Fallout from the credit crunch

Fallout from the credit crunch FEI Breakfast Seminar 25 November 2008 Current state of the capital markets Managing funding requirements Joe Healey Senior Vice-President Ernst & Young Orenda Corporate Finance Inc. 204 954-5568 joe.a.healey@ca.ey.com Current market conditions – subprime impact 25 November 2008 Page 3 When the taps run dry: getting things done during a credit crunch Where we are today ► 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 25 November 2008 Page 4 When the taps run dry: getting things done during a credit crunch 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 $1,200 U.S. Europe Asia ► $1,000 $800 $600 $400 $200 $0 Losses Banks Capital Raised Losses Capital Raised All Financial Institutions 25 November 2008 Page 5 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 6 When the taps run dry: getting things done during a credit crunch Funding scarcity ► The fallout of the credit crisis has been a scarcity of capital U.S. Loan Issuance $600 $500 $400 $300 $200 $100 $0 2Q04 2Q06 1Q03 3Q03 4Q03 1Q04 3Q04 4Q04 1Q05 2Q05 4Q05 1Q06 3Q06 4Q06 1Q07 1Q02 2Q02 3Q02 4Q02 2Q01 2Q07 4Q01 1Q00 2Q00 3Q00 4Q00 1Q01 3Q01 3Q07 Leverage Investment Grade Other 25 November 2008 Page 7 When the taps run dry: getting things done during a credit crunch 4Q07 1Q08 2Q08 3Q08 2Q03 3Q05 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 100 Avg. bid (% of par) 95 90 85 80 75 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 U.S. and European Bid/Ask Spreads 300 U.S. liquid loans Bid/ask spread (bps) 250 European liquid loans 200 150 100 50 0 Jul-07 Feb-08 Jul-08 Feb-07 Oct-07 Jun-08 Jan-08 Apr-08 Jan-07 Apr-07 Jun-07 Sep-07 Dec-07 Mar-08 Mar-07 Aug-07 Nov-07 25 November 2008 Page 8 When the taps run dry: getting things done during a credit crunch May-07 May-08 Aug-08 Sep-08 Oct-08 Market stabilization – money market indicators 25 November 2008 Page 9 When the taps run dry: getting things done during a credit crunch 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. 2. 3. 4. Real estate values stabilize or increase Rebound in home sales Easing of credit Decline in crude oil prices 25 November 2008 Page 10 When the taps run dry: getting things done during a credit crunch 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 5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% September 1 2008 , October 1 2008 , November 1 2008 , 3-Month U.S. LIBOR 25 November 2008 Page 11 When the taps run dry: getting things done during a credit crunch 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 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1 .00% 0.00% Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Feder al Funds Rate 3-Month LIBOR 25 November 2008 Page 12 When the taps run dry: getting things done during a credit crunch Market indicators (cont’d) Federal Funds Effect ive Rat e 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1 .00% TECH BUBBLE LOW INTEREST RATES HOUSING BUBBLE SUBPRIME CRISIS 0.00% Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 25 November 2008 Page 13 When the taps run dry: getting things done during a credit crunch Market indicators ► (cont’d) Widening LIBOR-OIS spread LIBOR - OIS Spread 6.0% 4.0% 3.5% 3.0% 4.0% Rate 5.0% 2.5% Spr ead 3.0% 2.0% 1.5% 1.0% 2.0% 1.0% 0.5% 0.0% October 1, 2008 OIS Rate 3-Month LIBOR November 1, 2008 LIBOR spr ead over OIS 0.0% September 1, 2008 25 November 2008 Page 14 When the taps run dry: getting things done during a credit crunch Canadian perspective 25 November 2008 Page 15 When the taps run dry: getting things done during a credit crunch Canadian perspective 3-Mont h BAs over 3-Mont h Canadian Treasuries 6.0% 3.0% 5.0% 2.5% 4.0% 2.0% Spr ead Rat e 3.0% 1.5% 2.0% 1.0% 1.0% 0.5% 0.0% Jul-07 A ug-07 Sep-07 Oct-07 No v-07 Dec-07 Jan-08 Feb-08 M ar-08 A pr-08 M ay-08 Jun-08 Jul-08 A ug-08 Sep-08 Oct-08 No v-08 0.0% 3-Mont h Tr easur y Bills 3-Mont h BAs Spr ead Source: Bank of Canada 25 November 2008 Page 16 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 17 When the taps run dry: getting things done during a credit crunch Availability of financing 25 November 2008 Page 18 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 19 When the taps run dry: getting things done during a credit crunch Availability of financing ► (cont’d) Capital that may be made available for new funding has changed dramatically Rat e Pre-Credit Crunch Rat e Post -Credit Crunch EBITDA (Mult iple) Senior Debt Tradit ional / Asset Based Loans BA + 150bps BA + 300bps 2.5x - 3.0x Second Lien Loans Subordinated / Mezzanine Debt BA + 500bps BA + 1,000bps 3.0x - 4.0x 12%- 14% 15%- 20% 3.0x - 4.0x Equity < 20% > 25% 25 November 2008 Page 20 When the taps run dry: getting things done during a credit crunch Availability of financing ► ► (cont’d) Debt/EBITDA multiples have decreased significantly in the large corporate market (EBITDA > $50MM) Second lien loans have virtually disappeared Average Debt Multiples of Large Corporate Loans (EBITDA > $50M) 8x 8x Average Debt Multiples of Middle Market Loans (EBITDA < $50M) 5.4x 5.0x 4x 4.6x 4.9x 4.2x 4.0x 4.0x 4.1x 4.3x 4.3x 4.4x 3.8x 3.7x 4x 4.8x 4.6x 4.1x 4.0x 3.6x 4.1x 4.3x 4.4x 4.8x 4.3x 4.6x 3.8x 3.9x 0x 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 -3 Q 08 08 3Q 0x 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 08 1Q FLD/EBITDA SLD/EBITDA Other Sr Debt/EBITDA Sub Debt/EBITDA FLD/EBITDA SLD/EBITDA Other Sr Debt/EBITDA Sub Debt/EBITDA Source: Standard & Poor’s, LPC 25 November 2008 Page 21 When the taps run dry: getting things done during a credit crunch 1Q -3 Q 3Q 08 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 25 November 2008 Page 22 When the taps run dry: getting things done during a credit crunch Treasury – focus on short term liquidity 25 November 2008 Page 23 When the taps run dry: getting things done during a credit crunch 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 policy 2. Align maturities with requirements ► Limit exposure to any single point in time ► Ladder portfolio to reduce exposure to short term market dislocations ► 25 November 2008 Page 24 When the taps run dry: getting things done during a credit crunch 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 ► 25 November 2008 Page 25 When the taps run dry: getting things done during a credit crunch Financing today – conclusion 25 November 2008 Page 26 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 27 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 28 When the taps run dry: getting things done during a credit crunch Financial reporting implications of current market conditions Mark Single Ernst & Young LLP 204 933-0227 mark.single@ca.ey.com 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 25 November 2008 Page 30 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 31 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 32 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 33 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 34 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 35 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 36 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 37 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 38 When the taps run dry: getting things done during a credit crunch 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 sharebased payment award ► Impacts of equity restructuring on share-based payment awards 25 November 2008 Page 39 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 40 When the taps run dry: getting things done during a credit crunch Taxes: Creating Value and Minimizing Risk in Turbulent Times Craig Roskos Partner, Tax Advisory Services Ernst & Young LLP 204 933-0209 craig.m.roskos@ca.ey.com Agenda ► ► Tax perspective of the current economic conditions Issues to consider Tax strategies to preserve cash ► 25 November 2008 Page 42 When the taps run dry: getting things done during a credit crunch 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: cash ►Reducing costs ►Efficient refinancing/restructuring ►Releasing 25 November 2008 Page 43 When the taps run dry: getting things done during a credit crunch What is the impact to your business? Acquisitions Cash Divestments Current market conditions Closures Tax function Accounting for tax Refinancing or Recaps Structures 25 November 2008 Page 44 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 45 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 46 When the taps run dry: getting things done during a credit crunch Cash Factoring receivables ► Sale and lease back ► Loss planning ► ► Crystallizing losses when required and preserving losses and adjusted cost base Ensure tax assumptions reflect business expectations in a downturn – can tax payments be deferred, are instalments correct ► Accuracy of forecasts ► 25 November 2008 Page 47 When the taps run dry: getting things done during a credit crunch 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) 25 November 2008 Page 48 When the taps run dry: getting things done during a credit crunch 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 Page 49 When the taps run dry: getting things done during a credit crunch 25 November 2008 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 25 November 2008 Page 50 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 51 When the taps run dry: getting things done during a credit crunch 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 25 November 2008 Page 52 When the taps run dry: getting things done during a credit crunch Q&A 25 November 2008 Page 53 When the taps run dry: getting things done during a credit crunch