On May 17, 2007, Northstar Healthcare Inc. completed the first Canadian initial public offering (IPO) of high dividend common shares by a US business. Listed on the Toronto Stock Exchange, Northstar was formed to indirectly acquire and manage ambulatory surgery centres in the United States, focusing initially on Houston and other metropolitan areas in Texas. At approximately $170 million (following full exercise of the over-allotment option), Northstar was the largest IPO in Canada during the first nine months of 2007. Investor interest in Northstar has continued since its IPO and as of October 12, 2007, its share price had increased by over 50% to $19.08.
The Northstar Offering
Northstar, a Canadian corporation, issued dividend paying common shares at a price of $12.25 per common share. The Northstar shares initially paid a monthly dividend of $0.10 per share ($1.20 annually), which represented a 9.8% yield on the IPO value. The net proceeds of the offering were used to indirectly acquire a majority interest in two ambulatory surgery centres in Texas. The company also manages four other Texas based facilities consisting of an ambulatory surgery centre and three pain management clinics. Going forward, Northstar’s stated objectives are to expand its asset base, enhance its long-term value and increase dividends through selective acquisitions of additional ambulatory surgical centres and organic growth. The Northstar offering generated tremendous interest from both retail and institutional investors. The anticipated regular dividends appealed to those yield-oriented investors that had fuelled the tremendous growth of Canadian income funds. At the same time, the common share structure attracted many institutional investors that were not active investors in the income fund sector. The high level of interest in this structure reflects, in part, the recent lack of new supply in the Canadian capital markets.
The Canadian IPO Market in 2007
Despite strong equity values, Canadian IPO activity decreased significantly in 2007. According to a recent survey by PricewaterhouseCoopers1, the first nine months of 2007 saw just 63 IPOs with a total value of approximately C$1.2 billion. By comparison, there were 95 IPOs with a total value of approximately C$4.7 billion during the same period in 2006. In recent years, the strength of the Canadian IPO market has been based on yield oriented offerings, such as income funds. Canadian tax law changes announced on October 31, 2006 effectively destroyed the income fund IPO market (other than qualifying real estate investment trusts) and temporarily cast a shadow of uncertainty over the broader capital market. Moreover, since the October 31 announcement, more than 20 publicly traded income funds have been taken private (further reducing available supply). In addition, several other significant Canadian public issuers (e.g., BCE, Alcan, etc.) have been or are in the process of being privatized.
With the growth of the income fund sector curtailed by tax law changes and a wave of privatizations, yield-oriented offerings continue to be in strong demand in Canada. To date there has been a scarcity of attractive IPOs of Canadian businesses to meet this demand. The high dividend common share structure provides a tax-efficient means for US businesses to fill this void. We might expect further US companies to follow the Northstar example and undertake IPOs on The Toronto Stock Exchange.
Why a Canadian IPO?
Private equity investors, owner-managers, employee stock ownership plans (ESOP)s, and companies looking to monetize certain divisions may wish to consider a Canadian IPO as a means of selling all or part of a US based business or portfolio of assets. This path to liquidity may be attractive for a number of reasons, including:
- Attractive Valuations: the demand for income generating equities from an aging population at a time of low interest rates, combined with a shortage of such securities in the Canadian capital markets, enable appropriate cash flow producing businesses and assets to achieve favorable valuations.
- Deal Flexibility: Canadian institutional and retail investors have been receptive to public issuers of broadly ranging sizes. While there are many successful larger cap issuers, smaller and mid-sized issuers are also able to attract market interest and ongoing research coverage in Canada.
- Speed of Execution: an IPO can generally be completed more quickly in Canada than a similar offering in the United States.
- Ease of Ongoing Access to Capital: Canadian "bought deal" offerings (described in greater detail below) permit issuers to return to the capital markets efficiently and quickly to fund future growth and acquisitions. Moreover, most of the risk of marketing a "bought deal" offering is undertaken by the underwriters from the announcement of the transaction.
- Monetization of Retained Interest: while sponsors are not required to retain an ongoing interest in the business after a Canadian IPO, if there is a retained interest the "bought deal" mechanism often enables sponsors to successfully and efficiently sell this down.
- Flexibility for Management: existing management can remain in place and be appropriately incentivized through a variety of compensation mechanisms, including long term incentive plans, stock option plans, deferred/restricted stock unit plans or stock appreciation rights plans. If desired, sponsors and/or management can retain control of the business through their retained interest.
The IPO Process
Once a determination has been made to explore a Canadian IPO, experienced underwriters and professional advisors can bring a high dividend common share offering to market quickly and efficiently. The process can be divided into three key phases:
- Phase One: preparing the structure and the preliminary prospectus;
- Phase Two: clearing the prospectus, completing the documentation and marketing the offering; and
- Phase Three: closing the offering and listing the shares.
While the length of the time required for Phase One may vary depending upon, among other things, the availability of information (including audited historical financial statements) and certain structural factors mentioned below, Phases Two and Three will generally take about five to seven weeks in total. This is much shorter than the typical process in the US and significantly reduces execution risk. In certain circumstances, this period may be further abbreviated by commencing the marketing of the offering immediately following the filing of the preliminary prospectus and prior to the receipt of initial comments from the securities regulators. Immediately prior to filing the final prospectus, the price and size of the offering will be set. The pricing will reflect both the projected cash available for distribution and investors’ valuation of the underlying business.
In general, the prospectus must include three years of audited financial statements in respect of the underlying business. The financial statements for the US business may be prepared in accordance with US generally accepted accounting principles as long as a note to the statements reconciles them to Canadian generally accepted accounting principles. Additional financial statements may be required in respect of "significant" acquisitions undertaken by the target business.
Subsequent Financings Through "Bought Deals"
After completion of an IPO, Canadian "bought deal" offerings provide an efficient means for issuers to access future funding from the capital markets. A bought deal is a financing vehicle where the underwriters agree to purchase securities from the issuer as principal before the securities are marketed, with very few conditions attached. Consequently, underwriters take a great deal of market risk (e.g., if the market price of the securities decreases, the underwriters may still be required to purchase securities from the issuer at a price greater than the market price of the securities).
Bought deals are advantageous to issuers for several reasons, including:
- certainty of the size of the proceeds that will be obtained (although issuers often pay for this certainty with a greater discount to market price than they might concede in a "fully" marketed offering); and
- the abbreviated time to market: a bought deal is typically executed from inception to closing in approximately three weeks. Underwriters can pre-market the securities (before a prospectus is filed) for four business days prior to the filing of a preliminary prospectus so long as they have entered into a firm commitment to purchase the securities and issued a news release regarding the bought deal.
The bought deal mechanism provides sponsors and management holding a retained interest with an efficient and effective means of subsequently exiting their interests in the business.
Which Businesses are Suitable?
The high dividend common share structure may be used for cash flow producing US-based businesses and assets in a wide variety of industries, ranging from real estate, energy, infrastructure and health care, to services, manufacturing, distribution, retail, media and entertainment. The preferred candidates will have:
- a strong or dominant position in their respective markets;
- predictable and sustainable cash flows; and
- potential for growth.
While potential for growth is certainly an advantage, a business with a low growth profile may achieve a better valuation in a Canadian high dividend common share IPO than under alternative exit scenarios. Other factors that may affect valuations include ongoing maintenance capital requirements and the depth and experience of the management team.
Why are Investors Interested?
Canadian institutional and retail investors have in recent years demonstrated a healthy appetite for income generating equity securities. A number of demographic, economic and market factors combined to stimulate this demand, including an aging population, low interest rates and volatile equity markets in the wake of the bursting of the "dot-com bubble". As a result, the Canadian income fund sector grew from 52 income funds with an aggregate market capitalization of $20 billion in 2000 to approximately 254 income funds with an aggregate market capitalization of over $200 billion at the end of October 2006. Despite this growth, observers have suggested that the Canadian market for yield-oriented securities remains proportionally smaller than the US market. Moreover, the available supply of yield-oriented securities in Canada has actually been contracting over the past year.
On October 31, 2006, the Department of Finance (Canada) announced a proposal to tax publicly listed income funds and partnerships (other than qualifying real estate investment trusts)2 in the same manner as corporations. Previously, Canadian income funds had generally been able to distribute pre-tax cash to their investors. While income funds that were publicly listed on October 31, 2006 are not subject to this new tax until 2011 (provided they do not exceed certain equity growth limits intended to prevent their "undue expansion"), the tax proposals have effectively curtailed the continued growth of the Canadian income fund sector.
On June 22, 2007, the new tax on publicly listed income funds and partnerships was enacted into legislation. Other than a few REITs, there have been no IPOs or further conversions of Canadian public corporations to the income fund structure since the announcement of this new tax. Consequently, the number of new issuances for 2007 is predicted to hit a ten-year low. At the same time, as discussed above, an increasing number of existing income funds have been acquired or privatized further reducing the supply of investment alternatives.
What is the Structure?
High dividend common shares are issued by a Canadian corporation ("Canco") and typically listed on the Toronto Stock Exchange. Canco is governed by the applicable corporate legislation of the federal or provincial jurisdiction of incorporation and, therefore, is not subject to the myriad of governance issues debated in recent years with respect to income funds (which are trusts under Canadian law). Here is a simplified summary of the structure underlying Canco:
Canco establishes a US holding company
("Holdco") and uses the net
proceeds of the common share offering to acquire:
- common shares of Holdco, and
- preferred securities of a US subsidiary of Holdco ("Subco").
- Holdco agrees to repurchase the Subco preferred securities from Canco in 10 to 12 years for their original issue price plus unpaid dividends.
- Subco uses the net proceeds to acquire an interest in the target business or assets.
This high dividend common share structure has been designed to maximize cash available to pay dividends to investors. Canco will pay periodic (monthly) dividends to its public investors; retained interest holders in the US receive pro rata distributions from one of the underlying US entities. Since the dividends to the public are typically paid in Canadian dollars, Canco will be expected to establish appropriate currency hedging arrangements.
The precise legal and tax structure of any particular high dividend common share IPO will depend on a number of factors, including:
- The legal form of the target business: if the acquisition of the target business is to be effected by means of an asset sale or if the target business is owned by a flow-through entity such as a limited liability company or a limited partnership, the transaction may be structured to enable Holdco to step-up to fair market value its proportionate share of the target assets. In addition to the US tax planning benefits arising from the structuring of the repurchase obligation, this stepped-up tax cost basis will generate additional tax shelter going forward. A similar step-up will not be available if the target business is acquired in corporate form. However, other sources of tax shelter (such as tax losses and existing tax depreciation) may be available to reduce the target’s tax liability;
- The retention of an interest by existing equity owners: existing equity owners may indirectly retain an interest in the target business through the ownership of shares or other equity interests that are designed to be economically equivalent to the publicly issued high dividend common shares. In addition to receiving an equivalent yield, holders of the retained interest will typically be entitled, at specified times, to certain liquidity rights in respect thereof;
- The leverage of the target business: depending on the existing leverage of the target business and market perception of acceptable debt levels, a high dividend common share IPO may involve a leveraging or deleveraging of the target business. The target’s third party debt obligations will rank ahead of Holdco’s obligations under the repurchase agreement in respect of the preferred securities of Subco. Existing senior credit facilities, if continued, will often need to be amended to ensure they are consistent with the proposed high dividend common share structure;
- Available depreciation, amortization and tax losses: the tax efficiency of the high dividend common share structure (and correspondingly the quantum of cash available for distribution) will be enhanced where the target has significant inherent tax shelter to reduce taxable income; and
- Future growth and acquisition strategy: Unlike other cross-border offering structures, the capital structure of a high dividend common share issuer is flexible and may generally adjust to meet the needs of the target business as it develops. The robustness of the high dividend common share structure enables the issuer to consider the full spectrum of capital market alternatives as it pursues subsequent offerings and future acquisitions.
How is the Business Taxed?
Under the high dividend common share structure, Canco should not be subject to a material amount of Canadian tax. This is because the dividends received by Canco on the Holdco common shares and Subco preferred securities should generally be considered to have been paid out of non-taxable exempt surplus or pre-acquisition surplus of the underlying US entities (provided that such dividends are generated from active business activities in the US). The high dividend common share structure is not affected by recent Canadian tax proposals with respect to the elimination of certain "double-dip" structures.
In the US, Holdco’s repurchase obligation in respect of the preferred securities of Subco is viewed as a financing transaction for US federal tax income purposes. Accordingly, Subco’s distributions on these preferred securities should be treated as deductible interest payments, which will reduce or eliminate the US federal income tax payable. The US earnings stripping rules will limit the permitted aggregate interest deduction to approximately 50% of the target’s EBITDA.
Currently, distributions paid by Subco to Canco on its preferred securities are subject to a 10% US withholding tax imposed on interest payments. However, the fifth protocol to the Canada- US Income Tax Convention (the "Protocol"), signed by the Canadian Finance Minister and US Treasury Secretary on September 21, 2007, eliminates withholding tax on cross-border interest payments between residents of Canada and residents of the United States. For related parties, such as Holdco and Canco, the Protocol provides that the elimination of withholding tax on cross-border interest payments will be phased-out over a three year period: the withholding tax rate will be reduced to 7% during the first calendar year in which the Protocol becomes enacted (anticipated to be in 2008), reduced to 4% in the following calendar year, and eliminated completely in all subsequent years.
Dividends paid by Holdco to Canco will continue to be subject to a 5% US withholding tax to the extent paid out of the earnings and profits of Holdco (amounts in excess of earnings and profits will not be subject to withholding tax).
How are Investors Taxed?
Distributions by Canco to its public investors will consist of common share dividends from a Canadian public corporation. For many investors, such dividends will be preferable on an aftertax basis to distributions from income funds and other similar investments. In particular:
- dividends paid to Canadian taxable investors will be eligible for the enhanced dividend tax credit. In this regard, Canco will generally adopt a policy to designate all dividends as "eligible dividends";
- dividends paid to US taxable investors will be subject to a 15% Canadian withholding tax (which amount will generally be creditable against the investor’s US tax liability). In addition, such dividends should be "qualified dividends" for US federal income tax purposes (taxed at 15% in the US); and
- dividends paid to US tax exempt investors will not be subject to Canadian withholding tax.
Unlike Canadian income funds, there are no tax limits restricting non-resident ownership of high dividend common shares.
Over the past six years, numerous cross-border IPOs of income-oriented equity securities have been undertaken in Canada. The structures for these offerings have evolved from various types of trusts to hybrid securities. The structure utilized on the Northstar IPO marks a departure from these earlier generations in that the public investors are issued conventional common shares. This high dividend common share structure appears to have been well received by the market. Its efficiency, flexibility and robustness enables it to adapt to numerous offering contexts and target businesses.
The increasing demand for income generating equities and the reduction in the number of publicly traded income funds and other dividend paying public companies suggests that other US companies may follow the path forged by Northstar.
Sponsors and managers may wish to explore this unique way of selling all or part of a US-based business or portfolio of assets.
*Goodmans LLP, one of Canada's leading business law firms, has acted on almost all of the Canadian IPOs of US businesses since 2001, and represented Northstar on its Canadian IPO.
The authors would like to thank Jennifer Sernaker and Jarrett Freeman of Goodmans LLP for their assistance in the preparation of this article.
1 PricewaterhouseCoopers "Survey of Canadian IPO Capital Markets, January 2007 – September 2007"
2 This exclusion was intended to give relief to REITs with passive investments in Canadian real estate.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.