Positioning for Growth: Refinancing your business and accessing capital Private Company Webcast...

Positioning for Growth: Refinancing your business and accessing capital

Private Company Webcast Series: Part 2 of 4

30 April 2013

Credit market updateApril 2013

Welcome

Steve Lewis Brian Allard

Meet the presenters


Agenda

► Current market conditions

► Types of financing

► Risk mitigation strategies

► Conclusion

► Selected Ernst & Young Orenda transactions


Current market conditions


Credit markets – global viewpoint

► The heightened uncertainty around the global economic outlook has decreased

► Tentative signs of stabilization in European bank funding and sovereign debt markets had improved conditions in global financial markets and resulted in a reduction of risk aversion, however, we are still in a vortex of uncertainty

► In the US, expansion is proceeding at a modest pace supported by a falling unemployment rate, improving credit markets and stronger consumer confidence

► Supported by this more positive outlook and an injection of liquidity from central banks, global equity prices have rallied and corporate and government bond spreads have narrowed


Interest rate environment

► This moderate recovery is fuelled by interest rates which continue to be at historic lows

► Since May 2011, Government of Canada yields have decreased by 139 bps for 10-year bonds and 114 bps for 30-year bonds on flight to quality flows primarily resulting from the Eurozone debt crisis

May/0

8

Aug/0

8

Nov/0

8

Feb/0

9

May/0

9

Aug/0

9

Nov/0

9

Feb/1

0

May/1

0

Aug/1

0

Nov/1

0

Feb/1

1

May/1

1

Aug/1

1

Nov/1

1

Feb/1

2

May/1

2

Aug/1

2

Nov/1

2

Feb/1

3

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50 Canadian Interest Rates [%]

GOC 5Yr GOC 10Yr GOC 30Yr


Interest rate forecast

► Despite this favourable interest rate environment, however, the consensus outlook is that the yield on 10-year and 30-year Government of Canada bonds will increase by up to 44 bps and 38 bps, respectively, by December 2013

► The interest rate outlook from the major Canadian banks is presented below

Source: BMO Capital Markets, CIBC World Markets, RBC Economics Research, Scotia Capital, TD Economics

2-yr 5-yr 10-yr 30-yr0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%Interest Rate Forecast - Q4 2013 [%]

CIBC (March 4, 2013)

Scotia (March 27, 2013)

RBC (March 2013)

TD (March 19, 2013)

Average


Corporate credit spreads

► The graph below illustrates the spread between 3-month BAs and 3-month Canada Treasury Bills

► Spreads have narrowed significantly since the days of the credit crunch, and continue to decline following a slight increase throughout 2011 reflecting uncertainty around the global economy and concerns over the Eurozone

Source: Bank of Canada

20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 200.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%3-Month BAs over 3-Month Canadian Treasuries

3 Month BAs 3 Month Canadian Treasuries Spread

Ra

te

Sp

rea

d

2013-04


Debt Multiples

► Debt multiples in the first quarter of 2013 are significantly higher from the first quarter of 2012

► On an annual basis, average debt multiples of middle market loans have been on the rise illustrating the availability of financing in the market

Source: S&P Capital IQ Leverage Commentary & Data

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

1Q12

1Q13

0.0x

2.0x

4.0x

6.0x

4.84.6

4.14.0

3.63.8 3.9

4.14.3 4.4

4.8

4.3

3.43.7

4.2 4.3

3.8

5.1

Average Debt Multiples of Middle Market Loans

FLD/EBITDA SLD/EBITDA Other Sr Debt/EBITDA Sub Debt/EBITDASeries5


Types of financing


Cost of capital

► The cost of capital varies based on the type of capital

Senior DebtTraditional

Asset Based Loans

Second LienLoans

Subordinated

Debt

Equity

Pre-Tax Cost of Capital

3% - 5%Coupon only

25%+

3% - 5%Coupon only

8% - 12%Coupon only

14% - 18%Coupon and warrants


Senior debt Cash flow loans

► Larger cashflow loans to borrowers of “strategic relevance” to lenders► Senior leverage < 3.5x although recent activity has been

pushing this higher

► Industry specific

► Sponsor makes deal “easier”

► Spreads in the range of 100 bps

► Smaller cashflow loans must fit in the “credit box” of lenders► Positive track record

► Balance sheet covenants


Senior debt Asset based loans

► Asset based loans (“ABLs”) are becoming increasingly attractive to certain borrowers► Loans > $60MM pose a syndication risk

► Spreads in the range of 175 – 350 bps over bankers acceptances

► Asset based loans are also attractive to lenders due to tightly structured borrowing bases developed during scheduled asset appraisals and field exams

► ABLs provide:► 3 Year committed financing

► Higher debt levels as the amount of financing is directly tied to the underlying working capital collateral balances

► Reduced covenants typically at less restrictive thresholds (i.e. tangible net worth or fixed charge coverage)

► Asset based financing is also well suited to finance growth as funding will rise and fall with the success of a company’s growth program


Senior debt Asset based loans

► The key issues around ABLs are:► Significant reporting requirements

► More cumbersome documentation

► Requirement for appraisals and field audits


Second lien loans

► Second lien loans are considered a cheaper and more flexible alternative to mezzanine financing for the mid to upper-middle market

► For the middle market, second lien loans combined with senior debt are an alternative to high yield bonds

► Second lien issuance plummeted sharply after the credit crunch and although it appears to be reviving, today’s market remains far from the excesses of 2006/2007► In general, the market for this paper is hedge funds, high-yield funds and other

relative-value players

Source: S&P Capital IQ Leverage Commentary & Data

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1Q12 1Q130

5

10

15

20

25

30

35Second Lien Volume (US $billions)


Mezzanine financing

► As an alternative to equity, mezzanine financing can be attractive for a number of reasons:► Greater certainty of close with approvals from fewer parties required

► More simplified documentation if warrants are not required

► Stable source of financing due to a longer-term investment horizon (committed to a 4 or 5 year term)

► Mezzanine loan characteristics can include the following:► Total leverage ≥ 4.00x although on occasion recent activity has

pushed this higher

► Inter-creditor agreement with senior lender(s)

► Subordinated security position

► Warrants could be necessary to provide the required return


Senior Loan Officer Survey, Bank of Canada

*The balance of opinion is calculated as the weighted percentage of surveyed financial institutions reporting tightened credit conditions minus the weighted percentage reporting eased credit conditions.Source: Senior Loan Officer Survey, Bank of Canada

► Survey results point to an overall easing of business-lending conditions in the first quarter of 2013

► Respondents consider competition among lenders as the key factor underlying the easing in business-lending conditions

2001

:Q1

2001

:Q3

2002

:Q1

2002

:Q3

2003

:Q1

2003

:Q3

2004

:Q1

2004

:Q3

2005

:Q1

2005

:Q3

2006

:Q1

2006

:Q3

2007

:Q1

2007

:Q3

2008

:Q1

2008

:Q3

2009

:Q1

2009

:Q3

2010

:Q1

2010

:Q3

2011

:Q1

2011

:Q3

2012

:Q1

2012

:Q3

2013

:Q1

-60

-40

-20

0

20

40

60

80

100Senior Loan Officer Survey: Overall lending conditions

EasingEasing

Tightening


Easing credit standards

► The Federal Reserve Board conducted an opinion survey in April 2012 of senior loan officers asking participants to rank the possible reasons for easing credit standards or loan terms

Reasons for easing credit standards or loan terms

% Viewed as Very

Important

% Viewed as Somewhat Important

Improvement in your bank’s current or expected capital position

2.9% 2.9%

More favourable or less uncertain economic outlook 2.9% 40.0%

Improvement in industry specific problems 5.7% 8.6%

More aggressive competition from other banks or nonbank lenders (other financial intermediaries or the capital markets)

51.4% 45.7%


Recent deals / Examples

Situation:

► 2 shareholders own a company with $2MM EBITDA before bonuses, and negligible shareholders’ equity.

► Company is a distributor with a seasonal working capital build-up.

► Bank would not allow payment of $1MM shareholder loans and demanded the shareholders inject $3MM into the company.

Solution:

► Company had sufficient accounts receivable and inventory to support a larger line of credit without leverage covenants.

► Negotiations with lenders enabled a solution which allowed repayment of shareholder loans, payment of bonuses and no requirement for an equity investment by shareholders.


Recent deals / Examples

Situation:

► Mining services company with $40MM EBITDA, $100MM of shareholders’ equity and $40MM loan facility.

► Company’s operations were about 50% outside of Canada/US and all significant growth opportunities were outside of North America.

► Company required further capital for growth and to repay $20MM shareholder loan.

► Existing bank was willing to provide incremental capital in form of subordinated debt.

Solution:

► Company had total cash float of about $15MM around the world.

► Arranged $80MM senior debt facility allocated to global operations with new global cash management system.

► More efficient cash use, substantially cheaper than subordinated debt, shareholder loan repaid and company continues to grow.


Risk mitigation strategies


“Companies are taking the view that they need to negotiate the financing when it’s available, not

necessarily when they need it.

There’s an old investment banking adage, ‘If the duck is quacking, you feed it.’ In other words, if you

can get the financing done, get it done…”


Financing risks

Availability / Liquidity

Risk that availability/liquidity in capital markets will be constrained

Credit Spread

Risk that credit spreads will increase

Interest Rate

Risk that interest rates will increase


Financing risk mitigation strategies

Availability / Liquidity

► Issue debt in advance of capital needs

► Negotiate committed bank financing

► Maximize the commitment period or term of the financing

Interest Rate


► Interest rate swap with forward start date

► Bond forward for fixed rate debentures

Credit Spread


► Maximize the commitment period or term of the financing

► Interest rate swap with forward start date


Alternatives to mitigate risk

Bond/Private

Placement

► Private placement is a direct placement of debt with one or two investors (narrowly marketed)

► Typically investment teams at Canadian life insurance companies and smaller pension funds

► Can also have a “public-style” or broadly marketed private placement, however need a minimum amount to access this market



Fixed Rate Bank Loan

► Bank provided fixed rate loan typically priced as “all-in” interest rate: bank cost of funds + credit spread for risk

► Commitment terms vary

► Currently 5 to 10 year tenures available. Up to 15 years for investment grade borrowers



Interest Rate Swap

► Contract between a borrower and a counterparty (i.e. a bank)

► Two parties in swap contract exchange fixed rate interest rate payments for floating interest rate payments

► Highly flexible; customized draw downs, interest-only periods, multiple rates, forward starting rates and terms up to 30 years


Mechanics of an interest rate swap

► Borrower obtains bank financing by entering into a loan agreement with lender where interest is priced on a floating rate basis, i.e. 3-month Bankers’ Acceptances (BAs)

► Swap is a contract between a borrower and counterparty and is independent of the underlying loan or credit facility

► ISDA Master Agreement and Schedule govern swaps

► Swaps can either be spot or forward starting where borrower fixes interest rate for a future draw(s)

Swap Counterparty(Typically Securities Division of Lender)

Borrower Lender

Swap rate

3-month BA

3-month BA + credit spread


Swap rates

► Swap rates declined in 2011 to historically low levels, driven by the reduction in the yield of underlying Government of Canada bonds

► The decline is a global trend driven by reduced prospects for economic growth due to weakening US and European economies

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0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%Canadian Swap Rate

10 yr 5 yr


Swap rates

► Flat swap curve

► Benefit is obtaining upfront committed capital without negative interest carry; simply pay standby fees on undrawn balance

3M

6M

9M

1Y

2Y

3Y

4Y

5Y

6Y

7Y

10Y

12Y

15Y

20Y

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00% Canadian Swap Curve


Pros and cons of interest rate swaps

Interest rate swap considerations

Advantages Disadvantages

► Committed future financing with certainty of cost

► Greater degree of predictability in cash flows

► Interest rate and credit spread risk can be mitigated for the term of the commitment

► Prepayment prior to maturity may be subject to a cash settlement (however, could receive a cash payment if the mark-to-market value is positive)


Conclusion


ConclusionLessons learned

► Markets are volatile. Mitigate risk. If you can access, or lock down credit, do it

► If appropriate, include multiple banks in your syndicate► Manage your lender relationships – avoid surprises► If in doubt, seek alternative proposals – you may be better

than you think► Optimizing capital extends beyond funding alternatives –

the “Capital Agenda”


Selected Ernst & Young Orenda transactions


Selected transactions

* Transaction services provided by a predecessor firm


Questions?

Steve Lewis, Senior Vice President

T: 416.943.2659E: [email protected]

Brian Allard, Senior Vice President

T: 416.943.2665E: [email protected]

Positioning for Growth: Refinancing your business and accessing capital Private Company Webcast...

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