Leading Canadian business figures have recently added their voices to the debate over the increasing pace of foreign takeovers of iconic Canadian compa- nies, demanding some form of government protection.
Dominic D’Alessandro, the CEO of Manulife Financial, used that company’s annual meeting to express concern that so many Canadian companies in the natural resources sector were owned elsewhere. Governments should consid- er the feasibility of ownership restrictions for ”œcertain sensi- tive sectors of our economy” similar to those that currently apply to financial institutions, he suggested.
Laurent Beaudoin, chairman of Bombardier, has urged government to intervene to safeguard Canadian corporate champions. Stéphane Dion, leader of the Opposition, has called for a review of the Investment Canada Act.
This reaction is typically Canadian. After all, we are a relatively small economy, living alongside, and committed to a free trade regime with, the strongest economy in the world. Canada has recently witnessed the acquisition by for- eign interests of such household names as Hudson’s Bay Company, Inco, Falconbridge, Dofasco, Fairmont Hotels and Resorts, Four Seasons Hotels, Abitibi Consolidated, Domtar, CP Ships, ATI Technologies, Algoma Steel, Intrawest, and others. We can foresee a continuation of this trend, as would-be buyers circle Alcan and Stelco.
But this is not the way to go. Hollowing out is indeed a serious problem, but protectionism is not the answer.
The concern over hollowing out is based on three relat- ed consequences: first, as Gerald Schwartz, CEO of Onex, quoted in the Financial Post, says, ”œWhen a head office leaves Canada, so do all the support positions at accounting firms, law firms, recruiters and other key suppliers of head office intellectual capital.” Not to mention investment bankers, lawyers, and other professionals whose services are on call and whose proximity counts.
Second, the loss of so many listed companies trading on domestic exchanges hurts capital markets. And third, Canada has not responded in kind by acquiring big-name foreign entities since Alcan’s purchase of Pechiney and Manulife’s acquisition of John Hancock Financial in 2003.
As a 2006 Secor Consulting report points out, not every takeover results in the loss of a head office. In the case of HBC, the financial spon- sor/buyer determined to leave the head office in place. In the Domtar/Weyerhauser and Abitibi/ Bowaters transactions (and as pro- posed by Alcoa should it be successful in its bid for Alcan), the formula can leave a real and substantial Canadian head office managed by existing staff with world product mandates for a portion of the merged company’s operations. Xstrata and CVRD have each pledged to maintain certain func- tions and a partial head office presence in Canada. Nevertheless, critics worry that, as the managers who negotiated, or in some cases resisted, the takeover see their power eroding relative to the ”œreal” head office and begin to leave, the local decision-making reverts to where the new ownership resides.
In many other cases, the sale of a Canadian company does indeed result in the effective disappearance of virtually all of the ”œgood” jobs associated with managing a fully functioning corporate head office. The Conference Board of Canada recently released a report (citing Statistics Canada) claiming that head office employment in Canada rose by 11 percent between 1999 and 2005, but it does not follow that the sup- porting professional service jobs that Schwartz is talking about have risen by an equivalent percentage.
None of this would matter, of course, if Canada were giving as good as it gets in takeover activity and adding the market capitalization of its foreign targets to the liquidity of the TSX. The same Conference Board report claims that the number of head offices in Canada climbed by 100 in the same six-year period, to 4,161, but this figure begs the question. The debate does not revolve around gross numbers (which can include a nomi- nal head office in the drawer of a local manager), but around true centres of managerial decisions from which sig- nificant industry-leading businesses are directed.
Looking for a big-name, impor- tant firm bought by a Canadian com- pany this year, one finds Putnam Investments, acquired by Great West Life. Last year, TD’s purchase of the remainder of Bank North probably leads the list. After that, there are numerous outbound transactions, but none that resonates the way the list of Canadian targets does.
According to figures from Thom- son Financial, there were 938 deals in 2006 in which the buy side was Cana- dian and the sell side foreign, where- as there were only 699 incoming transactions. The problem is that the dollar value of the Canada-on-top deals was only US$67,368,800, while the other way around the number was US$106,637,700. That means that we are buying smaller, less prominent enterprises from others, while they focus on our national champions.
The same is true for the year 2007. To date Canadian businesses have paid a total of US$58,907,100 to buy 489 non-Canadian entities, but foreign buyers spent US$87,387,500 to acquire 334 of ours. Transactions are also getting bigger (Alcoa/ Alcan is bigger than anything in our commercial his- tory), and the pace of takeover activ- ity is quickening.
The TSX tells us that the market capitalization of its S&P/TSX compos- ite index, at $1.7 trillion, is now dou- ble the size it was in 2000, but again, this masks the qualitative loss of com- panies that have been mainstays of their sectors for decades and could have been contenders in the global consolidation bakeoff.
In its March 2007 report, the Institute for Competitiveness and Prosperity of the University of Toronto’s Rotman School of Business reported that in 1985, Canada had 33 global leaders among its companies (defined as a Canadian-owned corpo- rations ranked in the top 5 of its partic- ular product or service category global- ly by sales revenue or assets). In 2003, we had 86 such firms. In 2006, the number had fallen back to 72, still more than double the figure for 1985 tables 1 and 2.
So, does the net loss of 14 nation- al champions in the period that is causing all the consternation justify the concern? The answer is ”œyes” if one takes into account the industry- leading nature on the firms that have disappeared.
But is more protection the solu- tion? Whoever coined the phrase ”œbeen there, done that” should speak up. Canada created a fury abroad with its Foreign Investment Review Act, which invited retaliation from our trading partners. In negotiating free trade agreements with the US and Mexico, Canada had to explicitly bargain for the grandfathering of legislative provi- sions, which offended against the principle of national treatment.
The comfort of legislated restrictions on foreign ownership (coupled with the protection from takeover bids afforded by differential voting classes of shares) is part of how we got into this mess. Canadian managers of many widely held public companies have not distinguished themselves by their dar- ing, initiative and entrepreneurial spir- it when it comes to undertaking acquisition strategies, particularly out of country. One reason is that the drive to do so to avoid the threat of being taken over by someone who has earned a higher price/earnings multiple by a more aggressive management style has not been necessary.
Canadians are not in trouble when foreigners want to take over our companies. We are in trou- ble when they don’t want to. When Brian Mulroney declared Canada ”œopen for business,” he launched the most sustained period of eco- nomic expansion in our history. We have not suffered from freer trade in direct investment or from globaliza- tion, but we have benefited from them enormously.
The appropriate focus should be on how to make our companies stronger and more competitive, and thus make our country more prosperous.
We cannot put the ”œdare” into the souls of Canadian CEOs and boards by exhortation or government intervention. But there are some things we can and must consider doing. Here is a very partial list.
Focus on the balance sheet: What does an athlete do when he or she makes up their mind to become a champion? They train. We need our business executives to think as if they were in a financial gym for the long haul, not just when a business transac- tion is imminent and there is a flurry of activity around financing a particular proj- ect. This means revisiting the mythology that there is something sacrosanct about strong investment grade credit ratings. The availability of massive amounts of inexpensive capital means that higher risk credits can optimize their cost of capital by borrowing more and lever- aging their equity ”” the most expen- sive capital of all ”” to build an acquisition war chest. Canada also needs to develop a high-yield capital market that is meaningful and get over the mindset that these bonds used to be called ”œjunk.”
Growth strategies must be top of mind: If you aren’t a buyer, you’re a seller. Life at the top of a big corpora- tion can’t be a comfortable steward- ship of the status quo. If your business is not growing organically fast enough to afford you a market multiple that is better than your peers’, an acquisition strategy may be the way to vault you into the leaders’ class.
Governments have a role, mostly to do less: Governments need to make our businesses players. That means putting in place a competitive tax sys- tem and regulation that encourages the development and survival of national champions. Canada cannot have rules that are different from our competitors’ on something as funda- mental as interest deductibility and expect to emerge on top. We need to adjust the balance between the fiduci- ary duty of boards to provide share- holders with an opportunity to encash their investments and the ability of a board to just say no if the business’s current growth path will produce equivalent value in the medium term. It is not certain such balance does not already exist, but fear of criticism tilts the decision toward a short-term search for a ”œwhite knight.”
Companies should identify them- selves as ”œyield” or ”œgrowth” investments: The current bias in favour of yield is driven in part by historically low inter- est rates and the rash of corporate scandals and errors of judgment, which have led shareholders to cry, ”œgive me the money.” Directors should tell investors whether a particular investment is appropriate for a yield- oriented investment objective or is geared for growth and will not be dis- tributing its dry powder to the owners in the immediate future. To some extent, the requirement for a stated dividend policy in a prospectus is just that, but these evidently lack clarity, since there is invariably tension between expectations for distributions and capital appreciation through growth. We need to leave the income trust mentality behind us and not get bogged down in what one journalist has called ”œcapitalism for slobs.”
Competition laws should permit the emergence of national champions: We need to rethink our competition laws. In the natural resource sector we are dealing with homogenous products sold at world prices quoted in US dol- lars. Why should Inco and Falconbridge not have merged in order to create a nickel and copper giant? Surely their respective proportions of the Canadian market were irrelevant? Surely there was enough countervail- ing supply of these products elsewhere in the world to offset any likelihood of lessened competition?
Let the banks merge: Finally, we need to allow our banks to consoli- date, both domestically and interna- tionally, not because we need greater concentration in the provision of retail banking services to domestic cus- tomers, but because retail banking is not all that banks do. They are also key participants as intermediaries in the global capital-formation process on the wholesale side. And, like it or not, the prejudices of international banks mean that Canadian merger partners are not naturally seen as the surviving entity, even when they are larger than their ”œtarget.”
Canadians should develop a pros- perity agenda designed to raise the competitiveness of our leading compa- nies. There is a long list of possible actions, but protectionism leads only to perpetuating our lack of responsive- ness to market forces.
