Use your assets

A lagging economic recovery and tight credit markets continue to plague expansion opportunities, but there is a cure

By Neil Blair + Joe Rodrigues
Illustration: Michelle Thompson

With the first four months of a new decade behind us, politicians and central bankers are conservatively optimistic that 2010 will see a global economic recovery. On February 19, 2010, Ben Bernanke, chairman of the US Federal Reserve, surprised the markets with a 0.25% increase in the overnight lending rate to 0.75%. Although such an increase can be interpreted as primarily symbolic, undoubtedly the Fed’s intentions were to signal that the US, if not the global, financial system is stronger than it was a year ago.

However, signs of weakness in the global recovery, especially the global credit markets, continue to plague the financial system. High-profile stories such as the Dubai World Islands project’s de facto default in November 2009 and the more recently out-of-control budget deficits for some European Union members continue to bestow concern on the public debt markets.

Based on the third quarter of 2009, with GDP results showing 0.1% growth for the quarter, Canada technically emerged from a recession. Canada’s emergence from recession has not been without a cost, with the budget deficit at a record high and rumours of federal and provincial asset sales making headlines. Comparatively though Canada’s deficit is not nearly as high as other developed economies and as global stability returns Canada is well placed for growth.

Despite the signs of recovery, a variety of companies in the industrial and automotive sectors still have a way to go before beginning to realize meaningful profitability — and tight credit markets are aggravating their problems. On one hand, there are opportunities to purchase struggling competitors at favourable prices, on the other, there are major challenges, such as managing the balance sheet and maintaining sufficient liquidity.

End of an era
The benign economic conditions of the past decade created an expectation of cheap debt capital. In many instances debt was treated as a commodity. Those conditions are behind us and are unlikely to return in the near term. While the equity markets have rallied from the lows of March 2009, credit remains tight, with much lower levels of leverage available for corporations in Canada and across North America. The megacap private equity deals that incorporated large leverage multiples involving corporations such as TXU Corp. and First Data Corp. are unlikely to be repeated any time soon. The Texas Energy Future Holdings merger with TXU Corp. in 2007 occurred at an enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA) multiple of 8.2x and the Kohlberg Kravis Roberts & Co. acquisition of First Data occurred at an enterprise value to EBITDA multiple of 13.4x.

While the megadeals dominated the headlines, the mid-market was also awash with an abundance of debt capital and corporations amassed unprecedented levels of leverage. The competition to provide financing among banks was fierce. Whether a corporation was large or small, the answer when looking for financing was the same: approach a number of financial institutions, create competition and draw down as much debt as required.

This worked in sync with the operating model of most financial institutions, which was to originate as many loans as possible and syndicate and securitize those loans into the secondary market as soon as the financing transaction was closed. Competition resulted in debt packages that were collateral and covenant light with cash flow analysis a major contributor to credit decisions and the leverage available.

The landscape today is very different for financial institutions and corporations. In the past, selling loans into securitization conduits reduce the capital requirements of banks. However, for financial institutions the securitization market has dried up and the regulatory environment is putting ever increasing scrutiny on risk-taking activity. Annual issuance of global collateralized debt obligations (CDO) have declined to US$4.2 billion in 2009 from US$520 billion in 2006, with a notable decline from 2008 to 2009 indicating that a rebound in this secondary debt market is nowhere in sight. In addition trillions of dollars remained trapped in various loan conduits from past CDO issuances.

Despite this, in Canada traditional forms of credit from primary and secondary lenders are beginning to flow albeit at higher costs and only for certain borrowers. Schedule 1 banks have increased spreads sometimes by as much as 200 basis points to 400 basis points over prime and are requiring significantly higher closing fees. That being said, there are still numerous corporations that are funding working capital through mezzanine and venture capital funding that is typically looking for returns in mid-teens to high 20s.

In short, while credit is still available, the economic climate has changed the appetite, approach and structures available. For corporations the routes to access capital have changed depending on industry, size and performance.

Rated debt in demand
Interestingly, total reported debt issuance in Canada has been at record highs. According to Investment Industry Association of Canada, there were $170 billion in financings for the first three quarters of 2009, which represents an increase of more than 33% from the same period in 2008. However, this increase has been predominately driven by government bond and public debt issues. For large corporations the public debt markets have been an excellent source of capital, with a large amount of interest from investors looking for investment-grade debt to provide them with steady yields. For example, in the third quarter of 2009 alone Canadian issuers Nexen Inc., Potash Corp. and Manulife Financial each raised more than $1 billion in the public debt markets.

Additionally, increased government spending has prompted large treasury issues and provided the much-needed stimulus that is starting to reap rewards as economic activity picks up.

While the statistics are impressive and suggest that credit is flowing, they are not representative of lending activity and availability in the middle market where access to public debt instruments is challenging, if not impossible, in many circumstances. Middle-market companies, chiefly because of their relatively small size and limited market reach, generally don’t qualify for investment-grade ratings. And the public market for noninvestment grade debt is relatively thin.

For corporations without access to public debt markets, the options are very different. For many private companies and middle-market companies, conventional routes have disappeared or the terms have changed so drastically that corporations are rethinking their growth strategies. Of course every situation is unique and for some companies access to capital remains relatively simple. However, there are many that are finding themselves without the numerous options available only about 18 months ago. Aggressive cash flow leverage is very challenging and the cost of capital — even with overnight bank lending rates at an all-time low — is expensive with increased interest-rate spreads and fees.

Even where access to capital is less onerous, corporations are reticent to open credit agreements, which have interest rate spreads and terms agreed to during the debt bonanza, for fear of eroding favourable terms. Where growth through capital is on the agenda, this is leading to innovative structures being utilized with, for example, sale and leasebacks on unencumbered properties providing cheaper access to capital while leaving current facilities in place.

Where traditional financing is required, the availability varies considerably by sector. It is particularly challenging in areas that have been more severely impacted by the economic downturn. Canada’s automotive sector is a good example. While many companies in this sector have an abundance of hard as-sets, many balance sheets have been overshadowed by operating losses. As the sector experiences one of the worst downturns in history, corporations have been challenged to raise capital, with financial institutions looking to reduce, not increase, exposure. As a result, even good businesses are having to re-think their approach to raising capital, with sector exposure rather than fundamentals driving credit decisions.

The ABL solution
Notwithstanding the difficult credit and economic environment, there are viable financing options. Asset-based lending (ABL) in particular has seen an increase in activity in Canada over the past few months. ABL has never been very popular in Canada because the traditional form of bank financing has been cash flow and earnings-based. For the most part, Canada is more comparable to Europe than the US in terms of volume of ABL transactions. ABL is a common form of commercial finance in the US comprising up to 50% of all operating loans. By comparison, although the banks do not release exact figures, it is generally understood that ABL in Canada comprises a much smaller fraction of the total.

Although ABL has been offered in Canada for the past 15 years and major Canadian banks began offering ABL to its clients in the late 1990s, until recently, most corporations have elected to remain with traditional operating- or term-loan arrangements.

The biggest attribute of ABL is that in times where earnings are low, or nonexistent, due to a trough in the economic cycle, ABL is still available because it is highly dependent upon collateral, not earnings per se. ABL is not unlike traditional operating loans in that financing is advanced based on the businesses level of accounts receivables and inventory. However, ABL will normally provide higher advance rates on both accounts receivable and inventory with rates as high as 90% of accounts receivable and 65% of inventory. Additionally, where traditional operating loans will normally only advance on total inventory, ABL loans are often structured to provide specific advance rates on raw materials, work-in-process and finished goods that can provide the borrower with even larger advances depending on the recoverability of the inventory classification. Additionally, asset-based lenders can provide term facilities against property, equipment and machinery using similar formulas to those used for operating loans. Essentially, where there is an asset that can be appraised, there is a loan that can be made. There is often a perception that ABL financing is a high-cost alternative to traditional loans; however, the reality is ABL products are priced relatively similar to other forms of comparable facilities. In addition, because of the reporting requirements, ABL financing is much lighter on cash flow covenants and that is ideal for seasonal businesses with fluctuating monthly performance or corporations looking to acquire distressed assets. In many cases the only covenant required will be a 12-month rolling fixed charge cover covenant ratio that can be as low as 1:1. ABL can also provide flexible lending limits, with the deal being structured to allow for advancement of funds over the authorized amount in certain circumstances if the collateral is available. This allows corporations to draw down more money in peak periods without having the cost burden of a substantial unused line fee in nonpeak periods.

The main catch is that asset-based lenders will typically track accounts receivable balances and inventory levels on a weekly, and in some cases daily, basis. In addition, lenders will often require receivables to be deposited into their account (or a lockbox) on a daily basis. This gives them further security over the receivable assets as they go directly to the financial institution. Although the reporting requirements are more onerous, management of many corporations find this improves their internal reporting and allows them to react to market conditions more quickly.

While RBC was one of the first Canadian institutions to offer such financing, the majority of major Canadian banks offer ABL to their clients. For instance, Scotiabank has hired a well-known figure in the ABL market in Canada, Wayne Ehgoetz, to head its ABL group through its Roynat subsidiary; TD has acquired the ABL business of ABN Amro, and CIBC has a strategic partnership with CIT’s ABL operations. In addition, Wells Fargo has broadened its position in the Canadian marketplace through its acquisition of Wachovia, GE continues to play an active role and a host of other independent boutiques and international banks offer ABL.

Further support for corporations struggling to raise capital in Canada is coming through government-backed institutions such as the Business Development Bank of Canada (BDC) and Export Development Canada (EDC), which have significantly increased their interest and ability to fund. BDC recently reported that the amount of loans accepted by its clients rose to $2.3 billion for the six-month period ended September 30, 2009, a 54% increase over the same period in 2008. These results were largely due to transactions made under the Business Credit Availability Program, where BDC, EDC and private-sector financial institutions collaborate to improve the availability of credit.

On the surface, ABL may seem limited in terms of structure and application. But it can be reasonably flexible and there are options available. Over-advances can be structured into ABLs, which, in part, rely on cash flow not direct collateral. These components, often referred to as a stretch piece or air ball, help companies seeking to maximize leverage. Experienced asset-based lenders understand the interplay between lending on margins that vary between 85% of orderly liquidation values and 65% of book values, knowing there is potential unused collateral that can be partially used to support stretch pieces. Moreover, excess collateral inside the working capital base can be, in some instances, used for term facilities in the event of a recapitalization of the company or other term-debt requirement.

New realities; new opportunities
The emergence of ABL, lower levels of leverage and tighter covenants are just a few of the realities that corporations in Canada have to live with as the global economy recovers. These conditions are the new reality and corporations wanting to undertake capital transactions will need to do so with this backdrop. This does not mean that as the economy returns to stability there will be less activity; merely that activity will be structured differently.

Increased capital and M&A activity will be driven over the next few years by corporations with debt facilities coming to an end that will find that structures and levels of leverage available to them often will be dramatically different to those negotiated five years previously. While there will undoubtedly be challenges, corporations that consider their options early, seek advice and are open to equity-based solutions will be well placed to recapitalize for the future and become part of the new reality.

For a transaction to take place there needs to be a willing purchaser and seller. Over the past 24 months, the spread between bid and sell expectations for transactions was so far apart that outside of distressed transacting this was not the case. As a result, the M&A market was almost nonexistent. As this market begins to stabilize and future earnings can be predicted with a bit more certainty, the pricing gap has started to close and 2010 is likely to see a return to M&A. While credit remains tight there is a propensity to lend and products such as ABL are allowing both corporations and private equity to look for opportunities to invest.

Vendors are also starting to see opportunities to realize value. While they may not realize some of the earnings multiples seen 36 months ago, good businesses with stability of earnings and strong management are receiving good prices. If, as everyone hopes, stability remains pent up, transaction demand will drive further M&A activity. One of the fundamentals that existed in 2005, 2006 and 2007 — the large number of baby boomers who need to realize capital from their business — has changed in only one respect: the baby boomers are older. In combination with an estimated record US$500 billion of dry powder sitting in private equity funds, there is clearly pent up M&A demand.

Conclusion
Corporations with a lending facility coming to the end of its term or that have requirements for debt to expand operations may be faced with various challenges. While credit is still tight, there are options with ABL as a viable one for a host of Canadian companies. As confidence returns to the market and M&A activity accelerates, we will no doubt see the return of more aggressive cash-flow lending but we are unlikely to see the highs of 2005, ’06 and ’07 for a long time. Even as market conditions and credit availability improve, ABL has made its mark and is in Canada to stay.

Neil Blair and Joe Rodrigues are vice-presidents of KPMG Corporate Finance Inc. in Toronto