Fallout from the credit crunch FEI Breakfast Seminar 25 November 2008
Feb 11, 2016
Fallout from the credit crunch
FEI Breakfast Seminar
25 November 2008
Current state of the capital marketsManaging funding requirementsJoe HealeySenior Vice-PresidentErnst & Young Orenda Corporate Finance Inc.204 [email protected]
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Current market conditions – subprime impact
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► The U.S. economy continues to slide towards recession ► Consumers continue to face enormous pressure to cut spending
due to an uncertain housing market and weak job market► 12 million, or 16% of US homeowners owe more than their homes
are worth► The IMF states that the global economy is headed for a
recession in 2009 and estimates losses from the financial crisis to be $1.4 trillion
► The Fed, ECB, BoC and 3 other central banks cut benchmark rates on October 8, 2008 – further cuts predicted
Where we are today
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Subprime related losses
► Financial institutions have experienced $966 billion of asset write-downs and credit losses - $708 billion are from over 100 of the world’s largest banks and securities firms
► Approximately $828 billion has been raised to meet these losses
Worldwide Subprime-Related Losses to Date
$0
$200
$400
$600
$800
$1,000
$1,200
Losses Capital Raised Losses Capital Raised
Banks All Financial Institutions
U.S. Europe Asia
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Subprime’s impact on financial services
► Increasing defaults in the subprime market trickled into the financial services sector in late 2006 and early 2007► Credit rating agencies began to downgrade certain mortgage
backed securities resulting in the evaporation of the subprime market
► Financial institutions were forced to write-down the book value of the securities held as assets on their books► Some of the highest losses have been incurred by U.S. banks such as
Citigroup ($68B), Merrill Lynch ($56B), UBS ($44B) and Wachovia ($97B)
► Canadian banks have also had writedowns
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Funding scarcity
► The fallout of the credit crisis has been a scarcity of capital
U.S. Loan Issuance
$0
$100
$200
$300
$400
$500
$600
1Q00
2Q00
3Q00
4Q00
1Q01
2Q01
3Q01
4Q01
1Q02
2Q02
3Q02
4Q02
1Q03
2Q03
3Q03
4Q03
1Q04
2Q04
3Q04
4Q04
1Q05
2Q05
3Q05
4Q05
1Q06
2Q06
3Q06
4Q06
1Q07
2Q07
3Q07
4Q07
1Q08
2Q08
3Q08
Leverage Investment Grade Other
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Funding scarcity (cont’d)
► In the secondary market, the average bid for multi-quote term loans is at its lowest point ever at 75.44
► The bid/ask spreads for both U.S. and European loans also indicates lower levels of liquidity
► As of October 2008, spreads were 219 basis points in the U.S. and 266 basis points in Europe
Historic Average Bid Prices
75
80
85
90
95
100
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
Avg.
bid
(% o
f par
)
U.S. and European Bid/Ask Spreads
0
50
100
150
200
250
300
Jan-
07Fe
b-07
Mar
-07
Apr-0
7M
ay-0
7Ju
n-07
Jul-0
7Au
g-07
Sep-
07Oc
t-07
Nov-
07De
c-07
Jan-
08Fe
b-08
Mar
-08
Apr-0
8M
ay-0
8Ju
n-08
Jul-0
8Au
g-08
Sep-
08Oc
t-08
Bid/
ask
spre
ad (b
ps)
U.S. liquid loansEuropean liquid loans
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Market stabilization – money market indicators
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Market stabilization
► Markets have not yet stabilized and the credit markets are still tight
► Standard & Poor’s predicts the credit crunch will end once four key economic and market variables are satisfied:1. Real estate values stabilize or increase2. Rebound in home sales3. Easing of credit4. Decline in crude oil prices
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Market indicators
► Although LIBOR has come down significantly, credit conditions remain tight► 3-month U.S. LIBOR is currently at levels not seen since October 2004
3-Month U.S. LIBOR
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
September 1, 2008 October 1, 2008 November 1, 20083-Month U.S. LIBOR
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Market indicators (cont’d)
► Prior to the credit crunch, the average spread between the 3-month U.S. LIBOR rate and the effective Federal funds rate was approximately 12 basis points
► On October 10th, 3-month U.S. LIBOR peaked at 4.82% representing a spread over the effective FFR of over 4.00%
LIBOR vs U.S. Federal Funds Rate
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
J an-98 J an-99 J an-00 J an-01 J an-02 J an-03 J an-04 J an-05 J an-06 J an-07 J an-08Federal Funds Rate 3-Month LIBOR
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Market indicators (cont’d)
Federal Funds Effective Rate
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
J an-98 J an-99 J an-00 J an-01 J an-02 J an-03 J an-04 J an-05 J an-06 J an-07 J an-08
TECH BUBBLE LOW INTEREST RATES HOUSING BUBBLE SUBPRIME CRISIS
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Market indicators (cont’d)
► Widening LIBOR-OIS spread
LIBOR - OIS Spread
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
September1, 2008
October 1,2008
November1, 2008
Rate
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
Spread
OIS Rate 3-Month LIBOR LIBOR spread over OIS
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Canadian perspective
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Canadian perspective
Source: Bank of Canada
3-Month BAs over 3-Month Canadian Treasuries
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
J ul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 J an-08 Feb-08 Mar-08 Apr-08 May-08 J un-08 J ul-08 Aug-08 Sep-08 Oct-08 Nov-08
Rate
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
Spread
3-Month Treasury Bills 3-Month BAs Spread
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Canadian perspective (cont’d)
► On September 5th, Canadian banking executives met for roundtable discussions ► The overall view is that the subprime mortgage crisis and credit crunch
will significantly impact global banking► Gord Nixon - “The days of cheap money are over, and credit spreads
across the board have, and will continue to significantly increase the cost of financing.”
► Rick Waugh - it needs to be determined which regulators will oversee financial companies in the U.S. and that process could last a year or more
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Availability of financing
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Availability of financing
► Credit markets in Canada are changing daily► Many international and U.S. institutions have pulled away from the
Canadian market or are in a state of uncertainty:► Remaining institutions may be “open for business” but there is
effectively no secondary market to syndicate or sell down exposure► Lending institutions are focused on optimizing the allocation of
scarce capital
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Availability of financing (cont’d)
► Capital that may be made available for new funding has changed dramatically
Rate Rate EBITDAPre-Credit Crunch Post-Credit Crunch (Multiple)
Senior DebtTraditional / Asset Based Loans
Second LienLoans
Subordinated / MezzanineDebt
Equity < 20% > 25%
12% - 14% 3.0x - 4.0x
BA + 150bps 2.5x - 3.0x
BA + 500bps 3.0x - 4.0x
BA + 300bps
BA + 1,000bps
15% - 20%
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Availability of financing (cont’d)
► Debt/EBITDA multiples have decreased significantly in the large corporate market (EBITDA > $50MM)
► Second lien loans have virtually disappeared
5.4x5.0x
4.6x4.2x 4.0x 4.0x 4.1x
4.3x 4.3x 4.4x4.9x
3.8x 3.7x
0x
4x
8x
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
1Q-3
Q083Q
08
FLD/EBITDA SLD/EBITDA Other Sr Debt/EBITDA Sub Debt/EBITDA
Source: Standard & Poor’s, LPC
4.8x 4.6x4.1x 4.0x
3.8x 3.9x4.1x 4.3x 4.4x
4.8x4.3x
4.6x
3.6x
0x
4x
8x
FLD/EBITDA SLD/EBITDA Other Sr Debt/EBITDA Sub Debt/EBITDA
Average Debt Multiples of Large Corporate Loans (EBITDA > $50M)
Average Debt Multiples of Middle Market Loans (EBITDA < $50M)
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What can get done?
► Asset based loans are increasingly attractive► Loans > $30MM pose a syndication risk► Market flex risk on terms, structure, pricing, etc.► Spreads in the range of 300 bps
► Cashflow loans to borrowers of “strategic relevance” to lenders► Leverage < 3.0x► Industry specific► Sponsor makes deal “easier”► Spreads in the range of 400 bps
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Treasury – focus on short term liquidity
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Treasury – focus on short term liquidity
► A portfolio approach to manage risk► Understand the liquidity needs of the company► Measurement/forecasting on a timely basis► Actively manage investments or borrowings
► Manage portfolio to:1. Understand degree of counterparty risk
► Review investment policy2. Align maturities with requirements
► Limit exposure to any single point in time► Ladder portfolio to reduce exposure to short term market
dislocations
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Treasury – focus on short term liquidity (cont’d)
► Manage counterparty risk► Traditional approach needs review► Additional due diligence required
► Clearly define goal of investment policy: income generation, or secure and efficient store of liquidity► Increase requirement for lower yielding but more secure
investments► Governments► BAs from Canadian chartered banks► Careful review of money market funds
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Financing today – conclusion
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Financing today – conclusion
► Be aware of the supply and demand constraints► Increased scrutiny and aggressive due diligence
requirements► The terms under which different lending institutions are
willing to lend may vary significantly► To succeed in this market, businesses must recognize
that the path to funding starts significantly ahead of the formal financing process
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Financing today – conclusion (cont’d)
► Plan early to deal with debt maturities► Expect increased pricing and tighter covenants► Expect a reduction in unutilized credit availability/carve back of
acquisition and expenditure accommodations► In large syndicates, plan for fall-out of fringe participants
► Review short to mid-term capital needs and strive to preserve capital► Review working capital cycle► Capital expenditures► Sale of non-core/redundant assets
Financial reporting implications of current market conditionsMark SingleErnst & Young LLP204 [email protected]
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Fair value in financial reporting - the debate
► Debate about merits of fair value in financial reporting ► Fair value measures necessarily reflect conditions at the balance
sheet date, they are not forecasts of future market prices► Investors want current fair value information and that transparency
about fair values is important ► Implications going forward
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Recent market events: accounting and reporting considerations
Valuation of investments► Measuring fair values► Evidence supporting fair value may not come from trading► Valuation models should reflect assumptions that market
participants would use in pricing an asset in a current transaction► Inputs should be restricted to information available to market
participants at the reporting date► IAS 39 Amendments – Reclassifications of financial assets
► Effective date is July 1, 2008, entities can make transfers as of that date provided this aligns with intent as of that date
► Extensive disclosure requirements when reclassifications are made
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Recent market events: accounting and reporting considerations
► Valuation of Investments (cont’d)► CICA Amendments
► To be effective for reclassifications made on or after July 1, 2008 provided statements have not previously been issued
► Amendments implemented on emergency basis without public comment period
► Amendments posted to the CICA AcSB website
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Recent market events: accounting and reporting considerations
► Internal controls over financial reporting► Current market conditions have changed the nature and extent of
risks and the related internal and disclosure controls & procedures necessary
► Credit risk and derivatives► Non-performance risk (including credit risk) of both parties impacts
fair value► Recent events may have effected the credit worthiness of both
parties to a derivative instrument► Deterioration of a derivative counterparty’s credit worthiness or
company’s own creditworthiness can cause hedge ineffectiveness
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Recent market events: accounting and reporting considerations
► Impairment of depreciable long-lived assets► Impairment indicators are more likely to be prevalent, requiring
assets to be evaluated for impairment► Long-lived assets to be held and used are reviewed for
impairment and tested for impairment whenever impairment indicators are present► Due to the current economic environment, it may be more likely
that impairment indicators exists► Impairment must be considered at both interim and annual
reporting dates► When a long-lived asset is tested for recoverability, it may also be
necessary to review depreciation and amortization estimates and methods
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Recent market events: accounting and reporting considerations
► Impairment of goodwill and indefinite life intangible assets► Impairment test for goodwill and indefinite life intangible assets
may be required to be performed on more than an annual basis► Tests for impairment of goodwill are required between annual
tests if circumstances suggest it is more likely than not that the fair value is less than its carrying value
► Tests for impairment of indefinite life intangible assets are required between annual tests if circumstances indicate the asset might be impaired
► Current economic and market conditions increase the risk that impairment indicators exist
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Recent market events: accounting and reporting considerations
Income taxes► Losses in recent years must be considered in evaluating deferred
tax assets for realization► Cumulative losses or expectations of cumulative losses generally
indicate the need for valuation allowance► Appropriate disclosures should be made to support either the
absence or existence of the valuation allowance► Liquidity concerns may cause companies to consider repatriation
of earnings from foreign operations► Consider accounting impact vs. cash flow impact
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Recent market events: accounting and reporting considerations
Inventory► Excess or obsolete inventories and lower of cost or market
adjustments may be necessary► Valuation issues associated with returns from merchants and
leftover merchandise from the retail season► Companies should disclose the manner in which lower of cost or
market is determined► Assess impact of idle plant capacity on overhead allocations
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Recent market events: accounting and reporting considerations
Post retirement benefits► Current market conditions suggest that benefit plan accounting
expense and funding requirements will increase► Increased credit risk and reduced liquidity in the marketplace have
likely affected the fair value of plan assets used in determining funded status and resulted in experience losses
► These factors will also make it challenging to choose an appropriate discount rate
► Assumed returns on plan assets should reflect current expectations about long term rates of return
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Recent market events: accounting and reporting considerations
Debt► Compliance with provisions in covenants► Ability to refinance maturing debt► Classification of debt as long-term vs. current – impact of going
concern assessment
Share-based payments► Accounting impacts of modifying, cancelling or replacing a share-
based payment award► Impacts of equity restructuring on share-based payment awards
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Recent market events: accounting and reporting considerations
► Revenue recognition► Impact of any enhanced rights of return will require more attention
on estimating returns► Customer requests for extended payment terms could change the
timing of revenue recognition
► Disclosure requirements- Re-evaluate financial statement and MD&A disclosure around
interest, FX, credit and liquidity risks- Re-evaluate financial statement and MD&A disclosure around
capital management- Re-evaluate critical accounting estimates disclosures- Assess going concern based on current market conditions
Taxes: Creating Value and Minimizing Risk in Turbulent Times
Craig RoskosPartner, Tax Advisory ServicesErnst & Young LLP204 [email protected]
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Agenda
► Tax perspective of the current economic conditions
► Issues to consider
► Tax strategies to preserve cash
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Tax perspective of the current economic conditions
► The current economic climate is a crucial time to leverage tax opportunities to create and preserve value
► Tax strategies may need to shift in focus to:►Releasing cash►Reducing costs ►Efficient refinancing/restructuring
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What is the impact to your business?
Accounting for tax
Structures
Cash
Tax functionDivestments
Acquisitions
Closures
Current market
conditions
Refinancing or Recaps
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Cash [
► Converting tax assets to cash► Review capital and current expenditures► Utilization of losses ► Tax instalments, payments and refunds
► Realizing or securing tax benefits► SR&ED tax credits► Carry back of losses► Clearing out Capital Dividend Account before losses► Crystallize CGE while eligible
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Cash [
► Deferral of Tax► Timing of recognition of profits► Capitalize new business ► Intellectual property planning
► Repatriation and Cross Border► Tax efficient repatriation of cash► Review existing transfer pricing and financing
structures
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Cash
► Factoring receivables► Sale and lease back► Loss planning
► Crystallizing losses when required and preserving losses and adjusted cost base
► Accuracy of forecasts► Ensure tax assumptions reflect business
expectations in a downturn – can tax payments be deferred, are instalments correct
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Cash
► Commodity taxes - Apply a variety of strategies to improve commodity taxes cash flow:
► Offsetting payroll remittances against GST/HST/QST refunds
► Accelerating GST/HST/QST input tax credit
► Have early billing date on transactions for GST/QST purposes
► For significant purchases with GST/HST/QST payable, use a legal entity that is in a net GST/QST payable position for the purchase (and re-supply)
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Review of current structure
► Is the current group / tax structure optimal for the current downturn?
► Matching profits and losses► Reviewing tax structures for revised profit or loss forecast► Taxable reorganization of corporate group ► Revisit management compensation planning
► Transfer pricing► Determine if intercompany transactions are being created to deal with cash
shortages and to crystallize losses in certain jurisdictions► Review current practice to ensure compliance with transfer pricing rules
► International Assignment Policy► Review international assignment policies to introduce cost efficiencies► Social security tax agreements should be reviewed for employer tax
savings► Are there outstanding tax equalizations for assignees that should be
completed
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Refinancing or recaps
► Refinancing► Debt/equity swaps – ensuring debt is not inadvertently
extinguished and taxed under debt forgiveness rules► Thin capitalization – determine how the position will change
subsequent to refinancing and changes in the balance sheet
► Acquisition of debt at a discount► Ensure undertaken in most tax efficient manner
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Closures
► Closure costs► Maximize tax relief for costs e.g., which entity should incur the costs,
when costs are incurred
► Losses► Efficient utilization of losses and potential creation of losses as a result of
closures► Timing for merging of entities to optimize use of tax attributes
► Pensions► Maximize tax relief for contributions
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Divestitures
► Preparation for exit► Tax efficient restructuring to package assets/companies for sale, including
elimination of intercompany debts► Maximizing value when selling companies with losses by preserving tax
attributes► Tax efficient exercise of incentive compensation plans
► Using an insolvency process to effect the sale of assets
► Tax planning to ensure divestitures are tax efficient► Creation of losses to offset gains on disposal► Any unrealized losses in the group that can be accessed?► Consider deferral mechanisms on sale such as capital gains reserves and
timing of sale
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Q & A