Originally published in The American Lawyer.
Since mid-2001, the Canadian equity new-issue market has been dominated by income fund issuers and their like. For anyone who has even a passing familiarity with the Canadian capital market, this is an obvious observation; however, it may still be news or at least interesting for U.S. issuers and their advisers to learn something about the liquidity options that may be available to them in the Canadian market.
In general terms, there are two ways in which Canadian liquidity can be realized: directly, by way of an initial public offering in Canada by the U.S. issuer of income securities (variously called income deposit securities, income participating securities and enhanced income securities by different investment banks); or indirectly, through the acquisition of a U.S. business by an established Canadian income trust or income security issuer. This article will provide background and insights on both these alternatives.
Income Securities in Canada
The income trust structure is well accepted in Canadian public markets and has grown considerably in recent years, particularly in an environment of relatively low interest rates and uncertain equity markets. As of February 20, 2006, there were approximately 235 income security issuers listed on the Toronto Stock Exchange, with an aggregate market capitalization of almost C$195 billion.
Significant uncertainty was created in the income fund market in the fall of 2005 with the Canadian federal Department of Finance’s release of its consultation paper, "Tax and Other Issues Related to Publicly Listed Flow-Through Entities" and the subsequent announcement of an interim moratorium on certain related advance tax rulings. That uncertainty ended in November 2005 when the Department of Finance announced the termination of the consultation process and resumed giving advance tax rulings on certain flow-through vehicles (such as income funds).
The typical income fund structure involves a business trust that holds equity and debt in a Canadian operating business, producing a stream of steady returns in the form of dividends and interest, which the trust, in turn, distributes to its unitholders. The trust is a flow-through vehicle for tax purposes, thereby maximizing distributable cash.
In 2002, private equity sponsors began using the Canadian income trust (IPO) model to take U.S.-based businesses public. The first of these transactions was completed in May 2002. Since then, six additional cross-border income fund IPOs have been completed for aggregate proceeds of over C$1.2 billion.
In 2003, income deposit securities (IDSs), or enhanced income securities (EISs), were introduced as a derivation of the income fund structure and as a means of tapping into the larger U.S. capital market. For convenience, we will refer to these as IDSs in this article. After the initial spate of northbound income trust offerings in 2002 and 2003, several of the major audit firms expressed concerns over these structures and declined to participate further unless amendments were adopted. This action cast a pall on these deals, and no further northbound deals were brought to market until 2004, when the income security form of offering was used by Medical Facilities Corp.
The IDS structure is, essentially, an income trust structure without the trust. Rather than holding units of a trust, the investor holds the underlying securities—subordinated notes and common shares of a holding company or the operating company—directly. These two securities are "clipped" together to form an IDS.
Holders of IDSs receive interest at a fixed rate on the subordinated notes and discretionary dividends on the common shares to produce a blended yield. The distribution policies of IDS issuers are similar to those of income trusts, REITs and master limited partnerships (MLPs), which distribute a significant portion of their free cash flow. The efficient structuring of the IDS maximizes this distributable cash. Predictable distributable cash is a key element of these offerings, as they are priced on the basis of a yield relative to expected distributable cash. Due to a lack of market receptivity, there have not been many completed offerings of IDSs in the United States.
Canada has its own version of IDSs, initially known as income participating securities, or more simply as income securities ISs. ISs are similar in structure to IDSs but are better suited to a U.S. company offering only in Canada. The regulatory review process for IS offerings in Canada has been less difficult and faster than clearing IDS offerings in the United States, primarily due to the well-established income trust market.
Liquidity Through Income Security Offerings
The first wave of northbound income trust offerings, combined with the next generation of IS offerings, has established the Canadian capital market as an attractive source of liquidity for private equity holdings and U.S. companies. Care must be taken, however, to select the right business and time to launch a deal in this market.
The success of the Medical Facilities offering in 2004 opened the doors to several more IS offerings in late 2004 and early 2005. These offerings were highly successful and led to a rush of new deals being stuffed into the pipeline for spring and summer 2005. Unfortunately, the buy side of the market was not so kind to these more recent offerings. The experience in early 2005 suggested a strong institutional appetite for larger deals (of C$300 million or more) at reasonable yields. This turned out not to be the case, with some deals being completed in smaller size and higher yields than had been expected, and others not getting done at levels acceptable to the vendors.
One of the lessons learned from this experience has been that the institutional market in Canada is rather thin and has a limited tolerance for digesting a large knot of complicated offerings in a compressed time period.
The market performance of the IS deals that were completed in 2005 has been improving, and it is expected that northbound IS deals will reenter the Canadian market. It is hoped that the next wave of these offerings will come at a more measured pace than was experienced in 2005.
Opportunity for U.S. Power
The U.S. independent power industry may find the Canadian market an attractive source of liquidity. Currently, only about 12 income security issuers listed on the TSX are based on power project portfolios. These companies vary: One has a single generating project as its only asset; another owns the project debt of some 23 U.S. landfill gas projects, along with two Canadian municipal district heating projects; and another company principally holds noncontrolling interests in some 15 power projects. Three of these offerings completed since April 2004 have consisted mainly of U.S. power operations.
Primary Energy Ventures LLC of Oak Brook, Illinois, sponsored the successful formation of one such company in August 2005, illustrating the great potential of the income security market for small and medium-size U.S. power industry players.Out of its portfolio of 14 operating projects, Primary Ventures put four inside-the-fence cogeneration projects with long-term tolling agreements (total capacity 283 MW) and an interest in a coal pulverization project into a new company called Primary Energy Recycling Corp. Primary Recycling raised approximately C$310 million in equity and subordinated debt as enhanced income securities in the IPO, privately placed another C$18.5 million in subordinated debt and added US$150 million in new senior bank debt. It used these proceeds to buy an 83% interest in the projects from Primary Ventures and to retire heavily covenanted and costly project financing.
The CEO of Primary Ventures also serves on the board of managers of Primary Recycling, and Primary Ventures runs the operations and management of the projects under a long-term management agreement. Under that agreement, Primary Ventures also receives incentives to develop or acquire new accretive projects to offer to Primary Recycling for acquisition. This provides Primary Ventures with a formidable liquidity alternative for its business development activities and represents a potential for growth that enhances Primary Recycling’s market value.
The independent power industry has long sought efficient access to the capital markets for portfolios of generating assets. The promise of the Canadian income security market to the U.S. power industry, however, extends not only to nonutility generators with portfolios of long-term contracts, but also to independent transmission companies and to large regulated companies with noncore assets that can be spun off to produce predictable and relatively stable yields for the Canadian investor market.
Liquidity Through Transformational M&A
In April 2004, Connors Bros. Income Fund completed its C$800 million combination transaction with Bumble Bee Seafoods, and in January 2005, BFI Canada Income Fund closed a C$1.1 billion transaction that combined its business with that of IESI Corp., a leading nonhazardous-waste management company in the United States.
These two transformational M&A transactions may signal the next wave in cross-border income securities. From the fund’s perspective, these transactions are a means to deliver immediate accretion to unitholders. From the vendor’s perspective, these transactions can provide partial liquidity for their investment and an exit strategy in the future for their retained interest.
In April 2004, Connors Bros. Income Fund, an established Canadian income trust that owns the largest producer of canned sardines in the world, combined its operations with those of Bumble Bee Seafoods, a California-based company, to create North America’s largest branded seafood company. The transaction was expected to be immediately accretive to unitholders by 12.5%. Following the completion of the transaction, the fund held an approximate 68.3% interest in the combined business, and the sellers held the remaining 31.7% interest (the so-called retained interest). This retained interest was exchangeable into units of the fund.
In January 2005, BFI Canada Income Fund and IESI Corp., a Texasbased company, completed the combination of their businesses to create one of North America’s largest nonhazardous solid-waste management companies. The transaction was structured to be immediately accretive to the fund’s cash distributions by 12%. Posttransaction, the former owners of IESI held approximately 35.6% retained interest in the combined business.
In both of these transactions, the acquired company was substantially larger than the acquiring fund and resulted in a fund with significantly greater market capitalization: from approximately C$230 million to C$800 million (post-transaction) in the Connors Bros.–Bumble Bee Seafoods deal, and from approximately C$680 million to C$1.5 billion (post-transaction) in the BFI Canada–IESI deal (in each case, assuming the exchange of the retained interest into units of the fund).
As enticing as these transformational M&A transactions may seem, they are not straightforward. They require the coordination of multiple and concurrent transactions that straddle the border—including an acquisition, a trust unit financing, the refinancing of senior credit facilities and a unitholder meeting to approve the transaction. The fund must also pay close attention to its transaction expenses, lest the cost of a broken deal affect the fund’s ability to make cash distributions to unitholders.
Internal Tax Structure
Among the important considerations in developing the internal capital structure in these transactions is the proper mix of debt and equity between the Canadian acquisition corporation and the U.S. target. When the Canadian acquiror receives interest on the subordinated notes issued by the U.S. target and dividends on the common shares of the U.S. target, both are U.S.-source income. As a result, U.S. withholding tax applies at a rate of 10% on the interest payments and 5% on the dividends. An essential element of the tax structuring is to ensure that the subordinated notes are considered debt for U.S. federal income tax purposes. If the subordinated notes were determined to be equity, the interest payments would not be deductible for tax purposes. The inability to deduct the interest on the subordinated notes would increase its U.S. federal taxable income and U.S. federal tax liability.
In the United States, determining whether an instrument such as the subordinated notes should be treated as debt or equity for tax purposes is a facts-and-circumstances test that takes into consideration a variety of factors (whereas in Canada, a form-over-substance test is applied). Since the subordinated notes are issued to a related party, there is heightened scrutiny.
In transactions such as Connors Bros.–Bumble Bee and BFI Canada– IESI, typically, a legal opinion is given that analyzes whether the subordinated notes should be treated as debt for U.S. federal income tax purposes. A number of actions are undertaken to assist in this analysis and to support the opinion. Representation letters are obtained from the issuer and the holder of the subordinated notes as to certain factual matters and their intended treatment of the subordinated notes. Additionally, an independent financial adviser is retained to vet the terms of the notes (including the interest rate, maturity date, material provisions relating to the payment of principal and interest, remedies upon events of default and covenant provisions). This independent financial adviser determines whether the terms of the subordinated notes are consistent with those of notes issued in arm’s-length transactions on market terms, and whether, after reviewing the financial model, the issuer should be able to repay the subordinated notes in accordance with their terms.
Inputs to the Financial Model
The financial model is the starting point for these transformational M&A transactions, and forecasts whether the acquisition can deliver the required accretion. The two essential pieces of the financial model are the capital structure (which, as described above, comprises the mix of internal debt and equity between the Canadian acquisition corporation and the U.S. target) and the accretive cash flow generation capabilities of the acquired business. As the financial model is built, the sources and uses of funds are fed in and accretion is tested. The sources of funds typically consist of proceeds from a public offering of subscription receipts by the fund (these subscription receipts are automatically exchanged into units of the fund on the closing of the M&A transaction) and borrowings under new Canadian and/or U.S. credit facilities. The uses consist of the repayment of existing credit facilities and expenses associated with the transaction and can include purchase consideration of the sellers if they are receiving cash in addition to their retained interest.
The Transaction Agreement
For the fund to achieve the expected accretion, it requires closing conditions that reflect the terms of the financial model. Having regard to the precedent transactions, the parameters of the financial model are built into the transaction agreement and the closing conditions. For example, the parties agree to the acceptable range of the size of the subscription receipt offering, the borrowings under the new credit facilities to fund the transaction, and the terms of the repayment of the existing debt (and the associated expenses). If there is substantial deviation from these parameters, the fund can terminate the transaction agreement without cost (except for its expenses).
A further protection provided to the fund in its undertaking to deliver the agreed-upon accretion to its unitholders is the survival of the representations and warranties. In a typical public company combination transaction, the sellers would generally insist on the representations and warranties expiring on closing; however, in transformational M&A transactions, the fund is concerned to sustain breaches of the representations and warranties without recourse, because these could have a substantial impact on cash distributions. Accordingly, in these transactions, the representations and warranties survive for a specified period of time, and the fund can recover from the former owners of the acquired business for any breaches thereof.
Subscription Receipt Offering
In conjunction with the acquisition and related funding requirements, the fund conducts a subscription receipt offering in Canada within the parameters set out in the transaction agreement. The size of the offering is informed by (a) the amounts needed to pay off existing debt and transaction expenses; (b) whether the existing owners of the acquired business will be bought out; (c) the availability of borrowings under the new credit facilities; and (d) the capacity of the Canadian capital markets to absorb the offering.
The reason for a subscription receipt offering rather than a unit offering is to provide a mechanism for the fund to return the offering proceeds to investors if the M&A transaction does not close. The subscription receipt offering closes in advance of the M&A transaction and the proceeds are held in escrow. Upon the closing of the M&A transaction and the satisfaction of the conditions thereunder, the subscription receipts are automatically exchanged for units of the fund (without payment of any additional consideration). The subscription receipt holders also receive an amount equal to the per unit distribution that they would have received had they owned units rather than subscription receipts from the time the offering closed. If the M&A transaction fails to close by a specified date or if the transaction agreement is terminated at any earlier time, the fund returns the issue price plus accrued interest to the subscription receipt holders.
The mechanism of a subscription receipt offering eliminates significant execution risk for the fund. However, this insurance comes at a cost: not only does the fund incur the expenses of the offering (without certainty that the cash raised is needed), but in the deals described above, it would have had to also pay one-half of the underwriters’ commission, regardless of whether the M&A transaction closed.
Senior Debt Refinancing
The capital structure of these transactions and the fund’s commitment to make cash distributions also affect the terms of any new credit facilities being entered into in conjunction with the M&A transaction. Senior lenders have to be cognizant of and make provision for cash flowing through and out of the structure more freely than in a typical senior debt facility. The acquired company must be permitted to make monthly distributions on its equity, enabling the fund to flow this cash to its unitholders. To provide some comfort to the senior lenders in this context, protections can be built into the facility— for example, restricting cash distributions to those that, in the ordinary course, are consistent with accepted market practice for subsidiaries of Canadian income funds, permitting cash distributions only to the extent of available free cash (as defined in the facility) and/or requiring that certain leverage or coverage ratios be met.
These transactions also involve the negotiation of the corporate governance rights granted to the retained interest holders. The fund may take the position that the retained interest holders have adequate rights through their direct or indirect equity stake in the combined business and should not be granted additional corporate governance rights; however, the retained interest holders may expect to have post-transaction governance rights comparable to those they formerly had in order to protect their significant interest in the combined business.
If the retained interest holders maintain an equity stake in the acquired business (or another fund subsidiary) rather than directly at the fund level, they will, at a minimum, want to ensure that their economic and voting rights are protected to be equivalent to those they would have had as unitholders. Beyond that, the grant of any additional corporate governance rights is the subject of negotiation and will depend on numerous factors such as (a) the retained interest holders’ proportionate stake in the fund going forward; (b) whether the retained interest is represented principally by one or two large investors or is relatively dispersed; and (c) the size of the acquired business relative to the fund.
The income securities market in Canada is large, liquid and growing. Over the past five years, it has shown an incredible capacity for accepting new structures and applications of the income securities product. History has taught us that the market is sensitive to the quality of issuers and their cash flows, and the timing of their entry to the market. Properly advised, the right U.S. issuers may find a very attractive source of liquidity north of the border.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.