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Fallout from the credit crunch

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  1. Fallout from the credit crunch FEI Breakfast Seminar 28 November 2008

  2. Financing in a Post-Crunch World Larry Prentice Senior Vice-President, Transaction Advisory Services Ernst & Young Inc.

  3. Credit Crisis Creates Chaos • Where we are • How has the game changed • What do we do about it

  4. As the Snowball Started …. • 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 • Credit spreads and costs of financing will increase • Days of cheap money are over • Need to sort out how banking regulation will be conducted • Overall, the banking industry is facing • more transparency and scrutiny of their balance sheets • an expectation that regulatory capital requirements will be increased

  5. … and then picked up speed … • On October 8th, the Bank of Canada, Federal Reserve, European Central Bank and 3 other central banks lowered interest rates in an unprecedented coordinated effort to ease the economic effects of the credit crisis • The BoC cut the overnight rate by 50 bps to 2.5% • Canada’s major banks did not initially follow suit and only lowered their prime rates by 25 bps to 4.5% citing high borrowing costs in global credit markets • On October 21, the BoC cut the overnight rate again by 25 bps to 2.25% • Canadian banks caught up to the changes, resulting in a Canadian prime rate of 4.0%

  6. … market liquidity evaporated • Banks lending to customers slowed down • Tighter controls • Higher pricing • New loans not available to new customers • Banks lending to other banks REALLY slowed down • Risks appeared where never seen before • Consequences critical to lending and borrowing institutions • Government involvement at unprecedented levels

  7. Bank Confidence Index • A key indicator of credit conditions is the LIBOR-OIS spread • The LIBOR-OIS spread is a comparison between 3-month U.S. LIBOR and the overnight index swap (OIS) rate • A widening spread indicates that banks believe other banks to which they are lending have a higher risk of default so they charge a higher interest rate to offset this risk The spread, currently around 160 bps, compares with 87 bps on the last trading day before Lehman declared bankruptcy, and an average of 11 bps in the five years prior to the financial crisis

  8. Obtaining Financing • Businesses will need to be cognisant of the supply and demand constraints with which they are faced • Transactions are subject to more scrutiny and aggressive due diligence requirements • Businesses can improve their odds of obtaining funding by being in a perpetual ‘state of readiness’ to be able to market themselves and take advantage of market/transaction volatility • A compelling growth story (reflecting the current economic environment) which must be supportable by hard data • Prepare and substantiate information required by lenders to ensure greater credibility throughout the financing process • Provide far more access to comprehensive information about the business and the industry than in the past • Invest in new, independent information to support business plan forecasts and “communicate the growth potential and value creation opportunities” to investors • Enable management to devote sufficient time to running the business • To succeed in this market, businesses must recognize that the path to funding starts significantly ahead of the formal financing process

  9. Industries under Stress • Real estate • Project financing problematic • Retail consumers are wary • Forestry and Automotive • ‘Nuff said • Mining • Base metal prices lower • Exploration financing has dried up • Retail • General consumer confidence is problematic Lender confidence in all business areas is low

  10. Financing is more conservative • Lending is being governed by greater discipline as underwriting standards have become more stringent resulting in lower multiples, higher pricing and tighter covenants • Cash flow lending has shifted to lower debt to EBITDA multiples • Senior debt currently in the 2.5 – 3.0x range • Up to 1.5x incrementally available from mezzanine lenders • This compares with senior multiples of 3.5 – 4.0x and total debt of 5.0 – 5.5x approximately a year ago • Moreover, subjective “addbacks”, “adjustments” or “normalizing entries” to earnings are also coming under greater scrutiny • Borrowers are being faced with increased due diligence from an ever shrinking base of lenders resulting in elongated deal timetables

  11. Pricing of Financing • The chart below illustrates the growth in lender conservatism, particularly with respect to second lien loans

  12. Recent Example – Grain Handling Co. (“GHC”) Description: A company focused on grain handling, processing and distribution for domestic and export markets and a provider of supplies and services to farmers. • In August 2006 GHC obtained C$113 million of senior debt financing including an operating line and term loan • Revolver Pricing: 3-month BA’s + 150 basis points • Term Loan Pricing: 3-month BA’s + 175 basis points • In 2008, GHC sought additional financing from its lending syndicate in the total amount of C$155 million • One large entity dropped out of the banking syndicate as pricing was too low, and another U.S. based bank declined to participate in the Canadian market • A 4-bank syndicate (2 existing, 2 new) is financing the operating line with a niche lender providing the term loan • Revolver Pricing: 3-month BA’s + 225 basis points • Term Loan Pricing: 3-month BA’s + 250 basis points

  13. Canadian Transactions Canadian Real Estate Market • Transaction volume has fallen significantly since Q3 2007 in Canada’s three largest markets • Transaction values on a significant downtrend since Q4 of 2007 • Due to financial issues in the U.S., these trends will likely continue source: RealNet – Office, Retail, Industrial, Apartment, Hotel; GVA, GTA, GCA markets

  14. Rate Spread between BOC 5-year benchmark to 5-year Conventional Mortgage Mortgage Spreads Widening • Bank of Canada rates on downward trend since Q3 of 2007 • Spreads between Bank of Canada benchmark rates versus mortgage rates have widened dramatically • Lending rates for investment properties have increased modestly • Current rate of approximately 6.0% • Loan-to-value rates have declined to approximately 60% or less

  15. Impact on Canadian Financing Scene • New incentives for transactions • Funds’ and investors’ need for liquidity • Problems from unexpected places • Supplier stability an issue for producers • Customer stability requires increased vigilance • Fewer financial alternatives • “Take out” financing a thing of the past • More candidates for restructuring • Higher bar for refinancing means fewer companies qualify

  16. Treasury –focus on short term liquidity • Current market dislocations require Treasurers to more closely focus on short term liquidity • A more disciplined approach is in order - • Stronger focus on quality of investments • Better understanding of organization’s liquidity requirements

  17. Treasury –focus on short term liquidity (cont’d) • A portfolio approach to manage risk makes sense: • Understand the liabilities, i.e. the liquidity needs of the company • Measurement/forecasting needs to be done on a weekly if not daily basis • Manage investments or borrowings to meet that liability stream • Manage portfolio to: • Understand degree of counterparty risk • Review investment policy • Align maturities with requirements • Limit exposure to any single point in time • Ladder portfolio to reduce exposure to short term market dislocations

  18. Treasury –focus on short term liquidity (cont’d) • Manage counterparty risk • Traditional approach of heavy reliance on debt ratings needs to be reviewed • 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

  19. Managing Financing Requirements • Be aware of the supply and demand constraints • Be prepared for 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

  20. Managing Financing Requirements (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

  21. Conclusion • Be wary • Expect to be surprised • Be flexible • Have alternatives available • Be prepared • Start early • Revisit assumptions regularly

  22. Financial reporting implications of current market conditions Gary Miller Partner, Assurance & Advisory Business Services Ernst & Young LLP

  23. Fair value in financial reporting - the debate • Debate about merits of fair value in financial reporting • Contributed to the current credit crunch conditions, or • Or has the credit crisis highlighted the benefits of fair value in financial reporting while exposing some of its limitations • Fair value measures necessarily reflect conditions at the balance sheet date, they are not forecasts of future market prices • Nonetheless investors want current fair value information and that transparency about fair values is important

  24. Recent market events: accounting and reporting considerations • Valuation of Investments • CICA Amendments to Canadian Accounting Standards • “Trading” securities are carried at fair value and changes in fair value are included in earnings. • Reclassifications out of trading were not permitted – abuse of hindsight • Accounting Standards Board has introduced amendments to CICA 3855 in response to the similar recent IAS 39 amendments • Permit reclassifications of securities (excluding derivatives) out of trading (to AFS or HTM) • “in rare circumstances” and • no longer held for the purpose of trading • 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

  25. Recent market events: accounting and reporting considerations • Year-end reporting points to watch • Internal controls over financial reporting • Credit risk in derivatives valuation • Impairment of goodwill and indefinite life intangibles • Employee benefits • Debt • Risk and other disclosures in financial statements, MD&A

  26. 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 to address them • Processes and controls relating to the development of inputs and assumptions for the valuation of significant assets and liabilities • Review of assets for recoverability or impairment • The need for external specialists (e.g. valuation or actuarial expert) to assist in the determination of the recorded amounts of certain assets and liabilities • Processes and controls for monitoring compliance with covenants • Internal auditors should reconsider their current audit plans in light of any new or increased risks facing the company

  27. Recent market events: accounting and reporting considerations • 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

  28. 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

  29. Recent market events: accounting and reporting considerations Employee 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

  30. 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

  31. Recent market events: accounting and reporting considerations • 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

  32. Taxes: Creating Value and Minimizing Risk in Turbulent Times Bruce Sprague Partner, BusinessTax Advisory Services Ernst & Young LLP

  33. Agenda • Tax perspective of the current economic conditions • Issues to consider • Tax strategies to preserve cash

  34. 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

  35. What is the impact to your business? Acquisitions Cash Divestments Tax function Current market conditions Accounting for tax Closures Structures Refinancing or Recaps

  36. 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

  37. 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

  38. 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

  39. 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)

  40. 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

  41. 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

  42. 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 • Consider US golden parachute provisions for any US executives • 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

  43. Governance Fred Withers Western Canada Managing Partner Ernst & Young LLP

  44. Issues & Questions • Why companies are continually blindsided by risk • The role of the board and the audit committee in risk oversight • MD&A disclosures in volatile and uncertain times

  45. Why companies are continually blindsided by risk • The most devastating risks come from where no one is looking • Pressure to perform in the short term obstructs companies’ ability to manage risk • There is a link between risk appetite and remuneration

  46. The role of the board and the audit committee in risk oversight • The board’s role in overseeing strategic risk • The audit committee’s role in overseeing financial and operational risks

  47. The board’s role in overseeing strategic risk • Ensure the presence of an effective risk organization • Influence, empowerment of risk management function • Sound risk identification and independent risk measurement • Effective monitoring of risk positions, supportive of mitigation actions • Review and approve key risk policies • The balance between growth, risk and returns • Risk measurement framework, e.g., risk metrics for quantifying exposures • Review/approve aggregate and specific risk appetite and related risk limits • Review risk positions routinely; review and approve exceptions • Consider effectiveness of controls and mitigation strategies

  48. The audit committee’s role in overseeing financial and operational risks • How audit committees should address risks associated with the financial crisis: • Conduct a “going concern” analysis • Review investments, investment policy and the treasury function • Review company – defined – benefit pension funds • Talk to the external auditor • Address increased disclosure requirements • Reserve for litigation risk

  49. The audit committee’s role in overseeing financial and operational risks • How audit committees can help to enhance risk oversight: • Continuing to ask out-of-the-box questions to identify risks • Finding a balanced approach to bottom-up and top-down risk identification • Ensuring risk is owned by executives throughout the business • Ensuring that an integrated picture of risk drives audit and compliance • Testing that company culture does not run counter to risk management efforts

  50. MD&A disclosures in volatile and uncertain times • Strategy and risk management • Risks and uncertainties • Concentrations of risk • Results analysis • Liquidity and capital resources • Critical accounting estimates • Fair value • Off-balance sheet arrangements and variable interest entities • Going concern