricunga district.

In the industrial sector, we are acting for Aecon Group in its proposed $1.5bn acquisition by CCCC International Holding Ltd. The transaction allows Aecon to gain significant capabilities and financial strength by joining the world’s largest network of engineering and construction companies.

We also recently acted for Toromont Industries in its acquisition of Hewitt Equipment in a $1bn transaction that expanded Toromont’s Caterpillar dealership into Québec, Western Labrador and the Maritimes, and strengthened its expertise in the mining, construction, power systems and forestry sectors.

Finally, in financial services, we acted for Sentry Investments in its $780m acquisition by CI Financial in a transaction that combined two of Canada’s largest independent asset managers.

Read more news and analyses on the Canadian legal market.